NogoodIn 2017 my Website was migrated to the clouds and reduced in size.
Hence some links below are broken.
One thing to try if a “www” link is broken is to substitute “faculty” for “www”
For example a broken link
http://faculty.trinity.edu/rjensen/Pictures.htm
can be changed to corrected link
http://faculty.trinity.edu/rjensen/Pictures.htm
However in some cases files had to be removed to reduce the size of my Website
Contact me at 
rjensen@trinity.edu if you really need to file that is missing

 

Accountancy Theory Part 2
Bob Jensen
at Trinity University 

My Accounting Theory Document Was Split into Two Files on December 15, 2010

Please do what you can to lend financial support to Wikipedia --- Keep Knowledge Open Sourced, Interactive, and Free ---
http://wikimediafoundation.org/wiki/WMFJA010/en/US?utm_medium=sitenotice&utm_campaign=20101125JA006&utm_source=20101124_JA011A_US&country_code=US
Wikipedia is about the power of people like us to do extraordinary things. People like us write Wikipedia, one word at a time. People like us fund it, one donation at a time. It's proof of our collective potential to change the world.

U.S. GAAP Financial Reporting Taxonomy Now Available (2014)---
http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176163688345

Over 400 Examples of Critical Thinking and Illustrations of How to Mislead With Statistics ---
http://faculty.trinity.edu/rjensen/MisleadWithStatistics.htm

Useful accounting news sites, associations, and organizations in 2020 ---
https://bestaccountingsoftware.com/accounting-news-sites-organizations/

Part 1 of My Accounting Theory Document
http://faculty.trinity.edu/rjensen/Theory01.htm

Part 2 of My Accounting Theory Document
See Below

 

Controversy Over  the SEC's Rule 144a

Cookie Jar Accounting
Go To http://faculty.trinity.edu/rjensen/theory01.htm#CookieJar

Moral Hazard:  Hedge Fund Shorts

Why do sales discounts have such high annual percentage rates?

FIN 48 Liability if Transaction Is Later Disallowed by the IRS

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

Management ((Managerial) and Cost Accounting

Zero-Based Budgeting

Creative Earnings Management, Agency Theory, and Accounting Manipulations to Cook the Books 

Goodwill and Other Asset Impairment Issues 

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

Minority Interests:  Lambs being led to slaughter?

Treasury Stock

Off-Balance Sheet Financing (OBSF)

Insurance:  A Scheme for Hiding Debt That Won't Go Away

How do we account for warranties?

Disclosure Issues Regarding Materiality

Disclosure provisions aimed at financing receivables
and Other Dislcosure Issues

CDOs: A Securitization Scheme for Hiding Debt That Won't Go Away

Pensions and Post-retirement benefits:  Schemes for Hiding Deb

Leases:  A  Scheme for Hiding Debt That Won't Go Away 

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

AICPA issues forensic accounting standards ---
https://www.journalofaccountancy.com/news/2019/jul/forensic-accounting-aicpa-standards-201921580.html?utm_source=mnl:cpald&utm_medium=email&utm_campaign=10Jul2019

Accounting for Executory Contracts Such as
Purchase/Sale Commitments and Loan Commitments

Debt Versus Equity (including shareholder earn-out contracts)

Synthetic Assets and Liabilities Accounting
Go to http://faculty.trinity.edu/rjensen/theory01.htm#Synthetics

Time versus Money
Go go http://faculty.trinity.edu/rjensen/theory01.htm#Time

Intangibles and Contingencies:   Theory Disputes Focus Mainly on the Tip of the Iceberg
Go to http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes

Intangibles:  An Accounting Paradox

Intangibles:  Selected References On Accounting for Intangibles

EBR:  Enhanced Business Reporting (including non-financial information)

The Controversy Over Revenue Reporting and HFV 
--- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

The Controversy Over Employee Stock Options as Compenation ---
http:/www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
 

Accounting for Options to Buy Real Estate

The Controversy over Accounting for Securitizations and Loan Guarantees  

The Controversy Over Pro Forma (Proforma, Non-GAAP) Reporting

Triple-Bottom (Sustainability, Social, Environmental, Human Resource) Reporting)  

Accounting for Carbon Trading

The Sad State of Government (Governmental) Accounting and Accountability

The Cost Conundrum:  What a Texas town can teach us about health care

Which is More Value-Relevant: Earnings or Cash Flows?

LIFO Sucks Teaching Case on LIFO Layers in Years of Rising Prices

The Controversy Over Fair Value (Mark-to-Market) Financial Reporting

Loan Losses and Bad Debts  

Multi-Column Earnings and OCI Reporting 

Where Fair Value Market Accounting Fails:  Unique Items Not Traded (e.g., bank loans, Bad Debts)

Underlying Bases of Balance Sheet Valuation (Fair Value, Exit Value, Entry Value, Economic Value)

Online Resources for Business Valuations
See http://faculty.trinity.edu/rjensen/roi.htm

Activities Based Costing (ABC)

Fade, Gain, and Cost Shifting Analysis  in gross profit analysis in construction accounting

Critical Thinking:  Why's It So Hard to Teach ---
http://faculty.trinity.edu/rjensen/assess.htm#ConceptKnowledge

Understanding the Issues 

Issues of Auditor Professionalism and Independence 
http://faculty.trinity.edu/rjensen/Fraud001c.htm 

Quality of Earnings, Restatements, and Core Earnings

Sale-Leaseback Accounting Controversies
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#SaleLeasback

Economic Theory of Accounting (including Game Theory)

Socionomics Theory of Finance and Fraud

Facts Based on Assumptions:  The Power of Postpositive Thinking

Bob Jensen's threads and other teaching cases on dividends, payout ratios, and dividends yield ---
http://faculty.trinity.edu/rjensen/roi.htm#Dividends

Bob Jensen's threads on return on investment, other ratios, and financial statement analysis ---
http://faculty.trinity.edu/rjensen/roi.htm

 

Critical Postmodern Theory --- http://www.uta.edu/huma/illuminations/

Mike Kearl's great social theory site

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

Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts of Private Companies ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm

Bob Jensen's threads on GAAP comparisons (with particular stress upon derivative financial
instruments accounting rules) are at http://faculty.trinity.edu/rjensen/caseans/canada.htm
The above site also links to more general GAAP comparison guides between nations.

Implications of Bad Auditing on Capital Markets
and Client's Cost of Captial
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits

Bob Jensen's threads on corporate governance are at
http://faculty.trinity.edu/rjensen/fraud.htm#Governance

Acceptance Speech for the August 15, 2002 American Accounting Association's Outstanding Educator Award --- http://faculty.trinity.edu/rjensen/000aaa/AAAaward_files/AAAaward02.htm

MAAW's Accounting Index Updated (great accounting literature guide) ---
https://maaw.info/AccountingForArticlesByTopic.htm

How Accountics Scientists Should Change: 
"Frankly, Scarlett, after I get a hit for my resume in The Accounting Review I just don't give a damn"
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm
One more mission in what's left of my life will be to try to change this
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm 

Recommendations for Change on the American Accounting Association's
Notable Contributions to Accounting Literature Award
http://faculty.trinity.edu/rjensen/TheoryNotable.htm

Essays on the State of Accounting Scholarship ---
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm#Essays

The Sad State of Economic Theory and Research ---
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm#EconomicResearch 

The 10 elements of financial statements, according to FASB ---
https://www.journalofaccountancy.com/news/2020/jul/elements-of-financial-statements-fasb.html?utm_source=mnl:cpald&utm_medium=email&utm_campaign=17Jul2020

The Cult of Statistical Significance:  How Standard Error Costs Us Jobs, Justice, and Lives, by Stephen T. Ziliak and Deirdre N. McCloskey (Ann Arbor:  University of Michigan Press, ISBN-13: 978-472-05007-9, 2007)
http://www.cs.trinity.edu/~rjensen/temp/DeirdreMcCloskey/StatisticalSignificance01.htm

Page 206
Like scientists today in medical and economic and other sizeless sciences, Pearson mistook a large sample size for the definite, substantive significance---evidence s Hayek put it, of "wholes." But it was as Hayek said "just an illusion." Pearson's columns of sparkling asterisks, though quantitative in appearance and as appealing a is the simple truth of the sky, signified nothing.

In Accountics Science R2 = 0.0004 = (-.02)(-.02) Can Be Deemed a Statistically Significant Linear Relationship ---
http://www.cs.trinity.edu/~rjensen/temp/DeirdreMcCloskey/StatisticalSignificance01.htm

 

"So you want to get a Ph.D.?" by David Wood, BYU ---
http://www.byuaccounting.net/mediawiki/index.php?title=So_you_want_to_get_a_Ph.D.%3F

Do You Want to Teach? ---
http://financialexecutives.blogspot.com/2009/05/do-you-want-to-teach.html

Jensen Comment
Here are some added positives and negatives to consider, especially if you are currently a practicing accountant considering becoming a professor.

Accountancy Doctoral Program Information from Jim Hasselback ---
http://www.jrhasselback.com/AtgDoctInfo.html 

Why must all accounting doctoral programs be social science (particularly econometrics) "accountics" doctoral programs?
http://faculty.trinity.edu/rjensen/theory01.htm#DoctoralPrograms

What went wrong in accounting/accountics research?
http://faculty.trinity.edu/rjensen/theory01.htm#WhatWentWrong

Bob Jensen's Codec Saga: How I Lost a Big Part of My Life's Work
Until My Friend Rick Lillie Solved My Problem
http://www.cs.trinity.edu/~rjensen/video/VideoCodecProblems.htm

One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

Accounting History Blast from the Past
Demski, J. S. 1973. The general impossibility of normative accounting standards. The Accounting Review (October): 718-723. (JSTOR link).

Cushing, B. E. 1977. On the possibility of optimal accounting principles. The Accounting Review (April): 308-321. (JSTOR link).

Abstract
Several authors have examined the issue of choice among financial reporting standards and principles using the framework of rational choice theory. Their results have been almost uniformly pessimistic in terms of the possibilities for favorable resolution of this issue. Upon further analysis, these results are revealed to be an artifact of the way in which the issue is initially formulated. Several possible methods of reformulating of this issue within the rational choice framework are proposed and explored in this paper. The results here support a much more optimistic conclusion and suggest numerous avenues of further research which could provide considerable insight into the conditions under which optimal accounting principles are possible.

 

 

Part 1 of Accounting Theory Document
http://faculty.trinity.edu/rjensen/theory01.htm

“Accounting for Business Firms versus Accounting for Vegetables” ---
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#BadNews 

Take the Enron Quiz ---
http://faculty.trinity.edu/rjensen/FraudEnronQuiz.htm

Where I Made My Consulting Money and How

Accounting History in a Nutshell

Re-branding the CPA Profession

History of Accountics

Accounting Theory Courses

Thoughts on Bill Paton and Some Other Historical Writers in Accountancy

"Why Accounting Matters," by Edith Orenstein

Accounting for the Shadow Economy

Behavioral and Cultural Economics and Finance

Media Reporting Controversies

Efficient Markets (EMH) versus Inefficient Markets
(including Black Swans and Fat Tails)

Islamic and Social Responsibility Accounting

XBRL:  The Next Big Thing

The Controversy Over Revenue Reporting and HFV 
--- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

The Controversy Over Employee Stock Options as Compenation ---
http:/www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

Key Differences Between International (IFRS) and U.S. GAAP (SFAS)

Accounting Research Versus the Accountancy Profession
Some ideas for applied research

Learning at Research Schools Versus "Teaching Schools" Versus "Happiness"
With a Side Track into Substance Abuse

Why must all accounting doctoral programs be social
science (particularly econometrics) "accountics" doctoral programs?

Why accountancy doctoral programs are drying up and
why accountancy is no longer required for admission or
graduation in an accountancy doctoral program
http://faculty.trinity.edu/rjensen/theory01.htm#DoctoralPrograms
 

A Pissing Contest Between Bob and Jagdish:  An Illustration of How to Lie With Statistics ---
http://www.cs.trinity.edu/~rjensen/temp/LieWithStatistics01.htm

 
Accountics Scientists Seeking Truth: 
"Frankly, Scarlett, after I get a hit for my resume in The Accounting Review I just don't give a damn"
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm
One more mission in what's left of my life will be to try to change this
http://www.cs.trinity.edu/~rjensen/temp/AccounticsDamn.htm 

Accounting History Blast from the Past
Demski, J. S. 1973. The general impossibility of normative accounting standards. The Accounting Review (October): 718-723. (JSTOR link).

Cushing, B. E. 1977. On the possibility of optimal accounting principles. The Accounting Review (April): 308-321. (JSTOR link).

Abstract
Several authors have examined the issue of choice among financial reporting standards and principles using the framework of rational choice theory. Their results have been almost uniformly pessimistic in terms of the possibilities for favorable resolution of this issue. Upon further analysis, these results are revealed to be an artifact of the way in which the issue is initially formulated. Several possible methods of reformulating of this issue within the rational choice framework are proposed and explored in this paper. The results here support a much more optimistic conclusion and suggest numerous avenues of further research which could provide considerable insight into the conditions under which optimal accounting principles are possible.

I think leading academic researchers avoid applied research for the profession because making seminal and creative discoveries that practitioners have not already discovered is enormously difficult. Accounting academe is threatened by the twin dangers of fossilization and scholasticism (of three types: tedium, high tech, and radical chic)
From http://faculty.trinity.edu/rjensen/395wpTAR/Web/TAR395wp.htm
 

“Knowledge and competence increasingly developed out of the internal dynamics of esoteric disciplines rather than within the context of shared perceptions of public needs,” writes Bender. “This is not to say that professionalized disciplines or the modern service professions that imitated them became socially irresponsible. But their contributions to society began to flow from their own self-definitions rather than from a reciprocal engagement with general public discourse.”

 

Now, there is a definite note of sadness in Bender’s narrative – as there always tends to be in accounts of the shift from Gemeinschaft to Gesellschaft. Yet it is also clear that the transformation from civic to disciplinary professionalism was necessary.

 

“The new disciplines offered relatively precise subject matter and procedures,” Bender concedes, “at a time when both were greatly confused. The new professionalism also promised guarantees of competence — certification — in an era when criteria of intellectual authority were vague and professional performance was unreliable.”

But in the epilogue to Intellect and Public Life, Bender suggests that the process eventually went too far. “The risk now is precisely the opposite,” he writes. “Academe is threatened by the twin dangers of fossilization and scholasticism (of three types: tedium, high tech, and radical chic). The agenda for the next decade, at least as I see it, ought to be the opening up of the disciplines, the ventilating of professional communities that have come to share too much and that have become too self-referential.”

Accountics is the mathematical science of values.
Charles Sprague [1887] as quoted by McMillan [1998, p. 1]
[NH1]

What went wrong in accounting/accountics research? 
How did academic accounting research become a pseudo science?
http://faculty.trinity.edu/rjensen/theory01.htm#WhatWentWrong

GMAT: Paying for Points

Accounting Journal Lack of Interest in Publishing Replications

Rankings of Academic Accounting Research Journals and Schools

Role of Accounting Standards in Efficient Equity Markets

Controversies in Setting Accounting Standards

Popular IFRS, IAS, and Other IASB Learning Resources:

Bright Lines Versus Principles-Based Rules

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

Should "principles-based" standards replace more detailed requirements for complex
financial contracts such as structured financing contracts and financial instruments derivatives contracts?

Why Let the I.R.S. See What the S.E.C. Doesn't?

Cookie Jar Accounting and FAS 106
Go to http://faculty.trinity.edu/rjensen/theory01.htm#CookieJar

Synthetic Assets and Liabilities Accounting
Go to http://faculty.trinity.edu/rjensen/theory01.htm#Synthetics   

Time versus Money
Go go http://faculty.trinity.edu/rjensen/theory01.htm#Time

Intangibles and Contingencies:   Theory Disputes Focus Mainly on the Tip of the Iceberg
Go to http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes

Radical Changes in Financial Reporting

The Controversy Between OCI versus Current Earnings

Accrual Accounting and Estimation

 

 

 

FASB Accounting Standards Updates ---
http://www.fasb.org/cs/ContentServer?site=FASB&c=Page&pagename=FASB/Page/SectionPage&cid=11761563164




Part 2 of Accounting Theory Document
See Below

"Psychology’s Treacherous Trio: Confirmation Bias, Cognitive Dissonance, and Motivated Reasoning," by sammcnerney, Why We Reason, September 7, 2011 --- Click Here
http://whywereason.wordpress.com/2011/09/07/psychologys-treacherous-trio-confirmation-bias-cognitive-dissonance-and-motivated-reasoning/

 


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

    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.
    "A Capital Idea," The Wall Street Journal,  April 26, 2007; Page A18 --- Click Here
  •  

    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.

    "Twitter's Recent 8-K Begs for More Transparency," by Anthony H. Catanach, Jr., Grumpy Old Accountants Blog, February 16, 2014 ---
    http://grumpyoldaccountants.com/blog/2014/2/16/twitters-recent-8-k-begs-for-more-transparency

    With all of the bad weather here in the East, this aging number cruncher has had his hands full with scraping and shoveling. But I just had to take a break and comment on Twitter’s recent Form 8-K (February 5, 2014), particularly given the Company CEO’s comments last Fall on the importance of transparency to being a good leader.

    According to Kurt Wagner of Mashable, CEO Dick Costolo said the following about transparency at a TechCrunch Disrupt event last September:

    The way you build trust with your people is by being forthright and clear with them from day one. You may think people are fooled when you tell them what they want to hear. They are not fooled. As a leader, people are always looking at you. Don't lose their trust by failing to provide transparency in your decisions and critiques.

    Well, when you go “on the record” about one of my favorite themes, I just had to give Twitter’s 8-K a look. And what did I find? Apparently, Twitter’s CFO does not share the same transparency philosophy as his boss.

    But before I begin, I thought it useful to report on the accuracy of some predictions that I made about Twitter’s financial performance before the Company’s IPO. In “What Will Twitter’s Financials Really Tell Us?”, I took a shot at forecasting the Company’s post-IPO balance sheet using a comp group consisting of Facebook, Sina Corp, Yelp Inc., and Meetme Inc. And while the average revenue to assets percentage for this comp group (46.84%) yielded total assets of only $1.3 billion instead of $3.4 billion, the forecasted balance sheet category percentages were quite close as illustrated in the following table:

    Continued in article

     


    Moral Hazard:  Hedge Fund Shorts

    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

     

    . . .

    Market neutral strategy: This strategy focusses on profits made either by arbitrage in a market neutral investment or by arbitrage over time, for instance investing in futures and shorting the underlying. This strategy was obtained by the Long-Term Capital Management fund of Nobel Prize laureates Myron Scholes and Robert C. Merton.

    Short selling strategy: The hedge fund shorts securities in expectation of a rebuy at a lower price at a future date. This lower price is a result of overconfidence of the other party, who thought they had bought an undervalued asset.

    Special situations: A popular and probably the most well-known strategy is the behaviour of hedge fund in special situations like mergers, hostile takeovers, reorganisations or leveraged buy-outs. Hedge funds often buy stocks from the distressed company, thereby trying to profit from a difference in the initial offering price and the price that ultimately has to be paid for the stock of the company.

    Timing strategy: The manager of the hedge fund tries to time his entrance to or exit from a market as good as possible. High returns can be generated when investing at the start of a bull market or exiting at the start of a bear market.

    Continued in article

     

    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

    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
     

     

    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 WSJ Video
     

    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 WSJ Video
     

    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)

    Introductory Note
    India is scheduled to adopt IFRS accounting standards but as of yet is still under domestic accounting standards.
    Also not there is some difference between capitalization of R&D between FASB standards in the USA versus international IFRS standards where the FASB requires more expensing of R&D relative to IFRS and India's current accounting standards:
    "IFRS and US GAAP: Similarities and Differences" according to PwC (October 2013 Edition)
    http://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/ifrs-and-us-gaap-similarities-and-differences-2013.pdf

    "Research and Development, Uncertainty, and Analysts’ Forecasts: The Case of IAS 38," by Tami Dinh Thi, Brigitte Eierle, Wolfgang Schultze, and Leif Steeger, SSRN, November 26, 2014 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2531094

    Abstract:
    This paper analyzes the consequences of the capitalization of development expenditures under IAS 38 on analysts’ earnings forecasts. We use unique hand-collected data in a sample of highly research and development (R&D) intensive German listed firms over the period 2000 to 2007. We find that the capitalization of development costs is significantly associated with both higher individual analysts’ forecast errors and forecast dispersion. This suggests that the increasing complexity surrounding the capitalization of development costs negatively impacts forecast accuracy. However, for firms with high underlying environmental uncertainty, forecast errors are negatively associated with capitalized development expenditures. This indicates that the negative impact of increased complexity on forecast accuracy can be outweighed by the information contained in the signals from capitalized development costs when the underlying environmental uncertainty is high. The findings contribute to the ongoing controversial debate on the accounting for self-generated intangible assets. Our results provide useful insights on the link between capitalization of development costs, environmental uncertainty, and analysts’ forecasts for accounting academics and practitioners alike.


    Teaching Case on How It Pay's to Look Under the Hood of Indian Financial Statements
    From The Wall Street Journal Accounting Weekly Review on November 21, 2013

    It Pays to Look Under Tata's Hood
    by: Abheek Bhattacharya
    Nov 15, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Accounting, Financial Ratios, Financial Reporting, International Accounting

    SUMMARY: Tata Motors is "India's largest auto company...[which] leapt onto the world stage after buying JaguarLand Rover in 2008. Now that the British luxury car maker makes up roughly 80% of Tata's revenue, this Indian firm is competing with BMW, Mercedes-Benz and a host of American and Japanese premium brands...Although its shares are up more than 20% so far this year, the stock trades at 9.6 times estimated profit for the fiscal year that ends next March...Yet Tata's valuation may be flattered by the way it treats certain costs...At issue is how Tata treats research and development costs...Indian accounting standards give Tata discretion in accounting for such spending...Tata capitalized roughly 80% of R&D activity last fiscal year."

    CLASSROOM APPLICATION: The article provides an excellent comparison of U.S. GAAP, IFRS, and Indian local accounting for R&D costs.

    QUESTIONS: 
    1. (Introductory) What three accounting treatments for research and development (R&D) activities are compared in this article?

    2. (Advanced) Briefly summarize the accounting under each of these systems in your own words.

    3. (Advanced) Do you agree with the statement in the article that, under IFRS, German auto makers can capitalize R&D? Explain your answer.

    4. (Introductory) How does the author compare the amount of R&D capitalization under these three accounting systems?

    5. (Advanced) What is the implication of these differing accounting treatments for the assessment of different auto manufacturers' financial performance? Be specific about the financial ratios used in the article to compare the companies' results, valuation, and stock price.

    6. (Advanced) How does the author adjust the amounts reported by these companies in order to make them comparable? Be specific in describing what accounting treatment and income measures to which the author converts the reported numbers.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "It Pays to Look Under Tata's Hood," by Abheek Bhattacharya, The Wall Street Journal, November 185, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702303789604579199210852043816?mod=djem_jiewr_AC_domainid

    India's Tata Motors TTM -1.05% is in the big league of global car makers. When it comes to accounting for certain costs, though, it doesn't play exactly the same way as its peers.

    India's largest auto company by market value leapt onto the world stage after buying JaguarLand Rover in 2008. Now that the British luxury car maker makes up roughly 80% of Tata's revenue, this Indian firm is competing with BMW, BMW.XE +0.37% Mercedes-Benz and a host of American and Japanese premium brands.

    And when compared with some of these peers, Tata looks to be a relative bargain. Although its shares are up more than 20% so far this year, the stock trades at 9.6 times estimated profit for the fiscal year that ends next March. That is at a discount to Daimler, DAI.XE +0.20% which owns Mercedes, and BMW.

    Yet Tata's valuation may be flattered by the way it treats certain costs. This has the effect of boosting its profit—in the near term, at least. Taking that into account, Tata is more expensive than it initially appears.

    At issue is how Tata treats research and development costs. Tata's R&D program, at 6% of sales, is higher than the 4% or 5% global car makers typically spend on new products and designs.

    Indian accounting standards give Tata discretion in accounting for such spending. The company can treat it as an immediate expense that cuts into income. Or it can capitalize the spending, recognizing it over a longer period of time. Tata capitalized roughly 80% of R&D activity last fiscal year. In this, Tata is ahead of Indian counterparts—Indian SUV-maker Mahindra & Mahindra 500520.BY +0.44% capitalized 44% of its R&D last fiscal year.

    Tata's practice also contrasts with global rivals. American and Japanese car makers expense all their R&D spending, as local accounting rules require. German auto makers, who report under international accounting standards, can capitalize R&D, though this has averaged only a third at BMW the last five years.

    To be sure, Tata may need more R&D than BMW and Mahindra. JLR sported outdated models and platforms before 2008, and Tata says it's treating the British unit as a young company hungry for new designs. The company says it has followed this practice for years, meaning it isn't changing course.

    Still, Tata's R&D accounting bolsters the bottom line. If all R&D spending were expensed, Tata's net profit for this fiscal year would fall by two-thirds, estimates Bernstein Research. Tuning the numbers this way decreases earnings by 10% at Daimler. And at BMW, it actually boosts earnings 1% since this car maker amortizes older R&D spending and bears the expense on its income statement.

    Continued in article


    "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

    TriCor Case May Illuminate Patent Limits
    by Shirley S. Wang
    The Wall Street Journal

    Jun 02, 2008
    Page: B1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB121236509655436509.html?mod=djem_jiewr_AC
     

    TOPICS: Financial Accounting, Intangible Assets, Research & Development

    SUMMARY: Aboott Laboratories have been involved in lawsuits and a government antitrust investigation in relation to its 33-year-old cholesterol medication TriCor. This drug generated sales of $1.2 billion in 2007 but the patent on the original product--which was developed in France--has now expired. When Abbott Labs acquired the TriCor licensing rights in the late 1990s, the company patented a new way to make the product. The antitrust suit examines whether Abbot Labs "...violated antitrust laws in its efforts to prevent an Israeli company from successfully selling a generic version of the drug." The bases for the arguments against Abbott Labs are that the company filed "...new patents on questionable improvements to TriCor...[and] engaged in a practice known as 'product switching'--retiring an existing drug and replacing it with a modified version that is marketed 'new and improved,' preventing pharmacists from substituting a generic for the branded drug when they fill prescriptions for it." Though not against the law per se, these practices may have violated antitrust laws if their sole purpose was to extend Abbott's monopoly on sales of the product.

    CLASSROOM APPLICATION: The article clearly illustrates issues in accounting for R&D and intangible assets and is therefore useful in intermediate financial accounting and MBA accounting courses. In addition, an ethical question of the cost impact on medical patients of these patent rights may be included in class discussion of this article.

    QUESTIONS: 
    1. (Introductory) Summarize accounting in the two areas of intangible assets and research and development (R&D) expenditures. How are these two areas related?

    2. (Introductory) Examine Abbott Laboratories' most recent quarterly financial statement filing with the SEC, available at http://www.sec.gov/Archives/edgar/data/1800/000110465908029545/a08-11202_110q.htm  or by clicking on the live link to Abbot Laboratories in the on-line version of the article, then SEC Filings under "Other Resources" in the left-hand column of the web page, selecting the 10-Q filing submitted 2008-05-02 and selecting the html version of the entire document. How large are Abbott Labs intangible assets and research and development expenditures? In your answer, specifically consider how you can best answer this question using some basis for assessment.

    3. (Advanced) Refer to your answer to question 2. How do the accounting practices for intangible assets and R&D expenditures impact the way in which you assess the size of these items relative to Abbott Labs operations?

    4. (Introductory) "Drug companies typically have three to ten years of exclusive patent rights remaining when their products hit the market." Why is this the case? In your answer, specifically state how these business conditions impact the required time period over which the cost of patents may be amortized.

    5. (Advanced) Again examine Abbott Labs 10-Q filing made on May 2, 2008, in particular the footnote disclosure related to intangible assets. Note 11--Goodwill and Intangible Assets. What accounting policy is consistent with the description of patent rights' useful lives discussed in answer to question 4 above?

    6. (Introductory) What steps has Abbott Labs undertaken to extend the life of its patent on TriCor? Are steps like these a business necessity or merely a method of generating excessive profits for pharmaceutical companies? In your answer, specifically consider ethical issues related to profitability, continued R&D for new pharmaceutical products, and the cost to both medical patients and insurance companies of patented, brand-name products versus generic equivalents.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

     


    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 :

    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.

    Baruch Lev's Value Chain Scorecard
     

    Discovery/Learning

    • Internal Renewal

    · Research and Development
    · IT Development
    · Employee Training
    · Communities of Practice
    · Customer Acquisition Costs

    • Acquired Knowledge

    · Technology Purchase
    · Reverse Engineering
    -Spillovers
    · IT Acquisition

    • Networking

    · R&D Alliances/Joint Ventures
    · Supplier/Customer Integration

    Implementation

    • Intellectual Property

      · Patents, Trademarks, Copyrights
      · Cross-licensing
      · Patent/Know-how Royalties

    • Technological Feasibility

    · Clinical Tests, FDA Approvals
    · Beta Tests
    · Unique Visitors

    • Customers

    · Marketing Alliances
    · Brand Support
    · Stickiness and Loyalty Traffic Measures

    • Employees

    · Work Practices
    · Retention
    · Hot Skills (Knowledge Workers

    Commercialization

    • Top Line

    · Innovation Revenues
    · Market Share/Growth
    · Online Revenues
    · Revenues from Alliances
    · Revenue Growth by Segments

    • Bottom Line

    · Productivity Gains
    · Online Supply Channels
    · Earnings/Cash Flows
    · Value Added
    · Cash Burn Rate

    • Growth Options

    · Product Pipeline
    · Expected Restructuring Impact
    · Market Potential/Growth
    · Expected Capital Spending

     

    The knowledge capital estimates that Lev and Bothwell came up with during their run last fall of some 90 leading companies (see accompanying table) were absolutely huge. Microsoft, for example, boasted a number of $211 billion, while Intel, General Electric and Merck weighed in with $170 billion, $112 billion and $110 billion, respectively.

    Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 --- http://equity.stern.nyu.edu/News/news/levbarrons1120.html
    Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

    • It is seldom, if ever mentioned, but Microsoft's overwhelming huge asset is its customer lock-in to the Windows Operating System combined with the enormous dominance of MS Office (Word, Excel, Outlook, etc) and MS Access.  The cost of shifting most any organization over to some other operating system and suite software comparable to MS Office is virtually prohibitive.  This is the main asset of Microsoft, but measuring its value and variability is virtually impossible.
      • Intellectual property
      • Trademarks, patents, copyrights
      • In-process R&D
      • Unrecorded goodwill
      • Ways of doing business and adapting to technology changes and shifts in consumer tastes
    For example, my (Baruch Lev's) recent computations show that Microsoft has knowledge assets worth $211 billion -- by far the most of any company. Intel has knowledge assets worth $170 billion, and Merck has knowledge assets worth $110 billion. Now, compare those figures with DuPont's assets. DuPont has more employees than all of those companies combined. And yet, DuPont's knowledge assets total only $41 billion -- there isn't much extra profitability there.

    Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 --- http://equity.stern.nyu.edu/News/news/levbarrons1120.html
    Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

     

    University logos of prestigious universities (Stanford, Columbia, Carnegie-Mellon, Duke, etc.) are worth billions when discounting their value in distance education of the future--- http://faculty.trinity.edu/rjensen/000aaa/0000start.htm 

     

     


    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

    "AT&T to Buy T-Mobile: Here’s Why," by Shira Ovide, The Wall Street Journal, March 20, 2011 ---
    http://blogs.wsj.com/deals/2011/03/20/att-buys-t-mobile-heres-why/

    For his students, Jim Mahar contrasts these two current illustrations as vertical versus horizontal mergers (March 22, 2011)---
    http://financeprofessorblog.blogspot.com/2011/03/vertical-and-horizontal-deals.html


    Teaching Case on Microsoft's Purchase of Skype

    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 WSJ Video
     

    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

    Bob Jensen's threads on mergers and acquisitions are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pooling

     


    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
    b
    y: 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


    Wasted Taxpayer Money:  Purchase Accounting Rule Will Enable Banks to Report Billions in TARP Profits
    "Banks Stand to Reap Billions From Purchased Bad Loans," by Julie Crawshaw, NewsMax, May 27, 2009 ---
    http://moneynews.newsmax.com/financenews/purchase_accounting_rule/2009/05/27/218542.html

    An accounting rule that governs how banks book acquired loans is making it possible for banks that purchased bad loans to reap billions.

    Applying this regulation — known as the purchase accounting rule — to mortgages and commercial loans that lost value during the credit crisis gives acquiring banks an incentive to mark down loans they acquire as aggressively as possible, says RBC Capital Markets analyst Gerard Cassidy.

    "One of the beauties of purchase accounting is after you mark down your assets, you accrete them back in," Cassidy told Bloomberg. "Those transactions should be favorable over the long run."

    Here’s how it works: When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent.

    Now, JPMorgan says that first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank with an accretable-yield balance that could result in additional income of $29.1 billion.

    So JPMorgan, Wells Fargo, Bank of America, and PNC Financial Services all stand to make big bucks on bad loans they bought from Washington Mutual, Wachovia, Countrywide and National City.

    Their combined deals provide a $56 billion in accretable yields, which is the difference between the value of the loans on the banks’ balance sheets and the cash flow they’re expected to produce.

    However, it’s tough to tell how much the yield will increase the acquiring banks’ total revenues because banks don’t disclose all their expenses and book the additional revenues over the lives of the loans.

    May 28, 2009 reply from Tom Selling [tom.selling@GROVESITE.COM]

    Thanks for providing fodder for what I hope will be a "fun" blog post. Under APB 16, you had to evaluate the adequacy of the allowance for bad debts in an acquisition. With the objective of curbing this particular abuse, the SEC issued a Staff Accounting Bulletin (SAB Codification Topic 2.B.5) that constrained the acquiror from changing the allowance for bad debts, unless the plans for collection was fundamentally different.

    The new problem arises, because when the loans were held by the acquiree, they were measured at contractual amount less the allowance for bad debts. Upon acquisition, they now have to be measured at fair value. If the acquirer wants to maximize future profits, it will maximize the difference between the old and new carrying value, subject to the following considerations: (1) auditor and/or SEC push back; (2) future goodwill impairment charges, and (3) capital adequacy regulations.

    As to Denny's comment about ultimate collectibility, current managers may not care if the loans go further south some years from now. This generation will be compensated based on accounting profits over the next 2-3 years -- and will be long gone before the proverbial stuff hits the fan.

    The more things change, the more they remain the same. I think that the biggest lesson here, Bob, and something I expect you will react to, is that multi-attribute accounting standards don't work.

    Best,
    Tom

    May 29, 2009 reply from Bob Jensen

    Hi Tom,

    When I first learned about how business firms were exploiting derivative financial instruments contracts in large measure to avoid accounting rules, and before FAS 119/133 issuance, I attended a workshop in Orlando back in the 1980s conducted by Deloitte's derivatives accounting expert John Smith (who later did a lot of IAS 39 work for the IASB).

    John told us about a Deloitte client in L.A. that was behaving so strangely that the auditor in charge brought it to John's attention (John was the top research partner in Deloitte at the time). Bank X was repeatedly taking reversing positions on an interest rate swap in a manner such that each time a reversing position was taken there was an ultimate cash flow loss. It seemed that Bank X was making a terrible mistake. John Smith posed this problem as a case to us derivatives accounting neophyte professors in the audience in Orlando.

    I recall that the first professor to shout out the answer from the audience was Hugo Nurnberg. Hugo was the first among us neophytes to recognize that, prior to FAS 133 rules, Bank X was making harmful economic decisions just to "frontload income" as Hugo put it. By frontloading income, the CEO got bigger bonuses in what was a bit like Ponzi damage to shareholders. Each year frontloaded income in similar contracting grows by enough to cover tailing cash flow losses. Bonuses and share prices accordingly grow and grow until, dah, frontloaded income is no longer sufficient to cover the tailing cash flow losses. I wonder if a California relative of Bernie Madoff was running Bank X. By the time the Ponzi exploded the Bank X CEO was probably living in luxury in Hawaii.

    This was one of the first times I became aware of how executives are willing to maximize personal gains at the ultimate expense of the shareholders for whom they are acting as agents. Since the roaring derivatives fraud days of the 1990s such behavior became the rule rather than the exception, which is why we're in such a dire economic crisis today. Alan Greenspan and Chris Cox belatedly admitted that they "made mistakes" by assuming bankers would put shareholder interests above their own personal greed --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#SEC

    I wonder if this current TARP poison plan is a bit of a Ponzi scheme to inflate banking share prices in what will once again be a royal screwing of investors?

    My timeline on the massive derivative financial instruments frauds is at http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

    Bob Jensen

    June 1, 2009 rely from The Accounting Onion [tom.selling@grovesite.com]

    From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

    "When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

    Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

    Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

     

    The Closed Loophole that Would Be Re-Opened by the FASB

    Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

    With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

    At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

    FASB Amnesia?

    FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

    § WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

    § Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

    § JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

    It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

    Where is the SEC!?

    Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

    For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

    Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

    But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

    A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.


    This teaching case should be of special interest to Tom Selling and other advocates of fair value accounting for all bank loan assets and debt.
    The case deals with the traditional and now renewed issue of whether a company can avoid short-term fair value adjustments by declaring a financial instrument asset or debt to be a long-term (e.g. loan investments to be held-to-maturity rather than being held as available-for-sale). With great reluctance the IASB caved in EU banker political pressures to allow historical cost accounting for long-term financial instruments. Similarly, the FASB changed loan impairment accounting for long-term receivables.

    Personally I never have liked short-term fair value adjustments to very long-term financial instruments (asset and debt financial instruments). The reason is that I place primary importance on accounting for the bottom line (net earnings) that becomes too volatile by the fictional unrealized gains and losses of fair value accounting for very long-term financial instruments like mortgages payable or mortgage loans receivable.  Until political pressures were applied, the IASB and FASB placed primary emphasis on balance sheet values even though fair value adjustment fictions of long-term financial assets and debt made it impossible to define net earnings ---
    http://www.fasri.net/index.php/2009/10/the-asset-liability-approach-primacy-does-not-mean-priority/

    Most long-term receivables will be settled for contracted maturity value and are not doubtful accountants. However, at any point where it appears that full collection of maturity value is in doubt (such as defaulted monthly payments on a mortgage loan), the the Allowance for Doubtful Accounts must be adjusted for the best possible estimate of ultimate loan losses just as Sears and other big companies adjust the Allowance for Doubtful Accounts for estimated receivables bad debt losses. Often estimations of such losses for bank loans are more complicated when loan collateral is involved as in the case of mortgage loans where new government regulations make foreclosure litigation more complicated and costly.

    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

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue

     


    FAS 141 and the Question of Value By PricewaterhouseCoopers CFOdirect Network Newsdesk, January 16, 2003 --- http://www.cfodirect.com/cfopublic.nsf/vContentPrint/CA13B226B214A04085256CB000512D34?OpenDocument 

    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
    T
    he 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 WSJ Video

    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 WSJ Video
     

    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 WSJ Video

    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.


    "The State of the Federal Budget Is Opaque," by Ryan Alexander, U.S. News, January 28, 2014 ---
    http://www.usnews.com/opinion/blogs/economic-intelligence/2014/01/28/the-governments-accounting-practices-makes-budget-debates-worse

    For budget nerds, tonight's State of the Union speech is a prelude to the president's budget, which will be introduced a little over a month from now. The State of the Union usually presents a broad vision of goals and priorities, but the budget gives us details about where the administration would direct dollars to see those priorities implemented.

    But even when we see the president's budget next month, we still won't have a true picture of where we stand financially and where we are going because we use a set of accounting principles that makes it hard to get a clear picture of what our obligations are. That is because the United States Government uses a cash based accounting system instead of accrual accounting, the standard accounting practice for large, complex entities.

    What is the difference and why does it matter? The short version is this: Cash accounting simply tracks money in and money out, while accrual accounting takes into account all outstanding obligations. This difference matters because, under cash accounting, it is possible to ignore or underplay outstanding obligations the government must pay under existing contracts and laws. Moreover, cash accounting makes it more difficult to plan and budget for infrastructure upgrades and other major investments.

    [See a collection of political cartoons on the budget and deficit.]

    For decades, accounting professionals, presidential commissions and the Congressional Budget Office alike have recommended changing to accrual accounting as a means to make the federal budget more transparent and to encourage fiscal responsibility. The Securities and Exchange Commission requires that publically traded companies use accrual accounting and otherwise follow the so-called Generally Accepted Accounting Practices. The reason accrual accounting is favored is simple: It encourages large entities to reflect and plan for long-term fiscal health rather than simply looking at today's cash flow, which is the accounting principle version of living paycheck-to-paycheck.

    Moving all federal budgeting and accounting to accrual standards seems like an obvious step. It will increase our understanding of our true deficits and debts and improve transparency and accountability across the government. So why, despite recommendations to make this change, starting as far back as the first Hoover Commission in 1949, hasn't the U.S. adopted this standard? The short answer is that making this change requires political will. And as we have seen for decades, politicians love to skew numbers to support their own positions instead of relying on vetted, neutral numbers.

    Lawmakers are able to game the Congressional Budget Office scoring rules to hide long-term costs outside the 10-year budget window. Shifting to accrual accounting would shift debates about the long-term liabilities and benefits of different government actions out of the realm of political arguments and into the realm of agreed upon facts.

    Continued in article

    Over 75% Off-Balance-Sheet Financing by Federal and State Governments
    "Hiding the Financial State of the Union -- and the States," State Data Lab, January 24, 2014 ---
    http://www.statedatalab.org/

    Next Tuesday, President Barack Obama will give the annual “State of the Union” address. One of the most important issues is the Financial State of the Union. But what about the Financial State of the States?

    Truth in Accounting has found that the lack of truth and transparency in governmental budgeting and financial reporting enables our federal and state governments to not tell us what they really owe. Obscure accounting rules allow governments to hide trillions of dollars of debt from citizens and legislators.

    The President and many governmental officials tell us the national debt is $17 trillion, but that does not include more than $58 trillion of retirement benefits that have been promised to our veterans and seniors. In addition, state officials do not report more than $948 billion of retirement liabilities.

    The charts above show 77% of the federal government's true debt is hidden and 75% of state government debt is hidden. Total hidden federal and state debt amounts to more than $59 trillion, or roughly $625,000 per U.S. taxpayer.

    The five states with the greatest hidden debt include Texas ($66 billion), Michigan ($67 billion), New York ($75 billion), Illinois ($106 billion), and California ($112 billion).

    Truth in Accounting promotes truthful, transparent and timely financial information from our governments, because citizens deserve to know the amount of debt they and their children will be responsible for paying in the future.

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    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.

    The State of New York's filing against Ernst & Young ---
    http://goingconcern.com/2010/12/lunchtime-reading-the-complaint-against-ernst-young/#more-23070

    Bob Jensen's threads on Lehman's Repo 105/108 transactions are at
    http://faculty.trinity.edu/rjensen/Fraud001.htm#Ernst

     


    "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.

    Fighting the Battle Against Off-Balance-Sheet Financing"  Winning a Battle Does Not Mean Winning a War
    But it's better than losing the battle

    "FASB Issues New Standards for Securitizations and Special Purpose Entities," SmartPros, June 15, 2009 --- http://accounting.smartpros.com/x66815.xml 

    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!


    More Than Half of Bank America's Book Value is Bogus

    "Curse the Geniuses Who Gave Us Bank of America:," by Jonathan Weil, Bloomberg, July 21, 2011 ---
    http://www.bloomberg.com/news/2011-07-21/curse-the-geniuses-who-built-bank-of-america-jonathan-weil-1-.html

    Ask anyone what the most immediate threats to the global financial system are, and the obvious answers would be the European sovereign-debt crisis and the off chance that the U.S. won’t raise its debt ceiling in time to avoid a default. Here’s one to add to the list: the frightening plunge in Bank of America Corp. (BAC)’s stock price.

    At $9.85 a share, down 26 percent this year, Bank of America finished yesterday with a market capitalization of $99.8 billion. That’s an astonishingly low 49 percent of the company’s $205.6 billion book value, or common shareholder equity, as of June 30. As far as the market is concerned, more than half of the company’s book value is bogus, due to overstated assets, understated liabilities, or some combination of the two.

    That perception presents a dangerous situation for the world at large, not just the company’s direct stakeholders. The risk is that with the stock price this low, a further decline could feed on itself and spread contagion to other companies, regardless of the bank’s statement this week that it is “creating a fortress balance sheet.”

    It isn’t only the company’s intangible assets, such as goodwill, that investors are discounting. (Goodwill is the ledger entry a company records when it pays a premium to buy another.) Consider Bank of America’s calculations of tangible common equity, a bare-bones capital measure showing its ability to absorb future losses. The company said it ended the second quarter with tangible common equity of $128.2 billion, or 5.87 percent of tangible assets.

    Investor Doubts

    That’s about $28 billion more than the Charlotte, North Carolina-based company’s market cap. Put another way, investors doubt Bank of America’s loan values and other numbers, too, not just its intangibles, the vast majority of which the company doesn’t count toward regulatory capital or tangible common equity anyway.

    So here we have the largest U.S. bank by assets, fresh off an $8.8 billion quarterly loss, which was its biggest ever. And the people in charge of running it have a monstrous credibility gap, largely of their own making. Once again, we’re all on the hook.

    As recently as late 2010, Bank of America still clung to the position that none of the $4.4 billion of goodwill from its 2008 purchase of Countrywide Financial Corp. had lost a dollar of value. Chief Executive Officer Brian Moynihan also was telling investors the bank would boost its penny-a-share quarterly dividend “as fast as we can” and that he didn’t “see anything that would stop us.” Both notions proved to be nonsense.

    Acquisition Disaster

    The goodwill from Countrywide, one of the most disastrous corporate acquisitions in U.S. history, now has been written off entirely, via impairment charges that were long overdue. And, thankfully, Bank of America’s regulators in March rejected the company’s dividend plans, in an outburst of common sense.

    Last fall, Bank of America also was telling investors it probably would incur $4.4 billion of costs from repurchasing defective mortgages that were sold to investors, though it did say more were possible. Since then the company has recognized an additional $19.2 billion of such expenses, with no end in sight.

    The crucial question today is whether Bank of America needs fresh capital to strengthen its balance sheet. Moynihan emphatically says it doesn’t, pointing to regulatory-capital measures that would have us believe it’s doing fine. The market is screaming otherwise, judging by the mammoth discount to book value. Then again, for all we know, the equity markets might not be receptive to a massive offering of new shares anyway, even if the bank’s executives were inclined to try for one.

    No Worries

    We can only hope Bank of America’s regulators are tracking the market’s fears closely, and have contingency plans in place should matters get worse. Yet to believe Moynihan, there’s nary a worry from them. When asked by one analyst during the company’s earnings conference call this week whether there was any “pressure to raise capital from a regulatory side of things,” Moynihan replied, simply, “no.”

    Continued in artocle

    Jensen Comment
    This reminds me of the great, great video of Frank Portnoy's explanation of how CitiBank's financial statements were bogus before the Government had to bail out Citi.

    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

    Bob Jensen's threads on misleading financial statements are at
    http://faculty.trinity.edu/rjensen/Theory01.htm

    Also see
    http://faculty.trinity.edu/rjensen/Theory02.htm


    "Twitter's Recent 8-K Begs for More Transparency," by Anthony H. Catanach, Jr., Grumpy Old Accountants Blog, February 16, 2014 ---
    http://grumpyoldaccountants.com/blog/2014/2/16/twitters-recent-8-k-begs-for-more-transparency

    With all of the bad weather here in the East, this aging number cruncher has had his hands full with scraping and shoveling. But I just had to take a break and comment on Twitter’s recent Form 8-K (February 5, 2014), particularly given the Company CEO’s comments last Fall on the importance of transparency to being a good leader.

    According to Kurt Wagner of Mashable, CEO Dick Costolo said the following about transparency at a TechCrunch Disrupt event last September:

    The way you build trust with your people is by being forthright and clear with them from day one. You may think people are fooled when you tell them what they want to hear. They are not fooled. As a leader, people are always looking at you. Don't lose their trust by failing to provide transparency in your decisions and critiques.

    Well, when you go “on the record” about one of my favorite themes, I just had to give Twitter’s 8-K a look. And what did I find? Apparently, Twitter’s CFO does not share the same transparency philosophy as his boss.

    But before I begin, I thought it useful to report on the accuracy of some predictions that I made about Twitter’s financial performance before the Company’s IPO. In “What Will Twitter’s Financials Really Tell Us?”, I took a shot at forecasting the Company’s post-IPO balance sheet using a comp group consisting of Facebook, Sina Corp, Yelp Inc., and Meetme Inc. And while the average revenue to assets percentage for this comp group (46.84%) yielded total assets of only $1.3 billion instead of $3.4 billion, the forecasted balance sheet category percentages were quite close as illustrated in the following table:

    Continued in article

     


    Bob Jensen's threads on SPEs, VIEs, SPVs, and synthetic leasing are at
    http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

    Bob Jensen's threads on off-balance-sheet financing are at
    http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on April 5, 2013

    Regulators Let Big Banks Look Safer Than They Are
    by: Sheila Bair
    Apr 02, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Banking, Derivatives, Fair-Value Accounting Rules, Investments, Regulation

    SUMMARY: The point of this opinion page piece by the former chairman of the FDIC is that "capital-ratio rules...[lead to the view that] fully collateralized loans are considered riskier than derivatives positions.... The recent Senate report on the J.P. Morgan Chase 'London Whale' trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios.... [B]ecause regulators allow banks to use a process called 'risk weighting,' [banks] raise their capital ratios by characterizing the assets they hold as 'low risk.'" Ms. Bair goes on to describe the process of asset measurement by comparing risk-weighted to "accounting-based" assets.

    CLASSROOM APPLICATION: The article may be used in a class when introducing fair value disclosures, accounting for derivatives, financial statement analysis for banking, or just the various asset valuation methods that may be used as identified in the U.S. FASB's or IASB's Conceptual Framework.

    QUESTIONS: 
    1. (Introductory) Who is Sheila Bair? What is Ms. Bair's concern with bank regulation and banks' capital ratios? In your answer, define the latter term.

    2. (Advanced) Define the contents of a bank's balance sheet: identify major assets, major liabilities, and the types of capital, or shareholders' equity you expect to see on a bank balance sheet.

    3. (Advanced) "On average, the three big universal banking companies (J.P. Morgan Chase, Bank of America and Citigroup) risk-weight their assets at only 55% of their total assets. For every trillion dollars in accounting assets, these megabanks calculate their capital ratio as if the assets represented only $550 billion of risk." How is it possible that total assets as reported in a bank balance sheet only contain risk representing a little more than half of their reported amounts?

    4. (Advanced) What are the different valuation methods that may be used for a bank's assets-in fact, for any company's assets? Cite authoritative literature from a conceptual framework discussing the use of these valuation methods and the types of assets for which they should be used.

    5. (Advanced) What are the three levels of determining fair values for which accounting standards require different types of disclosure? For which of these categories of assets is Ms. Bair concerned about bank's risk assessment? (Note that the bank regulatory capital requirements are different from the accounting disclosure requirements for assets reported at fair values.)

    6. (Advanced) Refer to the related article. Who was the London Whale and how did his and his manager's actions show that valuation models can be manipulated?

    7. (Advanced) Refer again to the London Whale. How do "capital regulations create incentives for even legitimate models to be manipulated," as stated by Ms. Bair?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    JP Morgan 'Whale' Report Signals Deeper Problem
    by Dan Fitzpatrick and Gregory Zuckerman
    Jul 14, 2012
    Online Exclusive

    "Regulators Let Big Banks Look Safer Than They Are," by Sheila Bair, The Wall Street Journal, April 2, 2013 ---
    http://online.wsj.com/article/SB10001424127887323415304578370703145206368.html?mod=djem_jiewr_AC_domainid

    The recent Senate report on the J.P. Morgan Chase JPM +0.21% "London Whale" trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios. Risk models are common and certainly not illegal. Nevertheless, their use in bolstering a bank's capital ratios can give the public a false sense of security about the stability of the nation's largest financial institutions.

    Capital ratios (also called capital adequacy ratios) reflect the percentage of a bank's assets that are funded with equity and are a key barometer of the institution's financial strength—they measure the bank's ability to absorb losses and still remain solvent. This should be a simple measure, but it isn't. That's because regulators allow banks to use a process called "risk weighting," which allows them to raise their capital ratios by characterizing the assets they hold as "low risk."

    For instance, as part of the Federal Reserve's recent stress test, the Bank of America BAC +0.33% reported to the Federal Reserve that its capital ratio is 11.4%. But that was a measure of the bank's common equity as a percentage of the assets it holds as weighted by their risk—which is much less than the value of these assets according to accounting rules. Take out the risk-weighting adjustment, and its capital ratio falls to 7.8%.

    On average, the three big universal banking companies (J.P. Morgan Chase, Bank of America and Citigroup C +0.75% ) risk-weight their assets at only 55% of their total assets. For every trillion dollars in accounting assets, these megabanks calculate their capital ratio as if the assets represented only $550 billion of risk.

    As we learned during the 2008 financial crisis, financial models can be unreliable. Their assumptions about the risk of steep declines in housing prices were fatally flawed, causing catastrophic drops in the value of mortgage-backed securities. And now the London Whale episode has shown how capital regulations create incentives for even legitimate models to be manipulated.

    According to the evidence compiled by the Senate Permanent Subcommittee on Investigations, the Chase staff was able to magically cut the risks of the Whale's trades in half. Of course, they also camouflaged the true dangers in those trades.

    The ease with which models can be manipulated results in wildly divergent risk-weightings among banks with similar portfolios. Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading—but not to determine the riskiness of good old-fashioned loans. The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans.

    Compare, for instance, the risk-based ratios of Morgan Stanley, MS 0.00% an investment bank that has struggled since the crisis, and U.S. Bancorp, USB 0.00% a traditional commercial lender that has been one of the industry's best performers. According to the Fed's latest stress test, Morgan Stanley reported a risk-based capital ratio of nearly 14%; take out the risk weighting and its ratio drops to 7%. USB has a risk-based ratio of about 9%, virtually the same as its ratio on a non-risk weighted basis.

    In the U.S. and most other countries, banks can also load up on their own country's government-backed debt and treat it as having zero risk. Many banks in distressed European nations have aggressively purchased their country's government debt to enhance their risk-based capital ratios.

    In addition, if a bank buys the debt of another bank, it only needs to include 20% of the accounting value of those holdings for determining its capital requirements—but it must include 100% of the value of bonds of a commercial issuer. The rules governing capital ratios treat Citibank's debt as having one-fifth the risk of IBM IBM -0.05% 's. In a financial system that is already far too interconnected, it defies reason that regulators give banks such strong capital incentives to invest in each other.

    Regulators need to use a simple, effective ratio as the main determinant of a bank's capital strength and go back to the drawing board on risk-weighting assets. It does make sense to look at the riskiness of banks' assets in determining the adequacy of its capital. But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.

    The main argument megabanks advance against a tough capital ratio is that it would force them to raise more capital and hurt the economic recovery. But the megabanks aren't doing much new lending. Since the crisis, they have piled up excess reserves and expanded their securities and derivatives positions—where they get a capital break—while loans, which are subject to tougher capital rules, have remained nearly flat.

    Continued in article

     


    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

     

    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!

    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."

    Jensen Comment
    One of my heroes is former Coopers partner and SEC Chief Accountant Lynn Turner. My two heroes, Turner and Partnoy, write about how bank financial statements should be classified under "Fiction."

    Frank Partnoy and Lynn Turner contend that 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 great video!

     

    Great Speeches About the State of Accountancy
    "20th Century Myths," by Lynn Turner when he was still Chief Accountant at the SEC in 1999 --- http://www.sec.gov/news/speech/speecharchive/1999/spch323.htm

    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

    From the Free Wall Street Journal Educators' Reviews for December 6, 2001 

    TITLE: Audits of Arthur Andersen Become Further Focus of Investigation 
    SEC REPORTER: Jonathan Weil 
    DATE: Nov 30, 2001 PAGE: A3 LINK: 
         http://interactive.wsj.com/archive/retrieve.cgi?id=SB1007059096430725120.djm
      
    TOPICS: Advanced Financial Accounting, Auditing

    SUMMARY: This article focuses on the issues facing Arthur Andersen now that their work on the Enron audit has become the subject of an SEC investigation. The on-line version of the article provides three questions that are attributed to "some accounting professors." The questions in this review expand on those three provided in the article.

    QUESTIONS: 
    1.) The first question the SEC might ask of Enron's auditors is "were financial statement disclosures regarding Enron's transactions too opaque to understand?" Are financial statement disclosures required to be understandable? To whom? Who is responsible for ensuring a certain level of understandability?

    2.) Another question that the SEC could consider is whether Andersen auditors were aware that certain off-balance-sheet partnerships should have been consolidated into Enron's balance sheet, as they were in the company's recent restatement. How could the auditors have been "unaware" that certain entities should have been consolidated? What is the SEC's concern with whether or not the auditors were aware of the need for consolidation?

    3.) A third question that the SEC could ask is, "Did Andersen auditors knowingly sign off on some 'immaterial' accounting violations, ignoring that they collectively distorted Enron's results?" Again, what is the SEC's concern with whether Andersen was aware of the collective impact of the accounting errors? Should Andersen have been aware of the collective amount of impact of these errors? What steps would you suggest in order to assess this issue?

    4.) The article finishes with a discussion of expected Congressional hearings into Enron's accounting practices and into the accounting and auditing standards setting process in general. What concern is there that the FASB "has been working on a project for more than a decade to tighten the rules governing when companies must consolidate certain off-balance sheet 'special purpose entities'"?

    5.) In general, how stringent are accounting and auditing requirements in the U.S. relative to other countries' standards? Are accounting standards in other countries set in the same way as in the U.S.? If not, who establishes standards? What incentives would the U.S. Congress have to establish a law-based system if they become convinced that our private sector standards setting practices are inadequate? Are you concerned about having accounting and reporting standards established by law?

    6.) The article describes revenue recognition practices at Enron that were based on "noncash unrealized gains." What standard allows, even requires, this practice? Why does the author state, "to date, the accounting standards board has given energy traders almost boundless latitude to value their energy contracts as they see fit"?

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

    From the Free Wall Street Journal Educators' Reviews for December 20, 2001

    TITLE: Enron Debacle Spurs Calls for Controls
    REPORTER: Michael Schroeder
    DATE: Dec 14, 2001
    PAGE: A4
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1008282666768929080.djm 
    TOPICS: Accounting Fraud, Accounting, Accounting Irregularities, Auditing, Auditing Services, Disclosure, Disclosure Requirements, Fraudulent Financial Reporting, Securities and Exchange Commission

    SUMMARY: In light of Enron's financial reporting irregularities and subsequent bankruptcy filing, Capitol Hill and the SEC are considering new measures aimed at improving financial reporting and oversight of accounting firms. Related articles discuss additional regulation that is being considered as a result of this reporting debacle.

    QUESTIONS:
    1.) Briefly describe Enron's questionable accounting practices. What accounting changes are being proposed in light of the Enron case? Certainly this is not the first incidence of questionable financial reporting. Why is the reaction to the Enron case so extreme?

    2.) Discuss Representative Paul Kanjorski's view of regulation of the accounting profession. What system of accounting regulation is currently in place? Discuss the advantages and disadvantages of both private-sector and public-sector regulation.

    3.) What changes are proposed in the related article, "The Enron Debacle Spotlights Huge Void in Financial Regulation?" Do these changes strictly relate to financial reporting issues? Are operational decisions or financial reporting decisions responsible for Enron's current financial position?

    4.) In the related article, "Enron May Spur Attention to Accounting at Funds," it is argued that fund managers will "start taking a more skeptical view of annual reports or footnotes . . . they don't understand." Are you surprised by this comment? Do you blame accounting for producing confusing financial reports or the fund managers for investing in companies with confusing financial reports?


    TITLE: Double Enron Role Played by Andersen Raises Questions 
    REPORTER: Michael Schroeder 
    DATE: Dec 14, 2001 
    PAGE: A4 LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1008289729306300000.djm  
    TOPICS: Accounting, Auditing, Auditing Services, Auditor Independence, Consulting, Internal Auditing

    SUMMARY: In addition to auditing Enron's financial statements, Arthur Andersen LLP also provided internal-auditing and consulting services to Enron. Providing additional services to Enron raises questions about Andersen's independence.

    QUESTIONS: 
    1.) What is independence-in-fact? What is independence-in-appearance? Did Andersen violate either independence-in-fact or independence-in-appearance? Why or why not?

    2.) If Enron had made good business decisions and had continued reporting positive financial results, would we be discussing Andersen's independence with respect to Enron? Why do we wait until something bad happens to become concerned?

    3.) Do you think providing internal auditing and consulting services gave Andersen a better understanding of Enron's business and operations? Should additional understanding of the business and operations enable Andersen to provide a "better" audit? What was wrong with Andersen providing consulting and internal-audit services to Enron?

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

    --- RELATED ARTICLES --- 
    TITLE: The Enron Debacle Spotlights Huge Void in Financial Regulation 
    REPORTERS: Michael Schroeder and Greg Ip 
    PAGE: A1 
    WSJ ISSUE: Dec 13, 2001 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1008202066979356000.djm 

    TITLE: When Bad Stocks Happen to Good Mutual Funds: Enron Could Spark New Attention to Accounting 
    REPORTER: Aaron Lucchetti 
    PAGE: C1 
    WSJ ISSUE: Dec 13, 2001 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1008196294985520800.djm 

     


    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 onethirtieth 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.

     

     

    Selected works of FRANK PARTNOY
    Bob Jensen at Trinity University

    1.  Who is Frank Partnoy?

    Cheryl Dunn requested that I do a review of my favorites among the “books that have influenced [my] work.”   Immediately the succession of FIASCO books by Frank Partnoy came to mind.  These particular books are not the best among related books by Wall Street whistle blowers such as Liar's Poker: Playing the Money Markets by Michael Lewis in 1999 and Monkey Business: Swinging Through the Wall Street Jungle by John Rolfe and Peter Troob in 2002.  But in1997.  Frank Partnoy was the first writer to open my eyes to the enormous gap between our assumed efficient and fair capital markets versus the “infectious greed” (Alan Greenspan’s term) that had overtaken these markets.

    Partnoy’s succession of FIASCO books, like those of Lewis and Rolfe/Troob are reality books written from the perspective of inside whistle blowers.  They are somewhat repetitive and anecdotal mainly from the perspective of what each author saw and interpreted. 

    My favorite among the capital market fraud books is Frank Partnoy’s latest book Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0- 477 pages).  This is the most scholarly of the books available on business and gatekeeper degeneracy.  Rather than relying mostly upon his own experiences, this book drawn from Partnoy’s interviews of over 150 capital markets insiders of one type or another.  It is more scholarly because it demonstrates Partnoy’s evolution of learning about extremely complex structured financing packages that were the instruments of crime by banks, investment banks, brokers, and securities dealers in the most venerable firms in the U.S. and other parts of the world.  The book is brilliant and has a detailed and helpful index.

     

    What did I learn most from Partnoy?

    I learned about the failures and complicity of what he terms “gatekeepers” whose fiduciary responsibility was to inoculate against “infectious greed.”  These gatekeepers instead manipulated their professions and their governments to aid and abet the criminals.  On Page 173 of Infectious Greed, he writes the following: 

    Page #173

    When Republicans captured the House of Representatives in November 1994--for the first time since the Eisenhower era--securities-litigation reform was assured.  In a January 1995 speech, Levitt outlined the limits on securities regulation that Congress later would support: limiting the statute-of-limitations period for filing lawsuits, restricting legal fees paid to lead plaintiffs, eliminating punitive-damages provisions from securities lawsuits, requiring plaintiffs to allege more clearly that a defendant acted with reckless intent, and exempting "forward looking statements"--essentially, projections about a company's future--from legal liability.

    The Private Securities Litigation Reform Act of 1995 passed easily, and Congress even overrode the veto of President Clinton, who either had a fleeting change of heart about financial markets or decided that trial lawyers were an even more important constituency than Wall Street.  In any event, Clinton and Levitt disagreed about the issue, although it wasn't fatal to Levitt, who would remain SEC chair for another five years.

     

    He later introduces Chapter 7 of Infectious Greed as follows:

    Pages 187-188

    The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

    Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

    Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

    Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

    But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.

     

    The book Infectious Greed has chapters on other capital markets and corporate scandals.  It is the best account that I’ve ever read about Bankers Trust the Bankers Trust scandals, including how one trader named Andy Krieger almost destroyed the entire money supply of New Zealand.  Chapter 10 is devoted to Enron and follows up on Frank Partnoy’s invited testimony before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

    The controversial writings of Frank Partnoy have had an enormous impact on my teaching and my research.  Although subsequent writers wrote somewhat more entertaining exposes, he was the one who first opened my eyes to what goes on behind the scenes in capital markets and investment banking.  Through his early writings, I discovered that there is an enormous gap between the efficient financial world that we assume in agency theory worshipped in academe versus the dark side of modern reality where you find the cleverest crooks out to steal money from widows and orphans in sophisticated ways where it is virtually impossible to get caught.  Because I read his 1997  book early on, the ensuing succession of enormous scandals in finance, accounting, and corporate governance weren’t really much of a surprise to me.

    From his insider perspective he reveals a world where our most respected firms in banking, market exchanges, and related financial institutions no longer care anything about fiduciary responsibility and professionalism in disgusting contrast to the honorable founders of those same firms motivated to serve rather than steal.

    Young men and women from top universities of the world abandoned almost all ethical principles while working in investment banks and other financial institutions in order to become not only rich but filthy rich at the expense of countless pension holders and small investors.  Partnoy opened my eyes to how easy it is to get around auditors and corporate boards by creating structured financial contracts that are incomprehensible and serve virtually no purpose other than to steal billions upon billions of dollars.

     

    Most importantly, Frank Partnoy opened my eyes to the psychology of greed.  Greed is rooted in opportunity and cultural relativism.  He graduated from college with a high sense of right and wrong.  But his standards and values sank to the criminal level of those when he entered the criminal world of investment banking.  The only difference between him and the crooks he worked with is that he could not quell his conscience while stealing from widows and orphans.

     

    Frank Partnoy has a rare combination of scholarship and experience in law, investment banking, and accounting.  He is sometimes criticized for not really understanding the complexities of some of the deals he described, but he rather freely admits that he was new to the game of complex deceptions in international structured financing crime.

    2.  What really happened at Enron? --- http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony 

     

    3.  What are some of Frank Partnoy’s best-known works?

    Frank Partnoy, FIASCO: Blood in the Water on Wall Street (W. W. Norton & Company, 1997, ISBN 0393046222, 252 pages). 

    This is the first of a somewhat repetitive succession of Partnoy’s “FIASCO” books that influenced my life.  The most important revelation from his insider’s perspective is that the most trusted firms on Wall Street and financial centers in other major cities in the U.S., that were once highly professional and trustworthy, excoriated the guts of integrity leaving a façade behind which crooks less violent than the Mafia but far more greedy took control in the roaring 1990s. 

    After selling a succession of phony derivatives deals while at Morgan Stanley, Partnoy blew the whistle in this book about a number of his employer’s shady and outright fraudulent deals sold in rigged markets using bait and switch tactics.  Customers, many of them pension fund investors for schools and municipal employees, were duped into complex and enormously risky deals that were billed as safe as the U.S. Treasury.

    His books have received mixed reviews, but I question some of the integrity of the reviewers from the investment banking industry who in some instances tried to whitewash some of the deals described by Partnoy.  His books have received a bit less praise than the book Liars Poker by Michael Lewis, but critics of Partnoy fail to give credit that Partnoy’s exposes preceded those of Lewis. 

    Frank Partnoy, FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance (Profile Books, 1998, 305 Pages)

    Like his earlier books, some investment bankers and literary dilettantes who reviewed this book were critical of Partnoy and claimed that he misrepresented some legitimate structured financings.  However, my reading of the reviewers is that they were trying to lend credence to highly questionable offshore deals documented by Partnoy.  Be that as it may, it would have helped if Partnoy had been a bit more explicit in some of his illustrations.

    Frank Partnoy, FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages). 

    This is a blistering indictment of the unregulated OTC market for derivative financial instruments and the million and billion dollar deals conceived in investment banking.  Among other things, Partnoy describes Morgan Stanley’s annual drunken skeet-shooting competition organized by a “gun-toting strip-joint connoisseur” former combat officer (fanatic) who loved the motto:  “When derivatives are outlawed only outlaws will have derivatives.”  At that event, derivatives salesmen were forced to shoot entrapped bunnies between the eyes on the pretense that the bunnies were just like “defenseless animals” that were Morgan Stanley’s customers to be shot down even if they might eventually “lose a billion dollars on derivatives.”
     
    This book has one of the best accounts of the “fiasco” caused almost entirely by the duping of Orange County ’s Treasurer (Robert Citron) by the unscrupulous Merrill Lynch derivatives salesman named Michael Stamenson. Orange County eventually lost over a billion dollars and was forced into bankruptcy.  Much of this was later recovered in court from Merrill Lynch.  Partnoy calls Citron and Stamenson “The Odd Couple,” which is also the title of Chapter 8 in the book.Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)

    Partnoy shows how corporations gradually increased financial risk and lost control over overly complex structured financing deals that obscured the losses and disguised frauds  pushed corporate officers and their boards into successive and ingenious deceptions." Major corporations such as Enron, Global Crossing, and WorldCom entered into enormous illegal corporate finance and accounting.  Partnoy documents the spread of this epidemic stage and provides some suggestions for restraining the disease.

    "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" by Frank Partnoy, Washington University Law Quarterly, Volume 77, No. 3, 1999 --- http://ls.wustl.edu/WULQ/ 
     

    4.  What are examples of related books that are somewhat more entertaining than Partnoy’s early books?

    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.

    John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)

    This is a hilarious tongue-in-cheek account by Wharton and Harvard MBAs who thought they were starting out as stock brokers for $200,000 a year until they realized that they were on the phones in a bucket shop selling sleazy IPOs to unsuspecting institutional investors who in turn passed them along to widows and orphans.  They write. "It took us another six months after that to realize that we were, in fact, selling crappy public offerings to investors."

    There are other books along a similar vein that may be more revealing and entertaining than the early books of Frank Partnoy, but he was one of the first, if not the first, in the roaring 1990s to reveal the high crime taking place behind the concrete and glass of Wall Street.  He was the first to anticipate many of the scandals that soon followed.  And his testimony before the U.S. Senate is the best concise account of the crime that transpired at Enron.  He lays the blame clearly at the feet of government officials (read that Wendy Gramm) who sold the farm when they deregulated the energy markets and opened the doors to unregulated OTC derivatives trading in energy.  That is when Enron really began bilking the public.

    Some of the many, many lawsuits settled by auditing firms can be found at http://faculty.trinity.edu/rjensen/Fraud001.htm
     

     

     

     

    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

    Here's a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don't want to raise contributions. Cutting benefits is out of the question. To be honest, you'd really rather not even admit there's a problem, lest taxpayers get upset.

    What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that's the essence of the managers' recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn't bother applying.

    Public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

    The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized. Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That's nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it's likely these gargantuan shortfalls will have to be borne by unsuspecting taxpayers.

    Some public pension administrators have a strategy, though: Keep taxpayers unsuspecting. The Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System declare in a recent solicitation for actuarial services that "If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration."

    Scott Miller, legal counsel of the Montana Public Employees Board, was more straightforward: "The point is we aren't interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory."

    While corporate pension funds are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, public employee pensions are not. However, financial economists are united in believing that market-based techniques for valuing private sector investments should also be applied to public pensions.

    Because the power of compound interest is so strong, discounting future benefit costs using a pension plan's high expected return rather than a low riskless return can significantly reduce the plan's measured funding shortfall. But it does so only by ignoring risk. The expected return implies only the "expectation" -- meaning, at least a 50% chance, not a guarantee -- that the plan's assets will be sufficient to meet its liabilities. But when future benefits are considered to be riskless by plan participants and have been ruled to be so by state courts, a 51% chance that the returns will actually be there when they are needed hardly constitutes full funding.

    Public pension administrators argue that government plans fundamentally differ from private sector pensions, since the government cannot go out of business. Even so, the only true advantage public pensions have over private plans is the ability to raise taxes. But as the Congressional Budget Office has pointed out in 2004, "The government does not have a capacity to bear risk on its own" -- rather, government merely redistributes risk between taxpayers and beneficiaries, present and future.

    Market valuation makes the costs of these potential tax increases explicit, while the public pension administrators' approach, which obscures the possibility that the investment returns won't achieve their goals, leaves taxpayers in the dark.

    For these reasons, the Public Interest Committee of the American Academy of Actuaries recently stated, "it is in the public interest for retirement plans to disclose consistent measures of the economic value of plan assets and liabilities in order to provide the benefits promised by plan sponsors."

    Nevertheless, the National Association of State Retirement Administrators, an umbrella group representing government employee pension funds, effectively wants other public plans to take the same low road that the two Montana plans want to take. It argues against reporting the market valuation of pension shortfalls. But the association's objections seem less against market valuation itself than against the fact that higher reported underfunding "could encourage public sector plan sponsors to abandon their traditional pension plans in lieu of defined contribution plans."

    The Government Accounting Standards Board, which sets guidelines for public pension reporting, does not currently call for reporting the market value of public pension liabilities. The board announced last year a review of its position regarding market valuation but says the review may not be completed until 2013.

    This is too long for state taxpayers to wait to find out how many trillions they owe.

    A Sickening Lobbying Effort for Off-Balance-Sheet Financing in IFRS
    The International Accounting Standards Board is working quickly to produce some updated and clarified guidance on how to account for financial assets and liabilities. The financial meltdown renewed attention on this matter, as well as the use of special-purpose entities to hold financial assets, a device that generally gets them off balance sheets. There is still disagreement on how big of a role off-balance-sheet accounting played in starting the financial crisis, but banks appear to be against changes that would bring about greater disclosure of assets and liabilities.
    Peter Williams, "Peter Williams Accounting: Off balance – the future of off-balance sheet transactions," Personal Computer World, July 3, 2009 --- http://www.pcw.co.uk/financial-director/comment/2245360/balance-4729409

    Bob Jensen's threads about fraud in government are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

    Bob Jensen's threads about fraud in government are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers


    "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

  • Bob Jensen's threads about audit professionalism --- http://faculty.trinity.edu/rjensen/Fraud001.htm#Professionalism


    "The Lease Accounting Proposal: What Investors Say," by Tom Selling, The Accounting Onion, September 18, 2009 ---
    http://accountingonion.typepad.com/theaccountingonion/2009/09/the-lease-accounting-proposal-what-investors-say.html

    In this post, I'll be reviewing two comment letters submitted to the FASB in response to its Discussion Paper (DP) on lease accounting* by the Investors Technical Advisory Committee (ITAC) of the FASB, and the CFA Institute Centre for Financial Market Integrity (CFA).   My original comments are here

    The lease accounting project is a strong test of the proposition that accounting standards are capable of cutting through the camouflage of legal form to get at the underlying economics of an arrangement. In that respect, FAS 13 has been a dismal failure, with untold amounts of shareholder value being destroyed by management machinations aiming to exploit complex accounting loopholes and bright line rules lacking no conceptual basis.

    Almost any new standard will be a significant improvement over FAS 13, so one of the dangers we face is setting the bar too low. For example, since FAS 13 was promulgated over 30 years ago, the field of financial management has progressed well beyond the point where precise measurement of lease value drivers is on the frontier of our knowledge. I'm not just talking about academic theorizing, either. According to the book, Real Options: A Practitioner's Guide, economic valuation of complex lease terms was first undertaken by executives at Airbus, who needed to know the true cost of the flexibility they were writing into their leases to accommodate their customers' risk preferences. That was over twenty years ago! I'm certainly don't consider myself to be at the cutting edge of financial modeling, but give me about a week, and I should be able to write a spreadsheet to value leased assets and lease obligations that can capture 100% of a lease's complexity for more than 90% of the leases out there.

    So, given the state of the art of leasing and finance, we should be expecting a lot more from the FASB than the usual medley of incremental piecemeal improvements they are proposing. We should not just expect that: (1) the assets and liabilities arising from leasing arrangements are appropriately measured on the balance sheet; but (2) that they should also be appropriately measured. As I will be describing, below, ITAC and CFA are pressing for (1), but are aiming far too low on (2). Ironically, given the prominence and reputation for integrity of ITAC and CFA groups, one thing that you can take to the bank is that their positions will be regarded as the upper bound on the concessions to investors that will come out of the final standard. Thus, the most to be had is recognition of leases on the balance sheet; but they will be reported as arbitrary numbers based on calculations that hearken back to the relative stone ages of financial management.

    I'll now discuss some of the specific issues starting with the ones I have the least qualms about, and ending with the stuff that gets my goat.

    Overall Approach to Lease Accounting

    The DP proposes to eliminate operating lease accounting, with the exception of "non-core" and short-term leases. While both ITAC and CFA strongly support the elimination of operating lease accounting, they are both against the notion of a "non-core leases" category. Nobody would ever expect that lease capitalization would have to be applied to immaterial items; but whatever "non-core" is supposed to mean, it doesn't always correspond to "immaterial." It's a ridiculously silly notion, but I'll nonetheless award points to both groups for pointing that out—much more tactfully than I would be capable of doing.

    ITAC further adds that exempting short-term leases would be an open invitation to gaming, which surely must have been obvious to the FASB but somebody needed to mention it.

    Scope of a Forthcoming Standard

    Without calling out the FASB for the real reason that lessor accounting issues were deferred, CFA reluctantly accepts the FASB's decision to defer consideration of lessor accounting. The real reason for the limited scope goes something like this: 'We're already taking too much heat from financial institutions on loan accounting, so let's not mess with them any more than we have to.' ITAC, for my tastes, is being too conciliatory (perhaps trying to rebuild the bridges it has burned on IFRS and fair value?) when they state that they are content for now to focus on lessee accounting.

    My own two cents — If there is any area in which balance sheet accounting standards can (and should be) symmetrical, leasing is it. If the FASB is serious about its commitment to an asset/liability view of recognition and measurement, then the only real revenue recognition issue in leasing is nothing more than how to present changes in lease-related assets and liabilities on the income statement. I would not object to deferral of income statement presentation issues from the scope of the next major accounting standard on leases, but I'm disappointed that ITAC and CFA are not exhorting the FASB to get everyone's balance sheet right. Let the big boy lessors present their income statement any old way they want; and let's require detailed roll-forward disclosures of the changes in the balance sheet amounts.


     

    Measurement

    Everything I have written to this point has been little more than caviling, compared to my consternation on the groups' positions regarding measurement. CFA states that discounting at the incremental borrowing rate would yield a reasonable approximation of fair value, even when there is "significant uncertainty." That's the great unsupported statement of their comment letter—probably because no support is possible.

    In the years since FAS 13, alternatives to discounted cash flow (DCF) analysis have been sought and developed because one eventually had to acknowledge a truth that is exactly the opposite of what CFA claims to believe: the truth is that picking the discount rate to value contingent cash flows, and coming up with a reliable measure of the fair value** of those cash flows, is nothing more than a guessing game. Ad hoc adaptations of discounted cash flow DCF modeling to option-ladened arrangements is so yesterday. That the FASB proposes to go back to the stone ages of financial theory is less surprising to me than learning that both CFA and ITAC are cool with their doing it.

    Here's a much more robust way to think about lease valuation. There are three categories of cash flows in leasing arrangements: (1) the unconditional rental payments to be made, (2) required payments whose amount is determined by reference to uncertain future events, and (3) optional payments. We should require that a preparer document and disaggregate the fair value of their leases by each of these components. This can only mean that options must be valued using option pricing models—i.e., nails should be driven with a hammer. Yes, not all of the cash flow elements of a lease are mutually exclusive, but modern valuation models take care of that. Disaggregation in disclosure of interrelated items is challenging, but reasonable assumptions can be made and disclosed.

    As to separate measurement of options, the FASB suggests, and both CFA and ITAC don't object to, a version of DCF that truncates the expected cash flows at the "most likely lease term." Given the financial technology nearly everyone has at their disposal, it's a ludicrous suggestion. Therefore, I expect it will be embraced universally by issuers. That alone should cause CFA and ITAC to question their judgment in this regard.

    ITAC supports the most likely lease term rule of thumb (incredibly, they elevate it to "principle" status in their comments), because it seems that everybody should be able to do it. So, not only are they proposing to pound nails with rocks instead of hammers, they don't think it's worth the effort to drive the nail flush. Who are we writing standards for? FASB ought to be thinking first of the Fortune 500, because that's the bulk of the U.S. economy. Simplistic models to accommodate smaller companies no longer make sense from a cost-benefit perspective.

    CFA states that one reason they support the expected lease term approach is out of expediency: "…an acceptable alternative in the interim until the use of fair value for non-financial assets is addressed by standard setters." And when will fair value for non-financial assets be addressed by standard setters? Given the glacial pace of standard setting, and the priorities that standard setters seem to have set for themselves, I'm giving even money that we won't have a general standard on that for at least another 20 years; and 2:1 odds that it won't happen before hell freezes over.  Is that really how long the CFA is willing to wait.

    The bottom line on the measurement issue is that if the FASB requires some ad hoc discounted cash flow model for measuring leases on financial statements, then one of two things are going to happen: either companies will have to measure leases twice – the approach they use for internal decision-making, and again with the FASB's stone age approach – or companies will throw out the approach they use for internal decision making and base their decision entirely on how a lease will be portrayed in the financial statements. Neither alternative should be acceptable to CFA or ITAC.

    And that brings me to my bottom line on the CFA and ITAC comment letters. Both groups are legitimately concerned about the quality of information that investors will get from a new lease accounting standard, and they evidently believe that getting leases on the balance sheet at any number is as much as they dare hope for without rocking the boat too much. However, both groups virtually ignore the potentially huge value that investors will realize if the new leasing standard leads to better decision making by managers. Assets that should be leased will be leased, and assets that should be bought will be bought. That can only be fully realized if lease accounting gets both recognition and measurement as right as it can be. CFA and ITAC need to hold the FASB's feet to the fire, because nobody will do it for them.

    Finally, here's my message for the FASB. Elimination of operating lease accounting is a good thing; it will certainly cut into the book of business of financial engineers and lawyers who accomplish little else than meeting management's financial reporting objectives by skirting the edges of the bright lines. But, if you choose to catapult lease measurement back to the stone ages, all you will accomplish is inviting those same advisors to adapt to a new game at shareholders' expense. You will not be pleased to eventually discover that, once again and forevermore, you will find yourself chasing your own tail to issue fresh interpretations of unprincipled rules to stop some of more egregious ploys; and worse, you will be pressured to issue new interpretations to widen some of the inherent loopholes in stone age valuation. In the process, your policy choices will surely destroy value for shareholders (although you will strenuously deny it).

    Alternatively, you can craft a principled and perforce simple standard requiring economic valuation of leases. There will be some work to do in specifying the objectives of the measurement process, but you will actually be able to afford flexibility in the choice of models and parameter selection. If you do that, some managers will pay consultants, but it will be for honest advice from valuation experts; they could also eschew professional advice and negotiate less complex lease terms that they can understand and value straightforwardly.  Honest advice is geared toward discovering the underlying economics of an arrangement, and it will cost a small fraction of the FAS 13-style advice. In the process of all this, your policy choices will create value for shareholders.  

    But, don't just take my word for this. Credit Suisse analysts recently issued a report entitled, What if All Financial Instruments Were at Fair Value?" [I can't find it on the web, so I don't dare post a link to my own electronic copy] In it, I discovered a refreshing message that I hope ITAC, CFA and FASB will take to heart:

    "With companies paying more attention to the fair values of their financial instruments, behavior could change. The controls that would need to be put in place and the due diligence involved could force companies to better understand their assets and liabilities. If that were to result in better management, companies could be rewarded with a lower cost of capital." [emphasis supplied]

     

    Shalom, and L'shana Tovah (Happy New Year!)

    -------------------------------

    *The IASB also has a DP out on the topic that is about 90% similar to the FASB's. So for simplicity, I just refer to the FASB's version from here on out.

    **I am an ardent supporter of replacement cost measurements, especially for leases. For example, I haven't the slightest idea how the FASB is going to come up with an exit price concept for non-transferable leases. But, to avoid distractions from other points, I am going to presume solely for the sake of sidestepping this issue that all leases are transferable. It doesn't cause replacement cost and fair value to converge, but it gets us close enough for my purposes in this post.

    September 18, 2009 reply from Bob Jensen

    Hi Tom,

    Readers that want to dig more into the history of Real Options, Option Pricing Theory, and Arbitrage Pricing Theory --- http://faculty.trinity.edu/rjensen/realopt.htm

    I appreciate your heads up on the Copeland and Anticarov book. Tom Copeland is one of my favorite textbook writers.

    Bob Jensen

    Bob Jensen's threads on off-balance sheet financing are at
    http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2


    Don't toss hedge accounting just because it's complicated

    I have trouble with Tom’s argument to toss out hedge accounting in FAS 133 and IAS 39 --- Click Here
     
    http://accountingonion.typepad.com/theaccountingonion/2009/06/regulate-derivatives-start-with-better-accounting.html

    It’s foolish not to book and maintain derivatives at fair value since in the 1980s and early 1990s derivatives were becoming the primary means of off-balance-sheet financing with enormous risks unreported financial risks, especially interest rate swaps and forward contracts and written options. Purchased options were less of a problem since risk was capped.

    Tom’s argument for maintaining derivatives at fair value even if they are hedges is not a problem if the hedged items are booked and maintained at fair value such as when a company enters into a forward contracts to hedge its inventories of precious metals.

    But Tom and I part company when the hedged item is not even booked, which is the case for the majority of hedging contracts. Accounting tradition for the most part does not hedge forecasted transactions such as plans to purchase a million gallons of jet fuel in 18 months or plans to sell $10 million notionals in bonds three months from now. Hedged items cannot be carried on the balance sheet at fair value if they are not even booked. And there is good reason why we do not want purchase contracts and forecasted transactions booked. Reason number 1 is that we do not want to book executory contracts and forecasted transactions that are easily broken for zero or at most a nominal penalties relative to the notionals involved. For example, when Dow Jones contracted to buy newsprint (paper) from St Regis Paper Company for the next 20 years, some trees to be used for the paper were not yet planted. If Dow Jones should break the contract, the penalty damages might be less than one percent of the value of a completed transaction.

    Now suppose Southwest Airlines has a forecasted transaction (not even a contract) to purchase a million gallons of jet fuel in 18 months. Since it has cash flow risk, it enters into a derivative contract (usually purchased option in the case of Southwest) to hedge the unknown fuel price of this forecasted transaction. FAS 133 and IAS 39 require the booking of the derivative as a cash flow hedge and maintaining it at fair value. The hedged item is not booked. Hence, the impact on earnings for changes in the value would be asymmetrical unless the changes in value of the derivative were “deferred” in OCI as permitted as “hedge accounting” under FAS 133 and IAS 39.

    If there were no “hedge accounting,” Southwest Airlines would be greatly punished for hedging cash flow by having to report possibly huge variations in earnings at least quarterly when in fact there is no cash flow risk because of the hedge. Reported interim earnings would be much more stable if Southwest did not hedge cash flow risk. But not hedging cash flow risk due to financial reporting penalties is highly problematic. Economic and accounting hit head on for no good reason, and this collision was avoided by FAS 133 and IAS 39.

    Since the majority of hedging transactions are designed to hedge cash flow or fair value risk, it makes no sense to me to punish companies for hedging and encouraging them to instead speculate in forecasted transactions and firm commitments (unbooked purchase contracts at fixed prices).

    The FASB originally, when the FAS 133 project was commenced, wanted to book all derivative contracts and maintain them at fair value with no alternatives for hedge accounting. FAS 133 would’ve been about 20 pages long and simple to implement. But companies that hedge voiced huge and very well-reasoned objections. The forced FAS 133 and its amending standards to be over 2,000 pages and hellishly complicated.

    But this is one instance where hellish complications are essential in my viewpoint. We should not make the mistake of tossing out hedge accounting because the standards are complicated. There are some ways to simplify the standards, but hedge accounting standards cannot be as simple as most other standards. The reason is that there are thousands of different types of hedging contracts, and a simple baby formula for nutrition just will not suffice in the case of all these types of hedging contracts.

    Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    June 29, 2009 reply from Tom Selling [tom.selling@GROVESITE.COM]

    First, I picked my OilCo example because it was also accounted for as a ‘hedge’ of an anticipated transaction—just like your Southwest example. I hope you agree that OilCo was speculating. As to Southwest, you say that Southwest was hedging, but I say they were speculating. If fuel prices had gone south instead of north, Southwest would have been at a severe cost disadvantage against the airlines that did not buy their fuel forward (and they would have become a case study of failure instead of success). In essence, the forward contracts leveraged their profits and cash flows. That’s not hedging, it’s speculating.

    FAS 133 has been an abject failure, as have all other ‘special hedge accounting’ solutions that came before it. There will always be some sort of mismatch between accounting and underlying economics, but ‘special hedge accounting’ is not the way to mitigate that. You say that some companies would have been unfairly penalized by entering into hedges without hedge accounting. I say, with current events providing evidence, that much more value was destroyed because special hedge accounting provided cover for inappropriate speculation. To managers, it has been all about keeping risks off the balance sheet and earnings stable; reducing (transferring) economic risks that shareholders may be exposed to is an afterthought. And, besides, most of the time shareholders can reduce their risks by diversification. As we have seen the hard way, transaction risk reduction (what FAS 133 requires) can be more than offset by increases in enterprise risk. On a global scale, FAS 133 (and IAS 39) has done much more to enable managers to use derivatives as instruments of mass economic destruction than help them manage economic risks. And of course, instead of 2000 pages of guidance (and the huge costs that go along with it), we’d have 20 pages.

    Although I did not mention it in my blog post, I could be reluctantly persuaded to allow hedge accounting for foreign currency forwards, but that’s as far as I would go.

    Best,
    Tom

    June 30, 2009 reply from Bob Jensen

    Hi Tom,

    Southwest Airlines was hedging and not speculating when they purchased options to hedge jet fuel prices. If prices went down, all they lost was the relatively small price of the options (actually there were a few times when the options prices became too high and Southwest instead elected to speculate). If prices went up, Southwest could buy fuel at the strike price rather than the higher fuel prices. If Southwest had instead hedged with futures, forward, or swap derivative contracts, it is a bit more like speculation in that if prices decline Southwest takes an opportunity loss on the price declines, but opportunity losses do not entail writing checks from the bank account quite the same as real losses from unhedged price increases.

    In any case, Southwest's only possible loss was the premium paid for the purchase options and did not quite have the same unbounded opportunity losses as with futures, forwards, and swaps. In reality, companies that manage risks with futures, forwards, and swaps generally do not have unbounded risk due to other hedging positions.

    What you are really arguing is that accounting for most derivatives should not distinguish “asymmetric-booking” hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors. I do not think FAS 133 is an "abject failure." Quite to the contrary (except in the case of credit derivatives)!

    I have to say I disagree entirely about “derivatives” being the cause of misleading financial reporting. The current economic crisis was heavily caused by AIG’s credit derivatives that were essentially undercapitalized insurance contracts. Credit derivatives should’ve been regulated like insurance contracts and not FAS 133 derivatives. Credit derivatives should never have been scoped into FAS 133.

    The issue in your post concerns derivatives apart from credit derivatives, derivatives that are so very popular in managing financial risk, especially commodity price risk and interest rate fluctuation risk. Before FAS 119 and FAS 133 it was the wild west of off-balance sheet financing with undisclosed swaps and forward contracts, although we did have better accounting for futures contracts because they clear for cash each day. Scandals were soaring, in large measure, due to failure of the FASB to monitor the explosion in derivatives frauds. Arthur Levitt once told the Chairman of the FASB that the FASB’s three biggest problems, before FAS 133, were 1-derivatives, 2-derivatives, and 3-derivatives --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

    When you respond to my post please take up the issue of purchase contracts and non-contracted forecasted transactions since these account for the overwhelming majority of “asymmetric-booking” derivatives contracts hedges being reported today. Then show me how booking changes in value of a hedging contract as current earnings makes sense when the changes in value of the hedged item are not, and should not, be booked.

    Then show me how this asymmetric-booking reporting of changes in value of a hedging contract not offset in current earnings by changes in the value of the item it hedges provides meaningful information to investors, especially since the majority of such hedging contracts are carried to maturity and all the interim changes in their value are never realized in cash.

    Show me why this asymmetric-booking of changes in value of hedging contracts versus non-reporting of offsetting changes in the value of the unbooked hedged item benefits investors. Show me how the failure to distinguish earnings changes from derivative contract speculations from earnings changes from derivative hedging benefits investors.

    What you are really arguing is that accounting for such derivatives should not distinguish hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors.

    Derivative contracts are now the most popular vehicles for managing risk. They are extremely important for managing risk. I think FAS 133 and IAS 39 can be improved, but failure to distinguish hedging derivative contracts from speculations in terms of the booking of value changes of these derivatives will be an enormous loss to users of financial statements.

    The biggest complaint I get from academe is that professors mostly just don’t understand FAS 133 and IAS 39. I think this says more about professors than it does about the accounting. In fairness, to understand these two standards accounting professors have to learn a lot more about finance than they ever wanted to know. For example, they have to learn about contango swaps and other forms of relatively complex hedging contracts used in financial risk management.

    Finance professors, in turn, have to learn a whole lot more about accounting than they ever wanted to know. For example, they have to learn the rationale behind not booking purchase contracts and the issue of damage settlements that may run close to 100% of notionals for executed contracts and less than 1% of notionals for executory purchase contracts. And hedged forecasted transactions that are not even written into contracts are other unbooked balls of wax that can be hedged.

    There may be a better way to distinguish earnings changes arising from speculation derivative contracts versus hedging derivative contracts, but the FAS 133 approach at the moment is the best I can think of until you have that “aha” moment that will render FAS 133 hedge accounting meaningless.

    I anxiously await your “aha” moment Tom as long as you distinguish booked from unbooked hedged items.

    Bob Jensen

    June 30 and July 31, 2009 replies by Tom Selling and BOB JENSEN

    Hi, Bob:

    All of my responses you will be in italics, below.

    Tom Selling


    Bob Jensen
    What you are really arguing is that accounting for most derivatives should not distinguish “asymmetric-booking” hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors. I do not think FAS 133 is an “abject failure.” Quite to the contrary (except in the case of credit derivatives).

    Tom Selling
    What is your evidence that failure to distinguish between hedging and speculation is misleading to investors?  My own anecdotal evidence is that investors reverse engineer the effect of hedge accounting, to the extent they can, on reported income by transferring hedging gains and losses from OCI to net income. That's because investors believe that management is hedging its bonuses and not shareholder value.

    Bob Jensen  
    My evidence is that millions of sole proprietorships extensively hedge prices and interest rates, including a huge proportion of farmers in the United States. Sole proprietors constitute the depth of derivatives markets.

    a sole proprietor has no disconnect between shareholder value and his/her compensation. and yet sole proprietors hedge all the time. many often speculate as well, but there is a huge difference in the financial risk between hedging and speculating (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION).

    a sole proprietor has access to all accounting records of the business. investors do not have access and rely on accountants and auditors to keep them informed according to gaap.

    and what’s to say that there’s always a disconnect between matching compensation versus shareholder value? sure there are lots of instances where managers have taken advantage of agency powers, but if this were true of virtually all corporations there would no longer be outside passive investors in corporations. you can fool some of the people some of the time, but not all the investors all of the time.

    a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

    if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WANTING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133.

    I AM NOT SO CYNICAL ABOUT MOST MANAGERS. IF YOU’RE CORRECT, FINANCIAL MARKETS WILL COLLAPSE.

    Fas 133 is wonderful in that it allows the balance sheet to carry derivatives and current fair value and keeps the changes in value out of current earnings if changes in hedged item booked value cannot be used to offset the one-sided, ASYMMETRICAL changes in derivative value caused by not booking the hedged items.

    YOU SEEM TO AVOID THE FOLLOWING WEAKNESS IN YOUR ARGUMENT:
    your argument has a huge inconsistency. there is no change in current earnings for effective hedges of booked items MAINTAINED AT FAIR VALUE. but if the hedged items are not booked, the change in current earnings can be enormous simply because the perfectly offsetting change in value of the hedged item is not booked. somehow this inconsistency does not seem to bother you.

    IN FACT, WHEN ACCOUNTING FOR HISTORICAL COST INVENTORIES THAT HAVE A FAIR VALUE HEDGE, FAS 133 REQUIRES THAT, DURING THE HEDGING PERIOD, WE DEPART FROM HISTORICAL COST ACCOUNTING SO THAT FAIR VALUE CHANGES OF THE INVENTORY CAN OFFSET FAIR VALUE CHANGES IN THE HEDGING DERIVATIVE. THIS IS NOT POSSIBLE, HOWEVER, WHEN THE HEDGED ITEMS ARE NOT BOOKED SUCH AS IN THE CASE OF FORECASTED TRANSACTIONS THAT ARE HEDGED ITEMS.

    some of your claims that hedging is speculation would make finance professors shake their heads BECAUSE THEY HAVE A MORE PRECISE DEFINITION OF SPECULATION VERSUS HEDGING. Please examine the spreadsheet that i use in my hedge accounting workshops. the spreadsheet is called “hedges” in the graphing.xls workbook at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

    Tom Selling
    As for symmetric versus asymmetric booking, the FAS 133 solution (fair value hedging) is to completely screw up the balance sheet by recording inconsistent amounts based on ridiculous hypotheticals.  I am a balance sheet guy: get the balance sheet as right as possible at a reasonable cost; derive accounting income from selected changes in assets and liabilities. 

    bob jensen
    i don’t understand your argument. all derivatives scoped into fas 133 are carried on the balance sheet at fair value whether or not the hedged items are booked.

    nOTHING IS being “screwed up” on the balance sheet!

    the debate between us concerns the income statement impacts of hedging versus speculating.


    Bob Jensen
    I have to say I disagree entirely about “derivatives” being the cause of misleading financial reporting. The current economic crisis was heavily caused by AIG’s credit derivatives that were essentially undercapitalized insurance contracts. Credit derivatives should’ve been regulated like insurance contracts and not FAS 133 derivatives. Credit derivatives should never have been scoped into FAS 133.

    Tom Selling
    You will never end up with a coherent set of accounting rules that are based on distinctions such as hedging versus speculation, or even hedging versus insurance.  Getting back to the example of Southwest Airlines, the fact that they used options to manage their future fuel costs when they thought that options were "cheap" enough just reinforces my view that they were speculating, and they happened to end up being a winner.  Perhaps, in contrast to other airlines, Southwest had some free cash flow that they could use to speculate because they were able to engineer for themselves a lower cost structure than their competitor.  But, that doesn't change my view they were speculating. Try this example: if I were to incessantly fiddle with the amount of flood insurance on my house based on long-range weather forecasts, that, too, would be speculating-- notwithstanding the fact that the contract I am doing it with is nominally an 'insurance contract.'

    Bob Jensen
    i would not accept this argument from a sophomore tom. the issue of hedging is often to lock in a price today rather than speculate on what the price will be in the future. that’s “hedging” of cash flow! IT IS NOT SPECULATION as defined in finance textbooks
    (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION).

    you are trying to CONFUSE the definition of cash flow “speculation.” cash flow speculation in derivatives means that by definition you have unknown cash flows due to FUTURE price or rate changes.

    in contrast, cash flow hedging means locking in a price or rate. you are not distinguishing between locking in a contracted price versus speculating on a future priceS.

    if you have no cash flow risk you MUST have value risk. such is life!
    fas 133 makes it very clear that if you have no cash flow risk, you MUST LIVE WITH value risk. and if you have no value risk, you have cash flow risk. rules for hedge accounting exist for both types of hedging in fas 133.

    I KNOW YOU LIKE TO THINK THAT A LOCKED IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT THIS IS NOT HOW "SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING DEFINITIONS FOR "LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE SPECULATION" WILL ADD MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE FINANCE DEFINITIONS OF A CASH FLOW "HEDGE" VERSUS "SPECULATION,"

    i think what you are really confusing in your argument is the distinction between cash flow risk and value risk. These two financial risks are more certain than love and marriage. you must have one (type of risk) without the other (type of risk). and the fas 133 rules are different for hedges of value versus hedges of cash flow.

    Tom Selling
    In short, where you see derivatives and insurance contracts, I only see contracts whose ultimate consequences are contingent on uncertain future events.   They should all be fair value with changes going to earnings.   

    Bob Jensen
    there’s a huge difference between hedging and insurance.
    insurance companies charge to spread risk. for example, SUPPOSE an insurance company sells hail insurance in iowa, it’s ACTUARILY "certain" that all crops in iowa will not be destRoyed by hail in one summer. but we can’t be certain what small pockets of iowa farmers will have their crops destroyed BY HAIL. hence most iowa farmers buy hail insurance, thereby spreading the risk among those who will and those who won’t have hail damage TO CROPS IN IOWA. insurance companies are required by law to have sufficient capital to pay all claims under actuarial probabilities OF HAIL LOSSES.

    however, when an iowa farmer buys an option in april that locks in the price of his corn crop in THE october HARVEST, this is not spreading the risk among all iowa farmers. perhaps he buys the option directly from his neighbor who decides to speculate on the price of october corn and get an option premium to boot. this is a cash flow risk transfer but is not the same as spreading the risk of hail damage among all iowa farmers

    there’s a huge difference between insurance and hedging contracts in that virtually all insurance contracts rely on actuarial science. life expectancy, hail, fire, wind, floods can be estimated with much greater scientific precision than the price of oil 18 months into the future. actuarial estimation is not without error, but actuaries won’t touch commodity pricing  and interest rate pricing where historical extrapolations are virtually impossible.

    One reason private insurance companies CAN sell hail insurance and not flood insurance to iowa farmers is that highland farmers are almost assured of not having floods but no farmer in iowa is assured of not having hail damage.

     without forcing all iowa farmers to buy flood insurance. the government had to put taxpayer money into flood coverage of lowlanders. this was not the case of FOR hail, FIRE, AND WIND DAMAGE risk.

    one reason private insurance companies would not sell earthquake insurance is that actuary science for earthquakes is lousy. we can predict where earthquakes are likely to hit, but science is extremely unreliable when it comes to predicting what century.

    fas 133 does recognize that there are many similarities between insurance and hedging in some context. these are discussed in paragraph 283 of fas 133. BUT THE DEFINITIONS OF INSURANCE VERSUS HEDGING ARE QUITE different IN FAS 133.

    ONE PLACE THE FASB SCREWED UP in fas 133 IS IN NOT RECOGNIZING THAT CREDIT DERIVATIVES ARE MORE LIKE INSURANCE THAN commodity HEDGING. not making aig have capital reserves for credit derivatives was a huge, huge mistake. those cash reserves most likely would not have covered the subprime mortgage implosion that destroyed value of almost all cdo bonds, but at least there would have been some capital backing and some regulation of wild west credit derivatives of aig.


    Bob Jensen
    The issue in your post concerns derivatives apart from credit derivatives, derivatives that are so very popular in managing financial risk, especially commodity price risk and interest rate fluctuation risk. Before FAS 119 and FAS 133 it was the wild west of off-balance sheet financing with undisclosed swaps and forward contracts, although we did have better accounting for futures contracts because they clear for cash each day. Scandals were soaring, in large measure, due to failure of the FASB to monitor the explosion in derivatives frauds. Arthur Levitt once told the Chairman of the FASB that the FASB’s three biggest problems, before FAS 133, were 1-derivatives, 2-derivatives, and 3-derivatives --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

    Tom Selling
    The way I see the basic problem that FAS 133 did fix was to require fair value for all contracts within its scope.   Prior to that, a $10 billion interest rate swap could stay off the balance sheet no matter how far interest rates strayed.  As you pointed out in a previous e-mail, the hedge accounting provisions in FAS 133 were a concession to special interests.  I could be wrong, but I don't recall a single investor group pounding the table and insisting that there be 2000 pages of rules to permit managers to smooth their income. 

    Bob Jensen
    ACTUALLY THE FASB INITIALLY DID NOT WANT TO MAKE ANY EARNINGS IMPACT CONCESSIONS FOR HEDGE ACCOUNTING. THE ORIGINAL FASB THOUGHT WAS TO DO JUST AS YOU SAY AND BOOK ALL DERIVATIVES AT FAIR VALUE WITHOUT 2,000 PAGES OF ADDED HEDGE ACCOUNTING RULES.

    THE HEDGE ACCOUNTING RULES CAME ABOUT BECAUSE COMPANIES JUMPED ON THE FASB FOR “PUNISHING” HEDGING COMPANIES BY CREATING ENORMOUS UNREALIZED EARNINGS VOLATILITY IN INTERIM PERIODS THAT WOULD NEVER BE REALIZED WHEN HEDGES WERE SETTLED AT MATURITY DATES.

    WITHOUT HEDGE ACCOUNTING, COMPANIES GO PUNISHED FOR HEDGING AS IF THEY WERE SPECULATING WHEN THEY ARE HEDGING (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS DEFINITION). I KNOW YOU LIKE TO THINK THAT A LOCKED IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT THIS IS NOT HOW "SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING DEFINITIONS FOR "LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE SPECULATION" WILL ADD MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE FINANCE DEFINITIONS OF A CASH FLOW "HEDGE" VERSUS "SPECULATION,"

    IT’S UNFAIR TO EQUATE CONCESSIONS TO SPECIAL INTEREST GROUPS TO HEDGE ACCOUNTING RULES IN FAS 133. I FIND THE ARGUMENTS FOR HEDGE ACCOUNTING VERY COMPELLING SINCE IN MOST INSTANCES OF HEDGING THE FLUCTUATIONS IN UNREALIZED VALUE CHANGES WASH OUT FOR HEDGE CONTRACTS THAT ARE SETTLED AT MATURITY DATES. IT WAS THE ARGUMENTS THAT WERE COMPELLING RATHER THAN POLITICAL CONCESSIONS TO SPECIAL INTEREST GROUPS. THE SIMPLE ARGUMENT WAS THAT BY LOCKING IN PRICES OR PROFITS COMPANIES WERE BEING PUNISHED AS IF THEY WERE SPECULATING (I DISCUSS YOUR CONFUSED DEFINITION OF “SPECULATION” ELSEWHERE IN THIS MESSAGE.)

    prior to fas 133, companies were learning that it was very easy to keep debt off the balance sheet with interest rate swaps. there is ample evidence of the explosion of this as companies shifted from managing risk with treasury bills to managing risk with swaps.

    there were many scandals due, in large measure, to bad accounting for derivatives prior to fas 133 --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
    of course lack of regulation of the derivatives markets themselves was an even bigger problem.


    Bob Jensen
    When you respond to my post please take up the issue of purchase contracts and non-contracted forecasted transactions since these account for the overwhelming majority of “asymmetric-booking” derivatives contracts hedges being reported today. Then show me how booking changes in value of a hedging contract as current earnings makes sense when the changes in value of the hedged item are not, and should not, be booked.

    Tom Selling
    I already took up that question.  One of the points I was trying to make in the OilCo case is that hedge accounting, while designed to reduce the volatility of reported earnings, often increases the volatility of economic earnings.  That's why OilCo's stock price went down as oil prices went up.  Let me try state it in terms of a manufacturer of a commodity product that contains a significant amount of copper.   Changes in market prices of the end product can be expected to be highly correlated with changes in the price of copper.  Therefore, a natural hedge is already in place for the risk that copper prices will rise in the future.  If you add a forward contract to purchase copper to the firm's investment portfolio, then you are actually adding to economic volatility instead of subtracting from it.  (I trust you don't need a numerical example, but I could provide one if you want it.)  If you add an at-the-money option to purchase copper, you are destroying value by paying a premium for what is essentially an insurance contract on a long run risk that doesn't exist.

    I think the fundamental difference between our positions, Bob, is that you believe that management is acting to maximize (long-run) shareholder value, and I (and perhaps the like Leslie Kren), more cynically believe that management is acting to lock-in their short-run, earnings-based compensation.  The 'special hedge accounting' provisions of FAS 133 is just one tool that they have for doing so.  And as icing on the cake because of its incredible complexity, it lines the pockets of 'advisors', financial intermediaries, auditors, and even educators like you and me. 

    Bob Jensen
    OPTION VALUE = INTRINSIC VALUE + TIME VALUE
    YOU ARE INSULTING THE INTELLIGENCE OF FINANCE PROFESSORS WHO WOULD SHAKE THEIR HEADS WHEN READING:   “ If you add an at-the-money option to purchase copper, you are destroying value by paying a premium for what is essentially an insurance contract on a long run risk that doesn't exist.”

    THERE IS LONG RUN RISK THAT THE FUTURE PRICE WILL GO UP OR DOWN. WHEN YOU BUY AN OPTION AT THE MONEY, THERE IS NO INTRINSIC VALUE BY DEFINITION. BUT THE REASON THE PRICE(PREMIUM) OF THE OPTION IS NOT ZERO IS THAT IT HAS TIME VALUE DUE TO THAT CONTRACTED INTERVAL OF TIME IT HAS TO GO INTO THE MONEY. CASH FLOW HEDGING WITH AN OPTION IS NOT “INSURANCE CONTRACTING” AS DEFINED IN FAS 133. THIS IS A HEDGE THAT LOCKS IN A PURCHASE OR SALES PRICE AT THE STRIKE PRICE SUCH THAT IT IS NOT NECESSARY IN THE FUTURE TO GAMBLE ON AN UNKNOWN FUTURE PRICE.

    a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

    if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WILLING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133.


    Bob Jensen
    Then show me how this asymmetric-booking reporting of changes in value of a hedging contract not offset in current earnings by changes in the value of the item it hedges provides meaningful information to investors, especially since the majority of such hedging contracts are carried to maturity and all the interim changes in their value are never realized in cash.

    Tom Selling
    Just because it may not be recognized in cash, that doesn't mean changes in value are not relevant to investors.  I suppose that's an empirical question.  But I should also add that by your comment, may I infer that you are also in favor of maintaining a held-to-maturity category for marketable debt securities?  If so, then we have a lot more important things to talk about than just hedge accounting!  Him him him him him him him

    Bob Jensen
    I AM A STRONG ADVOCATE OF HTM ACCOUNTING SIMPLY TO KEEP PERFORMANCE FICTION OUT OF THE FINANCIAL STATEMENTS. THIS IS ESPECIALLY THE CASE WHERE THERE ARE PROHIBITIVE TRANSACTIONS COSTS FROM EARLY SETTLEMENTS. MY ARGUMENTS HERE ARE MY CRITICISMS OF EXIT VALUE AT http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    THE IASB IMPOSES GREATER PENALTIES FOR VIOLATORS OF HTM DECLARATIONS THAN DOES THE FASB, BUT AUDITORS ARE WARNED TO HOLD CLIENTS TO HTM DECLARATIONS.


    Bob Jensen
    Show me why this asymmetric-booking of changes in value of hedging contracts versus non-reporting of offsetting changes in the value of the unbooked hedged item benefits investors. Show me how the failure to distinguish earnings changes from derivative contract speculations from earnings changes from derivative hedging benefits investors.

    Tom Selling
    Hedging and speculation is a question of intent, and I don't believe they can be reliably separated.  To this I would add that transaction hedging in FAS 133 is really not economic hedging. In order to make the distinction between hedging and speculation auditable, FAS 133 prohibits macro hedges.  Thus, managers claim that the hedges that actually enter into in order to get the income smoothing they need are actually less efficient (i.e., riskier) than if they were permitted to have hedge accounting for macro hedges.

    Bob Jensen
    once again you are confusing cash flow hedging from value hedging. i covered this above.


    Bob Jensen
    What you are really arguing is that accounting for such derivatives should not distinguish hedging derivative contracts from speculation derivative contracts. I argue that failure to distinguish between hedging and speculation is very, very, very, very misleading to investors.

    Derivative contracts are now the most popular vehicles for managing risk. They are extremely important for managing risk. I think FAS 133 and IAS 39 can be improved, but failure to distinguish hedging derivative contracts from speculations in terms of the booking of value changes of these derivatives will be an enormous loss to users of financial statements.

    Tom Selling
    Empirical question.  See above.


    Bob Jensen
    The biggest complaint I get from academe is that professors mostly just don’t understand FAS 133 and IAS 39. I think this says more about professors than it does about the accounting. In fairness, to understand these two standards accounting professors have to learn a lot more about finance than they ever wanted to know. For example, they have to learn about contango swaps and other forms of relatively complex hedging contracts used in financial risk management.

    Tom Selling
    I can't speak for other accounting professors who may choose to remain ignorant of the details of FAS 133.  I think it's a question of incentives.  But, I think I know FAS 133 pretty well (although surely not as well as you), and certainly well enough to have an informed opinion. I don't think FAS 133 stinks because it is too difficult to learn.  It stinks because, contrary to what you believe, I think that managers game the system and in the process are destroying shareholder value, and even our economy.



    Bob Jensen
    Finance professors, in turn, have to learn a whole lot more about accounting than they ever wanted to know. For example, they have to learn the rationale behind not booking purchase contracts and the issue of damage settlements that may run close to 100% of notionals for executed contracts and less than 1% of notionals for executory purchase contracts. And hedged forecasted transactions that are not even written into contracts are other unbooked balls of wax that can be hedged.

    Tom Selling
    I can't speak for finance professors either, but my very loose impression is that they will make the simplifying assumption that accounting doesn't matter.  In other words, the contract between shareholders and management is efficient in the sense that managers cannot gain by gaming the accounting rules.  Ha Ha Ha.

    Bob Jensen
    IF WHAT YOU SAY IS TRUE THAT VIRTUALLY ALL MANAGERS OUR OUT TO SCREW INVESTORS, THEN CAPITALISM AS WE KNOW IT IS DOOMED. IT IS SERIOUSLY CHALLENGED AT THE MOMENT, AND MAYBE WE WILL TURN ALL OF OUR LARGE CORPORATIONS OVER TO THE GOVERNMENT THAT NEVER SCREWS ANYBODY. WHY DIDN’T WE THINK OF THIS BEFORE. THE SOVIET UNION HAD IT RIGHT ALL ALONG.

    a subset of the evidence on executive compensation and shareholder value is given at http://snipurl.com/execcomp01

    if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS, they’re most likely WantING to cheat on every other opportunity, thereby making accounting standard setting as futile for many other standards other than hedge accounting in fas 133. I AM NOT SO CYNICAL ABOUT MOST MANAGERS. IF YOU’RE CORRECT, FINANCIAL MARKETS WILL COLLAPSE.

    “Accounting Doesn’t Matter”
    once again this is a sophomore statement. although i’m often critical that individual financial reporting events studies are not replicated, the thousands of such studies combined point to the importance of events, especially earnings announcements, on investor behavior. only sophomores in finance would make a claim that “accounting does not matter.”

    There may be a better way to distinguish earnings changes arising from speculation derivative contracts versus hedging derivative contracts, but the FAS 133 approach at the moment is the best I can think of until you have that “aha” moment that will render FAS 133 hedge accounting meaningless.


    Bob Jensen
    I anxiously await your “aha” moment Tom as long as you distinguish booked from unbooked hedged items.

    Tom Selling
    I like FAS 159 as a temporary measure, despite the inconsistencies it creates—they are no worse than FAS 133’s inconsistencies. 

     Offsetting changes in the value of unbooked hedged items are to the totality of our grossly inadequate accounting standards as a flea is to Seabiscuit's rear end.  Here's the best I can do: change the name of the balance sheet to "statement of recognized assets and liabilities"; change the name of the income statement to "statement of recognized revenues, expenses, gains and losses."  At least that way, readers will have a better idea of what accountants are feeding them.

    Bob Jensen
    fas 159 says absolutely nothing about a fair value option for unbooked contracts and forecasted transactions other than it does not allow fair value booking for these anticipated (often contracted) transactions

    And I certainly would not make fair value accounting for derivatives an option under fasb standards.

    hence fas 159 is of no help at all in accounting for hedging contracts of hedged items that are not booked.


    Thanks,
    Bob Jensen

     

    July 1, 2009 reply from Tom Selling [tom.selling@GROVESITE.COM]

    Bob, I’m sorry that you misunderstood some of my arguments. Perhaps I was not clear. I will conclude with a couple of general points, and you should feel free to have the last word.

    First, your arguments are largely premised on the assumption that everyone accepts your definition of “hedging.” FAS 133 defines a derivative for the purpose of applying FAS 133, but notably, it does not define hedging. That’s because, even more than “derivatives,” it defies a principles-based definition that can be applied without 2000 pages of rules. Moreover, your definition entails locking in a price or rate of a transaction. My own conceptualization involves reduction of enterprise risk. One of my points is that reduction in transaction risk can increase enterprise risk. I thought my OilCo example was crystal clear on that point, and would expect every sophomore to understand it.

    Second, when I stated that FAS 133 screws up the balance sheet, I was referring to the inconsistent measurements of hedged items--not hedging instruments. I stand by my earlier statement: hedge accounting screws up the measurement of assets and liabilities in order to get a desired income statement result. You may accept that tradeoff, but I don’t.

    Finally, sole proprietor farmers don’t hold diversified portfolios, which explains why they use forward contracts to hedge. And, if they used more costly options, I’d call it either insurance or speculation. I certainly wouldn’t call it hedging.

    Best, Tom

    July 1, 2009 reply from Bob Jensen

    Hi Tom,

    Whenever you finish your proposal for changing FAS 133 and IAS 39, I think you should run it by finance experts to see if it makes sense in terms of what they call hedging. I think they will not especially like new definition of a hedge that locks in price in a cash flow hedge a "locked-in price speculation," They're more apt to think of a speculation as one in which the price is not locked in by a hedge.

    Finance professors will be especially confused by your calling futures contracts hedging contracts and opions contracts speculations.When I consulted on hedging with an association of ethanol producers and farmers who supplied the corn, they were much more into purchased options than futures contracts for what they called “hedging purposes.” Note the finance definition of hedging below stresses options (and short sales).

    Purchased options are very popular for hedging purposes since the financial risk is capped (at the price paid for the options). Futures, forwards, and swaps have a lot of risk unless users take sophisticated offsetting positions. In any case options are very popular in hedging.

    One last point, but a very important point, that I forgot to mention. I’ve done some consulting for the Pilots Association of Southwest Airlines. One thing they were initially worried about was the possibility that Southwest could, in theory, manipulate earnings with FAS 133. It turns out that in both contract negotiations and bonus calculations, Southwest excludes hedge accounting and unrealized derivatives gains and losses.

    I think this is also the case for a lot of major companies in terms of executive compensation. Hence the premise that executives manipulate hedge accounting for their own compensation is pretty weak.

    Also FAS 133 disclosures make it possible, usually, to exclude unrealized derivatives gains and losses from financial analysis. Of course, it takes some sophistication to deal with AOCI versus changes in RE, but then again so does the new FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments ("FSP FAS 115-2") ---
    http://www.fasb.org/pdf/fsp_fas115-2andfas124-2.pdf

    FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens the blow of recognizing other-than-temporary impairments, was essentially unchanged from the original proposal. It remains a chancre on the body of accounting literature. The credit portion of an other-than-impairment loss will be recognized in earnings, with all other attributed loss being recorded in "other comprehensive income," to be amortized into earnings over the life of the associated security. That's assuming the other-than-temporary impairment is recognized at all, because the determination will still be largely driven by the intent of the reporting entity and whether it's more likely than not that it will have to sell the security before recovery. This is a huge mulligan for banks with junky securities.
    FASB's FSP Decisions: Bigger than Basketball?" Seeking Alpha, April 2, 2009 ---
    http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

     

    hedge http://www.investorwords.com/2293/hedge.html

    Definition

    An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale

    Bob Jensen
    "The New Role of Risk Management: Rebuilding the Model," Interview with Wharton professors Dick Herring and Francis Diebold, and also with John Drzik, who is president and chief executive officer of Oliver Wyman Group, Knowledge@wharton, June 25, 2009 --- http://knowledge.wharton.upenn.edu/article.cfm?articleid=2268

    Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Even though the neutrality-believing FASB is in a state of denial about the impact of FSB 115-4 on decision making in the real world, financial analysts and the Director of Corporate Governance at the Harvard Law School are in no such state of denial,
    "The Fall of the Toxic-Assets Plan," The Wall Street Journal, July 9, 2009 ---
    http://blogs.wsj.com/economics/2009/07/09/guest-contribution-the-fall-of-the-toxic-assets-plan/

    The government announced plans to move forward with its Public-Private Investment Program yesterday. Lucian Bebchuk, professor of law, economics, and finance and director of the corporate governance program at Harvard Law School, says that the program, which has been curtailed significantly, hasn’t made the problem go away.

    The plan for buying troubled assets — which was earlier announced as the central element of the administration’s financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks’ new ability to raise capital through stock sales without having to sell toxic assets. But the program’s inability to take off is in large part due to decisions by banking regulators and accounting officials to allow banks to pretend that toxic assets haven’t declined in value as long as they avoid selling them.

    The toxic assets clogging banks’ balance sheets have long been viewed — by both the Bush and the Obama administrations — as being at the heart of the financial crisis. Secretary Geithner put forward in March a “public-private investment program” (PPIP) to provide up to $1 trillion to investment funds run by private managers and dedicated to purchasing troubled assets. The plan aimed at “cleansing” banks’ books of toxic assets and producing prices that would enable valuing toxic assets still remaining on these books.

    The program naturally attracted much attention, and the Treasury and the FDIC have begun implementing it. Recently, however, one half of the program, focused on buying toxic loans from banks, was shelved. The other half, focused on buying toxic securities from both banks and other financial institutions, is expected to begin operating shortly but on a much more modest scale than initially planned.

    What happened? Banks’ balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets to investment funds has been killed by decisions of accounting authorities and banking regulators.

    Earlier in the crisis, banks’ reluctance to sell toxic assets could have been attributed to inability to get prices reflecting fair value due to the drying up of liquidity. If the PIPP program began operating on a large scale, however, that would no longer been the case.

    Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks’ assets. Indeed, because the government’s funding would come in the form of non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value for banks’ assets. The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

    A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets. For many toxic assets whose fundamental value fell below face value, banks may avoid recognizing the loss as long as they don’t sell the assets.

    Even if banks can avoid recognizing economic losses on many toxic assets, it remained possible that bank regulators will take such losses into account (as they should) in assessing whether banks are adequately capitalized. In another blow to banks’ potential willingness to sell toxic assets, however, bank supervisors conducting stress tests decided to avoid assessing banks’ economic losses on toxic assets that mature after 2010.

    The stress tests focused on whether, by the end of 2010, the accounting losses that a bank will have to recognize will leave it with sufficient capital on its financial statements. The bank supervisors explicitly didn’t take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won’t have to recognize in financial statements until then.

    Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. As long as banks don’t sell, the policies enable them to pretend, and operate as if, their toxic assets maturing after 2010 haven’t fallen in value at all.

    By contrast, selling would require recognizing losses and might result in the regulators’ requiring the bank to raise additional capital; such raising of additional capital would provide depositors (and the government as their guarantor) with an extra cushion but would dilute the value of shareholders’ and executives’ equity. Thus, as long as the above policies are in place, we can expect banks having any choice in the matter to hold on to toxic assets that mature after 2010 and avoid selling them at any price, however fair, that falls below face value.

    While the market for banks’ toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. In such a case, authorities should reconsider the policies that allow banks to pretend that toxic assets haven’t fallen in value. In the meantime, it must be recognized that the curtailing of the PIPP program doesn’t imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet.


    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

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


    New Off Balance Sheet Financing Vehicles

    Accounting for the Shadow Economy
    Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity.

    See below

    There are trillions of dollars of off balance sheet obligations that cannot be easily accounted for.
    Hernando de Soto
     

    A Lesson for Auditors:  Accounting for the shadow economy
    "Toxic Assets Were Hidden Assets:  We can't afford to allow shadow economies to grow this big," by Hernando de Soto, The Wall Street Journal, March 25, 2009 --- http://online.wsj.com/article/SB123793811398132049.html?mod=djemEditorialPage

    The Obama administration has finally come up with a plan to deal with the real cause of the credit crunch: the infamous "toxic assets" on bank balance sheets that have scared off investors and borrowers, clogging credit markets around the world. But if Treasury Secretary Timothy Geithner hopes to prevent a repeat of this global economic crisis, his rescue plan must recognize that the real problem is not the bad loans, but the debasement of the paper they are printed on.

    Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

    If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

    These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property.

    Ever since humans started trading, lending and investing beyond the confines of the family and the tribe, we have depended on legally authenticated written statements to get the facts about things of value. Over the past 200 years, that legal authority has matured into a global consensus on the procedures, standards and principles required to document facts in a way that everyone can easily understand and trust.

    The result is a formidable property system with rules and recording mechanisms that fix on paper the facts that allow us to hold, transfer, transform and use everything we own, from stocks to screenplays. The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

    Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity. To bring derivatives under the rule of law, governments should ensure that they conform to six longstanding procedures that guarantee the value and legitimacy of any kind of paper purporting to represent an asset:

    - All documents and the assets and transactions they represent or are derived from must be recorded in publicly accessible registries. It is only by recording and continually updating such factual knowledge that we can detect the kind of overly creative financial and contractual instruments that plunged us into this recession.

    - The law has to take into account the "externalities" or side effects of all financial transactions according to the legal principle of erga omnes ("toward all"), which was originally developed to protect third parties from the negative consequences of secret deals carried out by aristocracies accountable to no one but themselves.

    - Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant "underlying assets."

    - Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.

    - Governments can encourage assets to be leveraged, transformed, combined, recombined and repackaged into any number of tranches, provided the process intends to improve the value of the original asset. This has been the rule for awarding property since the beginning of time.

    - Governments can no longer tolerate the use of opaque and confusing language in drafting financial instruments. Clarity and precision are indispensable for the creation of credit and capital through paper. Western politicians must not forget what their greatest thinkers have been saying for centuries: All obligations and commitments that stick are derived from words recorded on paper with great precision.

    Above all, governments should stop clinging to the hope that the existing market will eventually sort things out. "Let the market do its work" has come to mean, "let the shadow economy do its work." But modern markets only work if the paper is reliable.

    Continued in article

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/Theory01.htm

    Off Balance Sheet Vehicles
    The Mother of All Ponzi Schemes According to Top Liberal (Progressive) Economists
    The Latest Bailout Plan’s a Disaster According to Paul Krugman and James K. Galbraith

    And yet American policy-makers appear convinced that more debt can rescue an economy already drowning in it. If we can just keep the leverage party going, all will be well. $787 billion to fund “stimulus,” another $9 trillion committed to guarantee bad debts, 0% interest rates and quantitative easing to drive more lending, new off balance sheet vehicles to hide from the public the toxic assets they’ve absorbed. All of it to be funded with debt, most of it the responsibility of taxpayers. If I may offer just one reason this will all fail: rising interest rates. Interest rates need only revert to their historical median in order to hammer asset values, and balance sheets, into oblivion.
    "Added Debt Won't Rescue the Great American Ponzi Scheme," Seeking Alpha, March 23, 2009 ---
    http://seekingalpha.com/article/127261-added-debt-won-t-rescue-the-great-american-ponzi-scheme?source=article_sb_picks

    Bob Jensen's threads on the bailout mess --- http://faculty.trinity.edu/rjensen/2008Bailout.htm


    Question
    When is $7 billion not a material bad debt exposure?

    Answer
    When the "bad debt" is from an "empty creditor"
    Now do you understand?

    "'Empty Creditors' and the Crisis How Goldman's $7 billion was 'not material," by Henry T.C. Hu, The Wall Street Journal, April 10, 2009 ---
    http://online.wsj.com/article/SB123933166470307811.html

    The defining moments of our financial crisis are now familiar. Last September, Lehman collapsed and AIG was teetering. Because an AIG collapse was viewed as posing unacceptable systemic risks, the Federal Reserve provided the company with an emergency $85 billion loan on Sept. 16.

    But a curious incident that fateful day raises significant public policy issues. Goldman Sachs reported that its exposure to AIG was "not material." Yet on March 15 of this year, AIG disclosed that it paid $7 billion of its government loan last fall to satisfy obligations to Goldman. A "not material" statement and a $7 billion payout appear to be at odds.

    Why didn't Goldman bark that September day? One explanation is that Goldman was, to use a term that I coined a few years ago, largely an "empty creditor" of AIG. More generally, the empty-creditor phenomenon helps explain otherwise-puzzling creditor behavior toward troubled debtors. Addressing the phenomenon can help us cope with its impact on individual debtors and the overall financial system.

    What is an empty creditor? Consider that debt ownership conveys a package of economic rights (to receive principal and interest), contractual control rights (to enforce the terms of the agreement), and other legal rights (to participate in bankruptcy proceedings). Traditionally, law and business practice assume these components are bundled together. Another foundational assumption: Creditors generally want to keep solvent firms out of bankruptcy and to maximize their value.

    These assumptions can no longer be relied on. Credit default swaps and other products now permit a creditor to avoid any actual exposure to financial risk from a shaky debt -- while still maintaining his formal contractual control rights to enforce the terms of the debt agreement, and his legal rights under bankruptcy and other laws.

    Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court.

    Goldman Sachs was apparently an empty creditor of AIG. On March 20, David Viniar, Goldman's chief financial officer, indicated that the company had bought credit default swaps from "large financial institutions" that would pay off if AIG defaulted on its debt. A Bloomberg News story on that day quotes Mr. Viniar as saying that "[n]et-net I would think we had a gain over time" with respect to the credit default swap contracts.

    Goldman asserted its contractual rights to require AIG to provide collateral on transactions between the two, notwithstanding the impact of such collateral calls on AIG. This behavior was understandable: Goldman had responsibilities to its own shareholders and, in Mr. Viniar's words, was "fully protected and didn't have to take a loss."

    Nothing in the law prevents any creditor from decoupling his actual economic exposure from his debt. And I do not suggest any inappropriate behavior on the part of Goldman or any other party from such "debt decoupling." But none of the existing regulatory efforts involving credit derivatives are directed at the empty-creditor issue. Empty creditors have weaker incentives to cooperate with troubled corporations to avoid collapse and, if collapse occurs, can cause substantive and disclosure complexities in bankruptcy.

    An initial, incremental, and low-cost step lies in the area of a real-time informational clearinghouse for credit default swaps and other over-the-counter (OTC) derivatives transactions and other crucial derivatives-related information. Creditors are not generally required to disclose the "emptiness" of their status, or how they achieved it. More generally, OTC derivatives contracts are individually negotiated and not required to be disclosed to any regulator, much less to the public generally. No one regulator, nor the capital markets generally, know on a real-time basis the entity-specific exposures, the ultimate resting places of the credit, market, and other risks associated with OTC derivatives.

    With such a clearinghouse, the interconnectedness of market participants' exposures would have been clearer, governmental decisions about bailing out Lehman and AIG would have been better informed, and the market's disciplining forces could have played larger roles. Most important, a clearinghouse could have helped financial institutions to avoid misunderstanding their own products, and modeling and risk assessment systems -- misunderstandings that contributed to the global economic crisis.

    Henry Hu is a professor at the University of Texas Law School.

    Bob Jensen's threads on the credit derivatives mess of AIG are at http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout


    Before reading this you may want to read about receivables factoring at
    http://en.wikipedia.org/wiki/Factoring_(finance) 

    Real World Examples of Factoring of Receivables

    From The Wall Street Journal Accounting Weekly Review on May 14, 2009

    Getting Your Due
    by Simona Covel
    The Wall Street Journal

    May 11, 2009
    (Print Edition Only:  Not available online)

    TOPICS: Advances, Factoring, Financial Accounting

    SUMMARY: "Borrowing against receivables isn't new. For hundreds of years, cash-strapped companies have hired...factors to advance them funds based on money owed by customers....A few companies are [offering]...products and services designed to make the process of borrowing against customer invoices cheaper and more transparent." One example of a company using these services is Data Drive Thru, Inc., a young start up that has made it to selling to big box stores such as Staples,. CFO Brad Oldham says, "Retailers may not be real fast paying, but they do pay." Data Drive Thru posts its invoices on Receivables Exchange LLC, which can be thought of as "eBay for receivables...Lenders then peruse the site, searching for receivables against which they are willing to lend. Lenders bid on those invoices, with the majority electing a fixed buyout price similar to eBay's 'buy it now' feature." Factoring can be expensive though less so on this facility than traditional past practices. Further, other companies have joined the market to provide verification services for the receivables being factored.

    CLASSROOM APPLICATION: Covering the unusual topic of factoring can be brought to "cyber" life with this article.

    QUESTIONS: 
    1. (Introductory) What is factoring of receivables? What journal entries are recorded when factoring receivables?

    2. (Advanced) How expensive is it to factor receivables? In your answer, quote one rate given in the article and express the rate as an annual interest rate.

    3. (Introductory) Why do companies undertake factoring as a means of obtaining cash if it is so expensive?

    4. (Advanced) What is "transparency" in the process of factoring receivables? Specifically, cite examples in the article of activities that help provide this quality in these financing transactions.

    5. (Advanced) Refer to the chart showing the average number of days it takes private companies to collect money owed by customers. How is this statistic calculated? Be specific, including the source of the financial data for the calculation.

    Reviewed By: Judy Beckman, University of Rhode Island

     


    Videos About Off-Balance-Sheet Financing to an Unimaginable Degree

    Truth in Accounting or Lack Thereof in the Federal Government (Former Congressman Chocola) --- http://www.youtube.com/watch?v=NWTCnMioaY0 
    Part 2 (unfunded liabilities of $55 trillion plus) --- http://www.youtube.com/watch?v=1Edia5pBJxE
    Part 3 (this is a non-partisan problem being ignored in election promises) --- http://www.youtube.com/watch?v=lG5WFGEIU0E

    Watch the Video of the non-sustainability of the U.S. economy (CBS Sixty Minutes TV Show Video) ---
    http://www.youtube.com/watch?v=OS2fI2p9iVs 
    Also see "US Government Immorality Will Lead to Bankruptcy" in the CBS interview with David Walker --- http://www.youtube.com/watch?v=OS2fI2p9iVs
    Also at Dirty Little Secret About Universal Health Care (David Walker) --- http://www.youtube.com/watch?v=KGpY2hw7ao8


    The history of financial reporting is replete with ploys to keep debt from being disclosed in financial statements. If standard setters require disclosures, the history of financial reporting is replete with ploys to keep the disclosed obligations from being booked under the liabilities section of the balance sheet.

    Examples of OBSF ploys in the past and some that still remain as viable means of keeping debt off the balance sheets.

     

     

    August 31, 2009 message from Tom Selling [tom.selling@GROVESITE.COM]

    Bob,

    If the bonds are marketable (a very small “if”), then it should matter very little if there is one less potential buyer in the market. Let me try explain the windfall angle in two different ways. First, before the defeasance, the bonds were unsecured; the trust essentially provides security on the bond principal (and also the interest). Second, and relatedly, the market’s discount rate on the bond’s future contractual cash flows should decrease, which will of course drive up the price of the bonds on the market; therefore, bondholders get an immediate realizable gain. The gain doesn’t arise out of thin air – it is a transfer of value from shareholders to bondholders.

    Perhaps we differ on this, because you may think that Exxon bonds were already priced as if they were risk-free. Even if that’s the case, it certainly doesn’t hold generally.

    Best,
    Tom

    September 1, 2009 reply from Bob Jensen

    Hi Tom,

    What I sort of lost track of is how popular defeasance is in spite of not being able to remove debt from the balance sheet with in-substance defeasance --- http://en.wikipedia.org/wiki/Defeasance
    It is especially popular with commercial mortgages and municipal bonds (which commonly have embedded defeasance options).

    You make a good point  in terms of AFS investors in bonds that are not AAA, especially if there are no embedded defeasance options. However, I think a majority of bonds being defeased (especially municipal bonds) are sold with embedded defeasance options such that defeasance is factored into fair value of bonds. The impact, however, can be confusing.

    "Limited arbitrage and liquidity in the market for credit risk," by Amrut Nashikkar et al., NYU Working Paper, February 9, 2009 --- http://pages.stern.nyu.edu/~msubrahm/papers/CDSPaper.pdf

    Bonds are unique and have several distinguishing characteristics, particularly covenants that make them different from the CDS contract in terms of credit risk. In this section, we look at how the characteristics of these covenants affect their basis. The full list of these covenants, along with their definitions and the expected signs of the coefficients, is given in Appendix A. The results reported in table 8, represent the coefficients of the dummy variables associated with each covenant in a pooled regression, controlling for the bond specific, firm-specific, and CDS market variables included above. Note that the coefficients reported in table 8 are obtained using a regression where the dependent variable is the basis and not the yield spread of the bond itself - that is, credit risk as measured by the CDS price for the same issuer has already been controlled for.

    We find that credit-sensitive bonds have a higher basis (are more expensive) by almost ten basis points, on average, compared to other bonds, although this effect is not statistically significant. Bonds that have an option to be defeased have a lower basis by up to eight basis points. Defeasance is the process whereby the issuer of the security sets aside cash in order to redeem the security. Defeasance thus serves to decrease the credit risk of a bond, and in doing so, acts as a signal to investors in the bond. A defeasance option allows the issuer of a bond to set-aside cash for the purpose of buying back the bond, when it is advantageous for the issuer to do so. One would normally expect defeased bonds to be more expensive relative to other bonds. We find the opposite, and puzzling result. This seems to indicate that a defeasance option serves as a signal that the issuer of the bond is of higher risk. In other words, if firms that are more likely to default have a higher likelihood of having defeasance options, investors would see that as a negative signal, and this would make the bonds cheaper relative to other bonds. We confirm this by looking at the types of firms that have defeasance as an option, and find that these are indeed primarily high leverage, poor credit rating firms.

    Continued in article

    There is also the possibility of raising bond prices with partial defeasance to cover catastrophic losses.
    "Stock Market Reactions to the Issue of Cat Bonds," by Philippe Mueller, June 2002 ---
    http://www.hec.unil.ch/cms_mbf/master_thesis/0025.pdf

    The basic structure can also be varied by creating different tranches within the issue. This allows creating securities with different credit ratings, which is needed to attract different classes of investors. A cat bond could for example be offered in a principal-at-risk and a principal-protected (defeased)  tranche. In the case of the principal-protected tranche, only a part of the capital is put at risk. The remainder is held in a separate account and is used to buy zero-coupon treasury bonds in case of a catastrophe event. This assures repayment of the full principal at a later date than planned. Principal-protected tranches can carry a rating up to triple-A with respect to principal repayment and are offered to have institutional investors with restrictions on the amount available for noninvestment grade securities subscribe to newly issued cat bond. The principal-at-risk tranche is usually rated B or BB. Historically, most successful cat bonds had at least one tranche rated investment grade. More recently, the trend has been towards lower rated securities with sometimes not even the most senior tranche reaching investment grade. As expected, the investor base accordingly also changed from mostly money managers, mutual funds and pension plans to hedge funds and insurance companies.

    Investor gains in general due to risk lowering due to defeasance may not be as great as you think in some instances. However, I have not conducted a search for test cases that may well have emerged in the latest economic crisis.
    "Is In-Substance Defeasance of Debt Too Good To Be True?" by Barbara Apostolou and Raymond Jefferds, Mid-American Journal of Business, Fall 1989, pp. 15-20 ---
    http://www.bsu.edu/web/majb/resource/pdf/vol04num2.pdf#page=14

    A potentially serious problem arises if a defeased corporation subsequently files for bankruptcy. The major unresolved problem in accounting for defeased debt concerns the possibility that trust assets of a bankrupt firm could be used to settle claims of general creditors. The question of what circumstances would allow invasion of a defeasance trust are not yet known. Until this question is tested in court, corporate managers cannot be assured that defeasance eliminates all the risk in the repayment of a debt issue. It remains unclear whether the courts would uphold the irrevocable nature of the trust or set it aside under the Bankruptcy Act. This problem cannot be addressed until or unless a test case arises.

    Another potential risk concerns the failure of the trustee to fulfill the obligations of the defeasance trust agreement. Suppose, for example, that the trustee experiences financial difficulty or misappropriates trust assets. The possibility of trustee negligence or malfeasance must be weighted against the fact that the defeasing corporation remains legally liable for defeased debt until full repayment is made. Is the legal liability for defeased debt clearly communicated to readers of the financial statements? What would be the likely legal consequences of a suit to recover bondholder losses in the event of bankruptcy on the part of either the trustee or the defeased corporation? These questions remain unanswered, although management can guard against this risk by choosing a trustee with both an excellent reputation for integrity and strong financial roots.

    Continued in article

    In the current economic crisis the bond ratings were impacted by suspected fraud among credit rating agencies such that without being defeased the bonds could continue to carry credit ratings that were too high ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze

     

    Default risk cannot explain the Muni puzzle: evidence from municipal bonds that are secured by U.S. treasury obligations
    Rev Fin 1998; 11:281-308
    © 1998 the Society for Financial Studies

    http://rfs.oxfordjournals.org/cgi/content/abstract/11/2/281

    JMR Chalmers
    Charles H. Lundquist College of Business, 1208 University of Oregon, Eugene, OR 97403, USA
    e-mail: jchalmer@oregon.uoregon.edu

    Abstract

    Fama (1977) and Miller (1977) predict that one minus the corporate tax rate will equate after tax yields from comparable taxable and tax-exempt bonds. Empirical evidence shows that long-term tax-exempt yields are higher than theory predicts. Two popular explanations for this empirical puzzle are that, relative to taxable bonds, municipal bonds bear more default risk and include costly call options. I study U.S. government secured municipal bond yields which are effectively default-free and noncallable. These municipal yields display the same tendency to be too high. I conclude that differential default risk and call options do not explain the municipal bond puzzle.

     


    Question
    How does fair IFRS value accounting differ for financial instruments versus derivative financial instruments?

    The IASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    Whereas firms are increasingly pressured by the FASB and the IASB to maintain financial assets at fair value, maintaining financial liabilities at fair values is much more controversial since the future cash flows of fixed-rate debt may depart greatly from current fair value. For cash flows of a fixed rate mortgage are well defined whereas the fair value of those cash flows may fluctuate day-to-day with interest rates. Fair value adjustments of debt that the firm either cannot or does not intend to liquidate may be quite misleading regarding financial risk.

    The same cannot be said for derivative financial instruments where FAS 133 and IAS 39 require maintaining the current reported balances at fair value.

    However, the FASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    "Exposure Draft on measurement of financial liabilities," IAS Plus, May 11, 2010 --- http://www.iasplus.com/index.htm

    The IASB has published for public comment an exposure draft (ED) of proposing to amend the way the fair value option in IAS 39 Financial Instruments: Recognition and Measurement is applied with respect to financial liabilities. Many investors and others have said that volatility in profit or loss resulting from changes in an entity's own credit risk is counter-intuitive and does not provide useful information – except for value changes relating to derivatives and liabilities held for trading (such as short sales). The IASB is proposing, therefore, that all gains and losses resulting from changes in 'own credit' for those financial liabilities that an entity chooses to measure at fair value should be recognised as a component of 'other comprehensive income', not in profit or loss. The ED does not propose any other changes for financial liabilities. Consequently, the proposals will affect only those entities that elect to apply the fair value option to their financial liabilities. Importantly, those who prefer to bifurcate financial liabilities when relevant may continue to do so. That is consistent with the widespread view that the existing requirements for financial liabilities work well, other than the 'own credit' issue that these proposals cover.

    "Odd Debt Rule to Lose Bite Adjustments That Whipsaw Bank Earnings Won't Affect Bottom Lines in Future," by Michael Rapoport, The Wall Street Journal, September 30, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443389604578024641162432714.html?mod=googlenews_wsj&mg=reno64-wsj

    Accounting rule makers are on the verge of rolling back a widely assailed provision that counterintuitively adds to U.S. banks' profits when their debt looks riskier to investors and penalizes them when it looks safer.

    The provision—known as the debt or debit value adjustment, or DVA—has come under increasing fire as major banks posted quarterly results whipsawed by big gains one quarter and big losses the next as the market value of their own debt fluctuated.

    Major banks and securities firms have posted almost $4 billion in cumulative DVA gains over the past year, but big DVA losses are expected in the third quarter, including an anticipated $1.9 billion at Bank of America Corp., disclosed Friday.

    The Financial Accounting Standards Board, which sets U.S. accounting standards, tentatively agreed in June to strip the changes out of net-income calculations, which would prevent the DVA swings from affecting banks' marquee earnings numbers any longer. The board is expected to formally propose the move by the end of the year— none too soon, in the view of some banking observers.

    "They cannot get rid of this rule fast enough in my opinion," said Chris Kotowski, an analyst with Oppenheimer & Co. J.P. Morgan Chase. Chief Executive James Dimon last year called the rule "one of the more ridiculous concepts that's ever been invented in accounting."

    Any change is unlikely to come before 2014, so it won't help banks during their third-quarter earnings season, which begins Oct. 12 with J.P. Morgan's results.

    But ultimately it may help banks' earnings be a little simpler and cleaner—and relieve banks of what has become a quarterly chore of explaining away an item that has distorted their bottom-line performance.

    The change "provides more clarity in financial results, and what we have now muddies the waters," said Robert Willens, a tax and accounting expert who heads his own firm, Robert Willens LLC.

    The peculiar gains and losses stem from a rule the FASB issued in 2007, allowing banks to value some of their liabilities at "fair value"—market value or the closest approximation—instead of original cost.

    Under current rules, banks must record losses when the value rises on some of their debt, and post profits when the debt's value declines.

    The rationale is that lower market prices make it cheaper for banks to repurchase their own debt.

    The banks choose which debt receives this treatment and often apply it to so-called structured notes, in which the payout to the holder is tied to changes in some other instrument. (Banks report DVA numbers slightly differently, so the numbers aren't always directly comparable.)

    That means that improving perceptions of a bank's creditworthiness hurt its earnings, and worsening perceptions of creditworthiness help earnings. That feeds big swings in earnings at banks like Morgan Stanley, which went from a $216 million DVA gain in the fourth quarter of 2011 to a $2 billion loss in the first quarter of 2012 to a $350 million gain in the second quarter.

    Sometimes the DVA gains and losses make a big difference in banks' bottom lines. In the first quarter of 2012, for instance, Morgan Stanley had a $78 million loss from continuing operations applicable to the company. Excluding its big DVA loss for the quarter, however, it had income from continuing operations of $1.4 billion.

    Under the tentative agreement the FASB reached in June, DVA gains and losses will go into "other comprehensive income," a separately reported form of earnings that includes a variety of items that don't stem from a company's operations, such as foreign-exchange effects and changes in the value of pension assets.

    The move is "a definite improvement" on the FASB's part, Mr. Willens said. "I guess they've seen the error of their ways."

    The change is expected to be part of a broader proposal revamping the accounting for financial assets and liabilities that the FASB expects to issue by year's end. That proposal is subject to public comment and possible changes before it would be implemented.

    The changes will give investors "greater information," said FASB member Russell Golden.

    Continued in article

     

    Unlike FAS 133, IAS 39 no longer requires bifurcation of embedded derivatives that are not "clearly and closely related" to the host instrument.

    "IASB Addresses 'Counter-intuitive' Effects of Fair Value Measurement of Financial Liabilities," SmartPros, May 10, 2010 ---
    http://accounting.smartpros.com/x69432.xml

    The International Accounting Standards Board (IASB) today published for public comment its proposed changes to the accounting for financial liabilities.

    This proposal follows work already completed on the classification and measurement of financial assets (IFRS 9 Financial Instruments). 
     
    The IASB is proposing limited changes to the accounting for liabilities, with changes to the fair value option.  The proposals respond to the view expressed by many investors and others in the extensive consultations that the IASB has undertaken—that volatility in profit or loss resulting from changes in the credit risk of liabilities that an entity chooses to measure at fair value is counter-intuitive and does not provide useful information to investors.
     
    When the IASB introduced IFRS 9 many stakeholders around the world advised the IASB that the existing requirements for financial liabilities work well, except for the effects of changes in the credit risk of a financial liability (‘own credit’) that an entity chooses to measure at fair value. 
     
    Building on that global consultation on IFRS 9, the IASB sought the views of investors, preparers, audit firms, regulators and others on the ‘own credit’ issue.  The views received were consistent with the earlier consultations—that volatility in profit or loss resulting from changes in ‘own credit’ does not provide useful information except for derivatives and liabilities that are held for trading.
     
    The IASB is therefore proposing that all gains and losses resulting from changes in ‘own credit’ for financial liabilities that an entity chooses to measure at fair value should be transferred to ‘other comprehensive income’.  Changes in ‘own credit’ will therefore not affect reported profit or loss.
     
    No other changes are proposed for financial liabilities.  Therefore, the proposals will affect only those entities that choose to apply the fair value option to their financial liabilities.  Importantly, those who prefer to bifurcate financial liabilities when relevant may continue to do so.  That is consistent with the widespread view that the existing requirements for financial liabilities work well, other than the ‘own credit’ issue that these proposals cover.  
     
    Commenting on the proposals, Sir David Tweedie, Chairman of the IASB, said:
     
    Whilst there are theoretical arguments for treating financial assets and liabilities in the same way it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding large profit, especially when investors tell us that such information is often excluded from their financial models.
     
    An IASB ‘Snapshot’, a high level summary of the proposals, is available to download free of charge from the IASB website at http://go.iasb.org/financial+liabilities.
     
    The exposure draft Fair Value Option for Financial Liabilities is open for comment until 16 July 2010.  It can be accessed via the ‘Comment on a proposal’ section on www.iasb.org from today.
     

    Jensen Comment
    What the IASB has not done is eliminate the enormous inconsistency in fair value accounting for financial assets versus financial liabilities.

    This proposed IAS 39 amendment allowing for an option to carry debt at fair value is still in exposure draft form.

    The worst part of all this is that students, let’s call them classic sophomores, are willing to jump to conclusions like the following:

    1.       Historical cost accounting, even when price-level adjusted, leads to ancient balances of assets and liabilities that are seriously out of date with current market values whether markets are entry or exit value markets.

    2.       Therefore, to the extent possible assets and liabilities should be carried at fair values (exit or entry) with changes in fair values reported in current earnings.

    What these sophomores do not understand that fair value adjustments create utter fiction for held-to-maturity or other “locked-in” items. Adjusting some assets and liabilities to fair values is utter fiction if there is no option or intent for fair value transactions to transpire before some shock such as contractual maturity or abandonment of a manufacturing operation (that makes factory real estate finally available for sale). The classic example is fixed-rate debt for which there is no embedded option to pay off the debt prematurely or purchase it back in an open market. If the cash flow stream is thus set in stone until maturity, any adjustments to fair value are accounting fictions. Temporal changes in current earnings for fictional accounting value changes are more misleading than helpful.

    Creditors might propose deals for early retirement, but they do so when it is not particularly advantageous for the debtor. Conversely, debtors may propose deals for early retirement, but they will do so when it is not particularly advantageous for the creditors. Hence such debt is usually retired early only when either the debtor or the creditor is willing to negotiate a heavy penalty. Without a willingness to incur heavy penalties, changes in earnings for accounting fictions are highly misleading in terms of fictional earnings volatility.

    When we have contracts that provide debtors more embedded options for premature settlements, then we might begin to think more seriously about adjusting the debt to fair value. Many debt contracts have embedded options for the debtor to pay the debt off before retirement (often at some contracted penalty such as bond call back prices). In the case of financial assets, we now have the classifications “Hold-to-Maturity” versus “Available-for-Sale” that we apply to financial assets.

    It seems that under the proposed IAS 39 amendment, providing an option to carry debt at fair value, we could allow debtors to similarly classify debt as “Hold-to-Maturity” versus “Available-for-Buy-Back” where the debtor declares an intent to buy the debt back if the fair value of the debt in the market fair value becomes attractive. This often happens for fixed-rate marketable bonds when interest rates rise and market values of the bonds decline. In fact, Exxon invented “in-substance defeasance” to simulate debt buy backs when the transactional cost penalties for actual buy backs were too high. Until FAS 125 no longer allowed removing defeased debt from the balance sheet, this was a means by which Exxon could report realized gains on debt value reduction and remove debt from the balance sheet without truly abandoning payoff obligations ---
    http://faculty.trinity.edu/rjensen/Theory01.htm

    In-Substance Defeasance
    In-substance defeasance used to be a ploy to take debt off the balance sheet. It was invented by Exxon in 1982 as a means of capturing the millions in a gain on debt (bonds) that had gone up significantly in value due to rising interest rates. The debt itself was permanently "parked" with an independent trustee as if it had been cancelled by risk free government bonds also placed with the trustee in a manner that the risk free assets would be sufficient to pay off the parked debt at maturity. The defeased (parked) $515 million in debt was taken off of Exxon's balance sheet and the $132 million gain of the debt was booked into current earnings ---
    http://www.bsu.edu/majb/resource/pdf/vol04num2.pdf

    Defeasance was thus looked upon as an alternative to outright extinguishment of debt until the FASB passed FAS 125 that ended the ability of companies to use in-substance defeasance to remove debt from the balance sheet. Prior to FAS 125, defeasance became enormously popular as an OBSF ploy
    .

    Since companies now have the option of classifying financial assets as HTM versus AFS, it seems symmetrical in the proposed IAS 39 amendment to allow financial liabilities to be classified as HTM versus AVBB (available-for-buy-back). However, in both the AFS and the AVBB classifications, the unrealized changes in fair values should be charged to AOCI rather than current earnings. This keeps accounting fictions out of current earnings, at least with respect to financial asset and liability value change fictions.

    One thing I propose for the proposed IAS 39 amendment is that the mandatory value changes for AFS financial assets not be declared optional for AVBB debt.(Although still mandatory in FASB standards, Pat Walters tells me that IAS 9 revisions make assigning value changes to AOCI optional). The changes should be mandatory (not optional) for AVBB liabilities just as they should still be mandatory for AFS assets. In both instances, however, changes in value should not impact current earnings until the changes in value are realized. I don't like optional choices regarding whether or not to charge fair value changes to AOCI or current earnings. This can only lead to inconsistencies in financial reporting for identical circumstances.

    Of course the AFS and AVBB classifications are built upon management declarations of intent. But the IASB imposes heavy penalties on companies that renege on their HTM classifications (that allow retention of historical cost accounting). Companies that renege on HTM classifications may long regret not staying true to their declared intent --- at bit like the penalty Tiger Woods is now paying for not staying true to marriage vows.

    May 16, 2010 reply from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    Bob:

    In IFRS 9 (eff 2013), the term "held to maturity" is gone. The classification "amortized cost" is effectively HTM, but the criteria is more specific than "intent and ability to hold to maturity" in IAS 39. IFRS 9 criteria are:

    A financial asset shall be measured at amortised cost if both of the following conditions are met: (a) the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

    Pat

    May 16, 2010 reply from Bob Jensen

    A rose by any other name is still HTM and is, I assume, still subjected to heavy IASB penalties for reneging on “amortized cost.”

    You just restored my faith in IASB sensibility regarding fact over fiction.

    Bob Jensen

     

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    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

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


    "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.

     


    RBI releases guidelines for Off-Balance Sheet Financing (OBSF) exposures

    Draft Guidelines on Prudential Norms for Off-balance Sheet Exposures of Banks – Capital

    Adequacy, Exposure,

    Asset Classification and Provisioning Norms

    At present, paragraphs 2.4.3 and 2.4.4 of the ‘Master Circular on Prudential Norms on Capital Adequacy’, DBOD.No.BP.BC.4/21.01.002/2007-08 dated July 2, 2007, stipulate the applicable credit conversion factors (CCF) for the foreign exchange and interest-rate related contracts under Basel-I framework. Likewise, paragraph 5.15.4 of our circular on ‘Guidelines for Implementation of the New Capital Adequacy Framework’ DBOD.No.BP.BC. 90/20.06.0001/2006-07 dated April 27, 2007, prescribes the CCFs for these contracts under the Basel-II framework. Further, in terms of paragraph 2.3.2 of the ‘Master Circular on Exposure Norms’, DBOD.No.Dir.BC.11/ 13.03.000/2007-08 dated July 2, 2007, the banks have the option of measuring the credit exposure of derivative products either through the ‘Original Exposure Method’ or ‘Current Exposure Method’.

    2. In accordance with the proposal contained in the paragraph 165 (reproduced in Annex 1) of the Annual Policy Statement for the year 2008-09, released on April 29, 2008, it is proposed to effect the following modifications to the existing instructions on the above aspects:

    2.1 Credit Exposure – Method of computing the credit exposure
    For the purpose of exposure norms, banks shall compute their credit exposures, arising on account of the interest rate & foreign exchange derivative transactions and gold, using the ‘Current Exposure Method’, as detailed in Annex 2.

    2.2 Capital Adequacy – Computation of the credit equivalent amount
    For the purpose of capital adequacy also, all banks, both under Basel-I as well as under Basel-II
    framework, shall use the ‘Current Exposure Method’, as detailed in Annex 2, to compute the credit
    equivalent amount of the interest rate & foreign exchange derivative transactions and gold.

    2.3 Provisioning requirements for derivative exposures
    Credit exposures computed as per the ‘current exposure method’, arising on account of the interest rate &
    foreign exchange derivative transactions, and gold, shall also attract provisioning requirement as
    applicable to the loan assets in the ‘standard’ category, of the concerned counterparties. All conditions
    applicable for treatment of the provisions for standard assets would also apply to the aforesaid provisions
    for derivative and gold exposures.

    2.4 Asset Classification of the receivables under the derivatives transactions
    It is reiterated that, in respect of derivative transactions, any amount receivable by the bank, which
    remains unpaid for a period of 90 days from the specified due date for payment, will be classified as nonperforming
    assets as per the ‘Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to the Advances Portfolio’, contained in our Master Circular DBOD. No. BP.BC.12/ 21.04.048/2007-08 dated July 2, 2007.

    2.5 Cash settlement of derivatives contracts
    Any restructuring of the derivatives contracts, including the foreign exchange contracts, shall be carried out only on cash settlement basis.

    3. The foregoing modifications will come into effect from the financial year 2008-09. The banks will, however, have the option of complying with the additional capital and provisioning requirements, arising from these modifications, in a phased manner, over a period of four quarters, ending March 31, 2009.

    Continued in article


    Many executives allegedly misstate earnings upward and debt downward to collect bonuses, stock options, and stock sales before restating earnings later on without having to repay their allegedly ill-gotten gains --- http://aaahq.org/AM2006/display.cfm?Filename=SubID_0847.pdf&MIMEType=application%2Fpdf

    Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 351, ISBN 0-8050-7510-0)

    The range of financial malfeasance and manipulation was fast. Energy companies, such as Dynegy, El Paso, and Williams, did the same complex financial deals (particularly using SPEs) Andy Fastow engineered at Enron. Telecommunication s firms, such as Global Crossing and WorldCom, fell into bankruptcy after it became clear they, too, had been cooking their books. Financial firms were victims as well as aiders-and-abettors. PNC Financial, a major bank, settled SEC charges that it abused off-balance-sheet deals and recklessly overstated its 2001 earnings by more than half. A rogue trader at Allfirst Financial, a large Irish bank, lost $750 million in a flurry of derivatives trading that put Nick Leeson of Barings to shame. And so on, and so on.

    . . .

    As with the prior financial scandals, substantial losses were related to over-the-counter derivatives. There were prepaid swaps, in which a company received an up-rong payment resembling a loan from a bank, but did not record its future obligations to repay the bank as a liability. There were swaps of Indefeasible Rights of Use, or IRUs, long-term rights to use bandwidth on a telecommunications company's fiber-optic network, which were similar to the long-term energy derivatives Enron traded --- and just as ripe for abuse. And there were more Soecial Purpose Entities, created by Wall Street banks.


    "FSP 140-3: Plugging a Hole in GAAP, or Another Off-Balance Sheet Financing Gimmick?" by Tom Selling, The Accounting Onion, March 4, 2008 --- http://accountingonion.typepad.com/

     I subscribe to a listserv for professors of accounting ( http://pacioli.loyola.edu/aecm/ ) to discuss emerging technologies, pedagogy, and pretty much anything else. One of the recent topics of discussion on the listserv had to do with the impact of accounting complexity on preparing students to become auditors. One participant in the conversation offered up the following quotation from a masters student's paper on the bogus reinsurance transactions between AIG and General Re:

    "When companies are involved in these complicated transactions, auditors often don't have the time, training, or knowledge to spot questionable items. When I audited a financial services company during my internship, I didn't really understand their business let alone the documentation that I was reviewing to ensure that controls were operating properly. So much of the work we conducted was based on mimicking the prior year's work papers that even after levels of review I believe fraud could have easily slipped by." [italics supplied]

    Coincidentally, FASB Staff Position (FSP) FAS140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions, has been recently finalized; this student's lament came to my mind while I was attempting to decipher the new accounting rule.

    In order to begin to explain the FSP, you need to know that FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, contains criteria that restrict "sale accounting" on transferred financial assets when there is a concurrent purchase agreement. Consequently, “repurchase agreements” (repos) may be subject to "loan accounting" instead of sale accounting. The difference in accounting treatments is as follows: under sale accounting, the asset comes off the balance sheet and is replaced by the proceeds from sale; under loan accounting, the asset stays on the balance sheet, so the credit offset to recognition of the proceeds is to debt. So most significantly, sale accounting is off-balance sheeting financing, and loan accounting is on-balance sheet financing.

    To the financial engineer attempting to defeat the best efforts of investors and/or regulators of financial institutions, loan accounting is a bad thing, and sale accounting is good. So one important for them is how to fabricate an 'arrangement' that gets under FAS 140's fence to permit sale accounting. Thus appears to have been invented by a mortgage REIT a variation on the repo (essentially a round trip for the asset) whereby the financial instrument now makes one more trip back to the original transferee. If you're confused, this picture may help:

    Continued in article (with exhibits)

    Bob Jensen's threads on General Re and AIG are at http://faculty.trinity.edu/rjensen/FraudRotten.htm#MutualFunds

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/Theory01.htm


    Questions
    Are GE's Recent Restatements Part of Jack Welch's Legacy?

    In this post-Enron and S-OX 404 environment, would a CEO today would so openly express such a blatant disregard for reporting to investors?

    The WSJ article also mentions that in addition to the firing of some division managers (perhaps one or more of the same cookie sharers), the SEC probe lead to the resignation of Phil Ameen, long-time VP and comptroller -- and prime specimen of the accounting equivalent of a wolf in sheep's clothing let loose in the barnyard. (Whew, that was a long way to go for a metaphor!) Believe it or not, Ameen was a member of the FASB's Emerging Issues Task Force (EITF) during much of the 1990s.  He was also an active and influential FASB lobbyist.  Separately, out of one side of this mouth came exhortations to simplify accounting, and out of the other side, to ditch simple solutions that might have impaired GE's ability to manage its earnings and reported debt . . .
    Tom Selling, The Accounting Onion, February 18, 2008 --- http://accountingonion.typepad.com/


    Shocking Impact of GASB 45

    Underfunded Pensions, Post-Retirement Obligations, and Other Debt
    Probably the largest form of OBSF is booked debt that is badly understated. Particularly problematic is variable debt that is badly underestimated. For example, a company or a government unit (e.g., city or county) may be obligated to pay medical bills or insurance premiums for retired employees and their families. Until FAS 106 companies did not report these obligations at all. Governmental agencies (not the Federal government) are just not becoming obligated to report such obligations under GASB 45. Accounting rules have been so lax that many of these obligations were never disclosed or disclosed at absurdly low amounts relative to the explosion in the costs of medical care and medical insurance. Pensions had to be booked, but the rules allowed companies to greatly understate the amount of the unfunded debt.

    "A $2-Trillion Fiscal Hole," by Chris Edwards and Jagadeesh Gokhale, The Wall Street Journal, October 12, 2006; Page A18 --- http://online.wsj.com/article/SB116062308693690263.html?mod=opinion&ojcontent=otep

    State and local governments are amassing huge obligations in the form of unfunded retirement benefits for their workers. Aside from underfunded pension plans, governments have also run up large obligations from their retiree health plans. While a new Governmental Accounting Standards Board rule will kick in next year and reveal exactly how large this problem is, we estimate that retiree health benefits are a $1.4 trillion fiscal time bomb.

    The new GASB regulations will require accrual accounting of state and local retiree health benefits, thus revealing to taxpayers the true costs of the large bureaucracies that they fund. We reviewed unfunded health costs across 16 states and 11 local governments that have made actuarial estimates, and found an average accrued liability per covered worker of $135,000. Multiplying that by the number of covered state and local employees in the country yields a total unfunded obligation of $1.4 trillion -- twice the reported underfunding in state and local pension plans at $700 billion.

    To put these costs in context, consider the explicit net debt of state and local governments. According to the Federal Reserve Board, state and local credit market debt has risen rapidly in recent years, from $313 billion in 2001 to $568 billion in 2005. But unfunded obligations from state and local pension and retiree health plans -- about $2 trillion -- are still more than three times this net debt amount.

    The key problem is that the great majority of state and local governments finance their retiree health benefits on a pay-as-you-go basis. In coming years that will create pressure to raise taxes as Baby Boomers age and government employees retire in droves. New Jersey's accrued unfunded obligations in its retiree health plan now stand at $20 billion, and the overall costs of its employee health plan are expected to grow at 18% annually for the next four years.

    To compound the problem, defined-benefit pension and retirement health plans are much more common and generous in the public sector than the private sector. Out of 15.9 million state and local workers, about 65% are covered under retirement health plans, compared to just 24% of workers in large firms in the private sector.

    The prospect of funding $2 trillion of obligations with higher taxes is frightening, especially when you consider that state politicians would be imposing them on the same income base as federal politicians trying to finance massive shortfalls in Social Security and Medicare. Hopefully, most state policy makers appreciate that hiking taxes in today's highly competitive global economy is a losing proposition.

    The only good options are to cut benefits and move state and local retirement plans to a pre-funded basis with personal savings plans. Two states, Alaska and Michigan, have moved to savings-based (defined-contribution) pension plans for their new employees. Alaska has also implemented a health-care plan for new state employees, which includes high-deductible insurance and a Health Savings Account. Expect to see more states following Alaska's lead.

    State and local governments also need to cut retirement benefits, which were greatly expanded during the 1990s boom. From a fairness perspective, cutting benefits especially of younger workers is reasonable given the generosity of state and local plans. Federal data shows that state and local governments spend an average of $3.91 per hour worked on employee health benefits, compared to $1.72 in the private sector.

    Underfunded -- or more accurately, over-promised -- retirement plans for state and local workers have created a $2 trillion fiscal hole. Every year that policy makers put off the tough decisions, the hole gets bigger. Hopefully, the new GASB rules will prompt them to enact the reforms needed to avert job-destroying tax increases on the next generation.

    Mr. Edwards is tax policy director at the Cato Institute. Mr. Gokhale is a senior fellow at Cato and a former senior economic adviser to the Federal Reserve Bank of Cleveland.


    Question
    What is the new European accounting ploy (termed the 2007 Accounting Miracle) to hide debt until the instant it becomes due?

     

     

    "Italy's Accounting Miracle," by Tito Boeri and Guido Tabellini, The Wall Street Journal, November 28, 2006 --- http://online.wsj.com/article/SB116466953696233804.html?mod=opinion&ojcontent=otep

     

    The latest murky accounting ploy has received the European Union's stamp of approval. As of 2007, Italy will be able to reduce its official budget deficit with the cash proceeds of new liabilities. The new debt will remain hidden until it comes due. If this is how the EU's revised Stability and Growth Pact will work, it would be wiser to scrap the budget rules altogether. At least then national capitals would not be so tempted to artificially reduce their budget deficits, and citizens would be better informed about the true state of public finances.

    Here's how the new gimmick works. Under current Italian law, employees must set aside a tax-exempt fraction of their gross wages, nearly 7%, into a severance scheme called TFR. Instead of creating personal accounts for their employees, each company collects the money in one large fund. When an employee leaves the firm, he receives the money he paid into the fund plus interest, currently about 3%. The TFR is thus debt that companies owe to their employees. That's why firms list it as liabilities in their financial statements.

    Under the new Italian budget law, though, part of the contributions to this severance scheme will be collected and held by Italy's social security administration to finance public expenditures. When the employee leaves his job or has health problems, the government, rather than the employer, will disburse his severance payments. The bottom line is that, by receiving the contributions for this new, implicit debt, the Italian government expects to reduce its yearly budget deficit by almost 0.5% of GDP. A debt instrument has miraculously become a surplus.

    This bookkeeping equivalent of turning water into wine is possible because EU accounting rules for government finances are much looser than the rules that the same governments apply to private firms. The bloc's statistics service, Eurostat, does not consider the future obligations implicit in public pensions as part of government liabilities. Hence, the transfer of the TFR to the Italian social security system is treated like the creation of a new pay-as-you go system.

    The Stability Pact's 2005 reform, though, specifically encourages Brussels to pay special attention to fiscal sustainability in the long run, and in particular to the future liabilities implicit in the pension systems. The Commission, however, has paid lip service to the principle of long-run sustainability, while in practice is giving its blessing to the Italian accounting miracle. In so doing, it has shown that the reform of the Stability and Growth Pact will not be enforced.

    This creates a dangerous precedent that other member states might be tempted to follow. Germany, for instance, has a "book reserve" system similar to the Italian TFR that automatically applies to a significant portion of its work force. The contributions to the German system are even more attractive as a potential source of government finance since, unlike the TFR, they can only be claimed by the workers upon retirement. Many other Europeans countries have sizable occupational pension plans. The EU is implicitly saying that the proceeds from nationalizing these plans can be used to meet its budget deficit targets. Firms in financial difficulties with occupational pension plans are always tempted to transfer to the state their pension liabilities, together with the annual contributions to the fund. Now myopic governments will have an additional incentive to meet these requests for "state aid." Public revenues increase immediately, while the debt disappears once it is transferred to the public sector.

    Europe's public finances can ill afford these kinds of miracles.

    Messrs. Boeri and Tabellini are economics professors at Bocconi University in Milan.


    This could make a good case study for an accounting theory course

     

    From The Wall Street Journal Accounting Weekly Review on December 8, 2006

     

    TITLE: Making Use of Frequent-Flier Miles Gets Harder
    REPORTER: Scott McCartney
    DATE: Dec 05, 2006
    PAGE: D5
    LINK: http://online.wsj.com/article/SB116528094651740654.html?mod=djem_jiewr_ac 
    TOPICS: Accounting, Auditing

    SUMMARY: The Department of Transportation (DOT) has undertaken audit procedures on airlines to review how they are "living up to their 1999 'Customer Service Commitment.'" This document was written when "airlines were under pressure from Congress and consumers for lousy service and long delays" in order to "stave off new legislation regulating their business." The airlines also report little about the frequent flier mile plans they offer, and particularly focus only on the financial aspects of these plans in their annual reports and SEC filings, rather than, say, information about ease of redeeming miles in which customers may be particularly interested.

    QUESTIONS:
    1.) What information do airlines provide about frequent flier mileage offerings and redemptions in their annual reports and SEC filings?

    2.) Why is this information important for financial statement users? In your answer, describe your understanding of the business model and accounting for frequent flier miles, based on the description in the article.

    3.) Why did the Department of Transportation (DOT) undertake a review of airline practices? What type of audit would you say that the DOT performed?

    4.) What audit procedures did the airlines abandon due to financial exigencies? What was the result of abandoning these audit procedures? In your answer, describe the incentives provided by the act of undertaking audit procedures on operational efficiencies and effectiveness.

    Reviewed By: Judy Beckman, University of Rhode Island

    "Making Use of Frequent-Flier Miles Gets Harder Falling Redemption Rate Is One of Many Service Issues, Government Report Find," by Scott McCartney, The Wall Street Journal, December 5, 2006; Page D5 --- http://online.wsj.com/article/SB116528094651740654.html?mod=djem_jiewr_ac

     

     

  • Which airline is the most accommodating when it comes to letting consumers cash in frequent-flier mileage awards? It's hard to know, a new government report says, because airlines disclose so little information.

    One thing is clear: Over the past four years, the percentage of travelers cashing in frequent-flier award tickets has declined at four of the five biggest airlines, even though miles accumulated by consumers have increased.

    The Department of Transportation's inspector general went back and checked how airlines were living up to their 1999 "Customer Service Commitment." Back then, airlines were under pressure from Congress and consumers for lousy service and long delays, and they promised reform to stave off new legislation regulating their business.

    Seven years later, Inspector General Calvin L. Scovel III found that under financial pressure, many airlines quit auditing or quality control checks on their own customer service, leading to service deterioration. Airlines don't provide enough training for employees who assist passengers with disabilities, the investigation found, and don't always follow rules when handling passengers who get bumped from flights.

    And as travelers have long complained, government auditors studying 15 carriers at 17 airports found airline employees often don't provide timely and accurate information on flight delays and their causes, and don't give consumers straightforward information about frequent-flier award redemptions.

    "They can do better and must do better, and if they don't do better, Congress has authority to wield a big stick," said U.S. Rep John Mica, the outgoing chairman of the House Aviation Subcommittee who requested the inspector general's customer-service investigation. He said he's eager to hear the airline industry's response before making final judgments, but the report card gives airlines only "average to poor grades in a range of areas that need improvement."

    Since airlines are returning to profitability and aggressively raising fares, there's more attention being paid to customer-service issues. Delays have increased; baggage handling worsened. As traffic has rebounded, airlines still under financial pressure because of high oil prices may not have adequate staff to live up to the promises they made on customer service.

    The report called on the DOT to "strengthen its oversight and enforcement of air-traveler consumer-protection rules" and urged airlines to get back on the stick for customer service. The inspector general also reminded consumers that since airlines incorporated the customer-service commitment into their "contract of carriage" -- the legal rules governing tickets -- carriers can be sued for not living up to their customer-service commitment.

    The industry says it is paying attention. The inspector general's Nov. 21 report "is a good report card for reminding us where we need to improve," said David Castelveter, a spokesman for the Air Transport Association, the industry's lobbying group, which coordinated the "Customer Service Commitment." Airlines will "react accordingly," he said.

    One of the stickiest areas is frequent-flier redemptions because airlines are loath to release detailed information about their programs, considering it crucial competitive information. Frequent-flier programs have become big money-makers for airlines since they sell so many miles in advance to credit-card companies, merchants, charities and others. That allows them to pocket cash years in advance of a ticket, then incur very little expense when consumers eventually redeem the miles, if they ever do.

    In 1999, airlines pledged to publish "annual reports" on frequent-flier redemptions. But at most carriers, the disclosure didn't change at all. Today, as then, carriers typically bury numbers deep in filings with the Securities and Exchange Commission and report only the number of awards issued, the estimated liability they have for the cost of awards earned but not yet redeemed and the number of awards as a percentage either of passengers or passenger miles traveled.

    The inspector general said the hard-to-find information has only "marginal value to the consumer for purposes of determining which frequent-flier program best meets their need."

    What you'd really want to know is which airline makes it easiest to get an award, particularly the cheapest domestic coach ticket, typically 25,000 miles, which is the most popular award. But airlines don't disclose how many awards are at the lowest level, and how many consumers have to pay double miles or so for a premium award of an "unrestricted" coach ticket.

    The award market follows ticket prices and availability, so recent years have seen an increase in the price people have to pay to get the awards they want, and less availability of award seats, particularly at the cheapest level, because some airlines have cut capacity and demand for travel has been strong. Add in the flood of miles airlines are issuing, and the value of a frequent-flier mile has declined sharply.

    The inspector general's report compares award-redemption rates at big airlines over the past four years and found a relatively steady drop at four carriers: UAL Corp.'s United Airlines, Continental Airlines Inc., AMR Corp.'s American Airlines and Northwest Airlines Corp. US Airways Group Inc. actually saw higher rates of redemption in 2005 than in 2002, and Delta Air Lines Inc. was unchanged. Both Delta and US Airways had higher redemption rates than competitors.

    to claim short-trip tickets, adding more seats to award inventory this fall and offering a new credit card with easier redemption features. Northwest said its numbers have remained relatively consistent -- roughly one in every 12 seats is a reward seat.

    Other airlines said declining redemption rates result from factors including an increase in paying customers, fuller planes and shifts in airline capacity. American says the number of awards it has issued has remained fairly constant, and while the number of passengers it carries has climbed, its seat capacity hasn't. In addition, several airlines said customer preferences like using miles for first-class upgrades or hoarding miles longer to land big international trips can affect the redemption rate. "Reward traffic does not spool up and absorb capacity increases as fast as revenue traffic does," said a Continental spokesman.

    Those numbers don't include awards that their customers redeem on partner airlines, so some of the decline could be attributable to an increase in consumers' opting to grab award seats on foreign airlines or other partners, says frequent-flier expert Randy Petersen. American, for example, does disclose more redemption data on its Web site and showed that last year, it issued more than 955,000 awards for travel on its partners, compared with the 2.6 million used on American and American Eagle flights.

    "The data can be misleading," said Mr. Petersen, founder of InsideFlyer.com. He'd like to see more data, including numbers on how many customers made requests but couldn't find seats.

    But further disclosure is unlikely to happen unless the government forces it. "Left to their own devices," said Tim Winship, publisher of FrequentFlier.com, "I see no reason to expect airlines to step up and disclose more."

    Frequent-flier award accountancy is something akin to voo doo and crystal ball estimation.

    Airlines Make More Money Selling Miles Than Seats The golden goose isn’t your ticket or bag fee—it’s the credit card you use to collect frequent flier miles ---
    https://www.bloomberg.com/news/articles/2017-03-31/airlines-make-more-money-selling-miles-than-seats?cmpid=BBD033117_BIZ&utm_medium=email&utm_source=newsletter&utm_term=170331&utm_campaign=bloombergdaily

     . . .

    Investors have failed to appreciate how crucial these programs are to airline profitability amid the stability consolidation brought, said Joseph DeNardi, a senior airline analyst with Stifel Financial Corp. in Baltimore. Since August, he’s issued a steady stream of client notes arguing that the market has undervalued the five largest airlines.

    DeNardi has repeatedly explained that investors have little insight into the billions of dollars large banks pay for these affiliations. At each airline investor call or conference, DeNardi has steadfastly prodded executives for greater reporting detail.

    In many ways, the Big Three U.S. airlines have organized themselves into two distinct businesses. There’s the traditional activity—the one with jets—which involves pricing seats for as much as possible, collecting a bag fee, and selling some food and drinks while keeping a close eye on costs. The other business is the sale of miles—mostly to the big banks, but also to companies that range from car rental firms to hotels to magazine peddlers.

    The latter has expanded so much that it accounts for more than half of all profits for some airlines, including American Airlines Group Inc., the world’s largest.

     Jensen Comment
    Accounting for "sales of miles" has always been problematic due to time differences between award dates and when customers book flights and uncertainties whether the awards will expire without being used by customers. This entails something akin to voo doo and crystal ball estimation.

    Accounting rules for booking frequent-flier miles recently changed and became very complicated under the revised accounting revenue recognition standard
    Foundations of Airline Finance

    by Bijan Vasigh et al.
    Routledge, Second Edition, 2015
    Beginning on Page 154
    Note the illustrations
    https://books.google.com/books?id=FVRWBQAAQBAJ&pg=PA167&lpg=PA167&dq=GAAP+%22Frequent+Flier+Miles%22&source=bl&ots=EzGeMCTu9n&sig=u90HFsYsQ0mLbmF_k0Xm4bVWlKs&hl=en&sa=X&ved=0ahUKEwil-M7f2IHTAhWW3oMKHeJGASc4ChDoAQgqMAM#v=onepage&q=GAAP%20%22Frequent%20Flier%20Miles%22&f=false

    This is an excellent illustration how accounting is more than counting beans and how specialized airline accountants and auditors must become in extremely technical issues.

     


     

    Insurance:  A Scheme for Hiding Debt That Won't Go Away

    "FASB Expands Discussion on Insurance Contracts," Journal of Accountancy, September 20, 2010 ---
    http://www.journalofaccountancy.com/Web/20103349.htm
    A joint project with the IASB.


    From the CFO Journal's Morning Ledger on June 21, 2013

    Insurance-accounting overhaul moves toward final phase
    The IASB just issued its latest draft of proposed new rules for accounting for insurance contracts,
    Emily Chasan reports. The proposal this week revises a 2010 exposure draft to reduce the impact of artificial, noneconomic volatility in insurance accounting and would change the way companies present insurance-contract revenue in their financial statements. New rules on insurance accounting are expected to make fundamental changes to the way companies account for insurance contracts, and add more principle-based rules to one of the most industry-specific areas of accounting. Read the exposure draft here (PDF).

    "Insurers Inflating Books, New York Regulator Says," by Mary Williams Walsh, The New York Times, June 11, 2013 ---

    New York State regulators are calling for a nationwide moratorium on transactions that life insurers are using to alter their books by billions of dollars, saying that the deals put policyholders at risk and could lead to another taxpayer bailout.

    Insurers’ use of the secretive transactions has become widespread, nearly doubling over the last five years. The deals now affect life insurance policies worth trillions of dollars, according to an analysis done for The New York Times by SNL Financial, a research and data firm.

    These complex private deals allow the companies to describe themselves as richer and stronger than they otherwise could in their communications with regulators, stockholders, the ratings agencies and customers, who often rely on ratings to buy insurance.

    Benjamin M. Lawsky, New York’s superintendent of financial services, said that life insurers based in New York had alone burnished their books by $48 billion, using what he called “shadow insurance,” according to an investigation conducted by his department. He issued a report about the investigation late Tuesday.

    The transactions are so opaque that Mr. Lawsky said it took his team of investigators nearly a year to follow the paper trail, even though they had the power to subpoena documents.

    Insurance is regulated by the states, and Mr. Lawsky said his investigators found that life insurers in New York were seeking out states with looser regulations and setting up shell companies there for the deals. They then used those states’ tight secrecy laws to avoid scrutiny by the New York State regulators.

    Insurance regulation is based squarely on the concept of solvency — the idea that future claims can be predicted fairly accurately and that each insurer should track them and keep enough reserves on hand to pay all of them. The states have detailed rules for what types of assets reserves can be invested in. Companies are also expected to keep a little more than they really expect to need — called their surplus — as a buffer against unexpected events. State regulators monitor the reserves and surpluses of companies and make sure none fall short.

    Mr. Lawsky said that because the transactions made companies look richer than they otherwise would, some were diverting reserves to other uses, like executive compensation or stockholder dividends.

    The most frequent use, he said, was to artificially increase companies’ risk-based capital ratios, an important measurement of solvency that was instituted after a series of life-insurance failures and near misses in the 1980s.

    Mr. Lawsky said he was struck by similarities between what the life insurers were doing now and the issuing of structured mortgage securities in the run-up to the financial crisis of 2008.

    “Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices,” Mr. Lawsky said. “And ultimately, those practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multitrillion-dollar taxpayer bailout.”

    The transactions at issue are modeled after reinsurance, a business in which an insurance company pays another company, a reinsurer, to take over some of its obligations to pay claims. Reinsurance is widely used and is considered beneficial because it allows insurers to spread their risks and remain stable as they grow. Conventional reinsurance deals are negotiated at arm’s length by independent companies; both sides understand the risk and can agree on a fair price for covering it. The obligations drop off the original insurer’s books because the reinsurer has picked them up.

    Mr. Lawsky’s investigators found, though, that life insurance groups, including some of the best known, were creating their own shell companies in other states or countries — outside the regulators’ view — and saying that these so-called captives were selling them reinsurance. The value of policies reinsured through all affiliates, including captives, rose to $5.46 trillion in 2012, from $2.82 trillion in 2007.

    Continued in article

    Also see
    "World Needs More Hardheads Like Benjamin Lawsky," by Jonathan Weil, Bloomberg News, June 13, 2013 ---
    http://www.bloomberg.com/news/2013-06-13/world-needs-more-hardheads-like-benjamin-lawsky.html

    Bob Jensen's threads on creative accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     


    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


    Question
    Why are the FASB and IASB hung up on insurance contracts standard?

    "Cross-Cutting Issues Impede Boards' Insurance Contracts Acquisition Costs Discussions," Bloomberg, June 6, 2012 ---
    http://www.bna.com/crosscutting-issues-impede-b12884909858/

    Cross-cutting issues involving other accounting rules appear to be impeding the Financial Accounting Standards Board and the International Accounting Standards Board from wrapping up discussions on how acquisition costs will be accounted for under an insurance contracts standard.

    The accounting of acquisition costs is important to insurers because they incur costs in acquiring and originating insurance contracts and these costs can be very high at contract inception.

    The boards May 24 redeliberated on the issue of how an insurer should account for the cash flows relating to the recovery of acquisition costs in the building block approach, including the presentation of information about those cash flows but did not conclude discussions on the topic which will continue in July. Suggestions included:

    Among issues that prevented the boards from moving forward in deliberations included current revenue recognition standard being developed, according to comments made by board members. Specifically, the implication that acquisition costs meet the criteria for an asset—one that raises issues of inconsistency within the insurance contracts discussions.

    Some board members said that acquisition costs should be dealt with consistently among accounting standards—pointing out that it was on the table for review. "I don't think we can answer the expense of an asset until we talk about revenue recognition," said FABB member Russell Golden. "…..it seems like if we're going to go down the [asset] route we ought to decide if it's an asset for all or an expense [but we] cannot decide today. Today we can decide do you want these in the margin or do you want these out of the margin," he said.

    Resolve Premiums.

    There are other issues, including guidance under U.S. GAAP to be considered to ensure consistency—that are also cross-cutting. Within the insurance industry direct acquisition costs (DAC) were always accounted for as an asset (basically allowing certain costs to acquire the business to be accounted for an asset). In the U.S. however—effective this year—there was a change in what could be included in that asset and what would be required to be expensed.

    The guidance, ASU No. 2010-26, Accounting for Costs Associated With Originating or Renewing Service Contracts, amends the guidance for insurance entities that apply the industry-specific guidance in ASC 944-30. It narrows the types of acquisition costs that can be deferred by insurers.

    Another issue stems from the accounting guidance under FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. This indicates that an entity's origination costs of a loan is the same as its acquisition cost (when it looks at what can be included in its origination cost).

    Those issues aside, some IASB members said the boards' first need to resolve issues surrounding premiums within the insurance contracts discussions before deciding on acquisition costs.

    The issue was all about presentation and is therefore linked very closely with premiums, said IASB member Stephen Cooper.

    "We haven't taken a decision yet about premiums," said Cooper. "Strikes me that the answer depends upon that decision; how can we make a decision on this before we can make a decision about premiums. It seems to me the only other question we can answer is whether you want an asset or not—can't answer any of the other questions," he said.

    Proposed Alternatives.

    The staff paper included the following as potential approaches (as written in the board handout) for the boards to consider:

    The IASB completely ruled out ever voting for Alternative A and the FASB completely ruled out ever voting for Alternative C.

    Potential Solution.

    In fact, all three alternatives were potentially problematic. "If we have premiums written I think C is the only way to do it B doesn't make any sense, said Cooper. "If we're going to have premiums earned neither of them make any sense," he said.

    He stated moreover that the problem with "C" is that "you have day revenue when you've done nothing—that doesn't make any sense…problem with B is your revenue is less than the premiums you actually receive—and you have no expense."

    Continued in article

     


    DataLine 2010-39:
    Insurance Contracts -- Fundamental Accounting Changes Proposed
    Source: PricewaterhouseCoopers
    Author name: PwC assurance services
    Published: 09/24/2010

    Summary:
    The FASB has issued a discussion paper seeking comments on its preliminary views on accounting for insurance contracts that would fundamentally change the accounting by insurers and other entities that issue contracts with insurance risk. The discussion paper is an outgrowth of the IASB and FASB’s joint efforts to develop a single converged insurance standard. The FASB's release of the discussion paper follows the IASB's late-July issuance of an exposure draft containing its proposals on the same topic. Both documents address recognition, measurement, presentation, and disclosure for insurance contracts. The discussion paper compares the IASB's proposal to the FASB's preliminary views to date and to current US GAAP. The FASB is asking constituents to consider whether the FASB should ultimately adopt some version of the IASB's proposal or whether targeted changes to existing US GAAP would be sufficient. There is greater urgency for the IASB to adopt some version of its exposure draft as a final standard since comprehensive guidance on insurance accounting does not currently exist under IFRS; a final IASB standard is expected in mid-2011. Given the potential impact of the changes being considered, management should consider assessing the implications of the possible changes on existing contracts and its current business practices and commenting on both documents. The comment letter period on the FASB discussion paper ends on December 15, 2010 (or November 30, 2010 for roundtable participants). The comment period for the IASB's exposure draft ends on November 30, 2010. This DataLine discusses both documents and offers the firm's insights on the proposals.

    Click Here for the Full Article ---
    http://cfodirect.pwc.com/CFODirectWeb/download?sourcetype=contentattachment&content=GBAD-89LJ3C&filename=DataLine%202010-39.pdf


    The SEC and Eliot Spitzer (before resigning) have launched probes into sales by insurance firms of products that help customers burnish results.  Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

    "Fresh Probes Target Insurers' Earnings Role," by Theo Francis and Jonathan Weil, The Wall Street Journal, November 8, 2004, Page C1 --- http://online.wsj.com/article/0,,SB109988032427267296,00.html?mod=home_whats_news_us 

    The Securities and Exchange Commission and New York Attorney General Eliot Spitzer each have launched investigations into sales by insurance companies of questionable financial products that help customers burnish their financial statements, according to people familiar with the matter.

    The SEC's enforcement division is conducting an industrywide investigation into whether a variety of insurance companies may have helped customers improperly smooth their earnings by selling them financial-engineering products that were designed to look like insurance but in some cases were little more than loans in disguise, people familiar with the matter say. The agency is focusing on a universe of products that are intended to achieve desired accounting results for customers' financial statements, as opposed to traditional insurance, whose primary goal is transferring risk of losses from a policyholder to the insurer selling the coverage.

    Meanwhile, New York state investigators are preparing to issue subpoenas as soon as this week to several large insurance companies. After months of combing through industry documents in its continuing probe of insurance-broker compensation, Mr. Spitzer's office has grown increasingly concerned about insurance-industry products, detailed in The Wall Street Journal last month, that customers can use to manipulate their income statements and balance sheets.

    Although Mr. Spitzer's office and the SEC began looking into the issue separately, they have discussed sharing information and resources, according to a person familiar with the probes.

    Normally, an insurer is paid a specific amount of premiums to take on a risk of uncertain size and timing. In the "insurance" at issue, the risk of loss to the insurer selling the policy is limited and sometimes even eliminated -- partly because, in these policies' simplest form, the premiums are so high; other times, the loss already has occurred.

    Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

    Continued in the article

    Insurance companies historically have been rancid with white collar crime and consumer rip offs.  Bob Jensen's threads on insurance company scandals are at http://faculty.trinity.edu/rjensen/fraudRotten.htm#Insurance



    Off-Balance-Sheet Entities: The Good, The Bad And The Ugly - This article defines some typical off-balance-sheet items and discusses when they are justified and when they are misleading.

    The Good
    Off-balance-sheet companies were created to help finance new ventures. Theoretically, these separate companies were used to transfer the risk of the new venture from the parent to the separate company. This way, the parent could finance the new venture without diluting existing shareholders or adding to the parent's debt burden. These separate legal entities could be privately held partnerships or publicly traded spin-offs.

    Sometimes the separate companies were created to pursue a business project that was a part of the parent's main line of business. For example, oil-drilling companies established off-balance-sheet subsidiaries as a way to finance oil exploration projects. These subsidiaries were jointly funded by the parent and outside investors who were willing to take the exploration risk. The parent company could have sold shares or borrowed the money directly, but the accounting and tax laws were designed to allow the project funding come from investors who were interested in investing in specific explorations rather than investing in the parent company.

    Other times these separate companies were created to house businesses that were decidedly different from the parent's line of work (in order to unlock "value"). For example, Williams Co's, created Williams Communications to pursue the communications business. Williams Companies spun off Williams Communications, but the bankers required the parent to guarantee the debt of Williams Communications. Because Williams Communications was a new company, this is not an unusual request.

    This use of off-balance-sheet entities is good in that it transfers risk from the parent's shareholders to others that were willing to take the business risk. Investors in Williams Companies (an energy resource company) may not have wanted to invest in a communications company, so management created a separate entity to house that business. Likewise, oil companies used off-balance-sheet entities to remove the exploration risk from their business to share it with others that wanted a bigger piece of the potential return from exploration.

    The Bad
    While GAAP and tax laws allow off-balance-sheet entities for valid reasons noted above, bad things happen when economic reality differs significantly from the assumptions that were used to justify the off-balance-sheet entity. Problems also occur when egos get too big.

    In Williams's case, the decision to spin off the communications business was reasonable at the time. The parent had the infrastructure on which to build a communications network, but it was an energy company. By spinning off the subsidiary, it was not forcing its investors to take on the risk of a communications company, and it was able to take advantage of the market's demand for communication stocks. At the same time, the need to guarantee the debt of a new subsidiary is a reasonable request that bankers make in this type of transaction.

    What went "wrong" was that economic reality differed from the assumptions that were used to justify the spin off. Dotcom mania resulted in over-capacity, causing problems for all telecommunications companies. The loan guarantee, which is never expected to be triggered, is now an issue for the company because of the recession and the slump in the telecommunications sector.

    Enron exemplifies how ego can be the basis for the misuse of off-balance-sheet items. Here, off-balance-sheet vehicles appear to have been used to pump up financial results rather than for legitimate business purposes. What started as a plan to legitimately use off-balance-sheet vehicles morphed into ways to manufacture earnings as trades went bad. While one could argue that this is also a case of economic reality differing from expectations, the way management reacted to the situation allows us to classify it as an ego thing.

    This financial engineering is usually fueled by the need to reach certain operating targets established by Wall Street or compensation plans. Once management succumbs to this "Dark Side", more time is spent on trying to game the system than trying to manage the core business. It is then only a matter of time before the house of cards falls.

    The Ugly
    It gets ugly when the markets start to punish a stock just because it has an off-balance-sheet item. Granted, it is not always easy to read a company's SEC filings, let alone dig into the footnotes and figure out how the off-balance-sheet items might impact results. But the companies that provide full disclosure will probably be the better investments.

    Conclusion The loss of faith in accounting's ability to provide full disclosure could have a bigger impact on the stock market than the events of September 11th. The attacks were an exogenous factor and we bounced back nicely. The loss of confidence in financial statements is an attack on one of the core elements of investment decision making. To quote Johnny Cochran, "If the statements aren't true, what will we do?"

    However, the focus on off-balance-sheet accounting will have two major benefits. First, it will result in new regulations that will hopefully prevent future Enrons. Some of these changes will likely be the following:

    Prevention of officers of the parent from being officers of the off-balance-sheet subsidiary

    Increasing the percentage ownership by outside and non-affiliated companies

    Enforcing disclosure rules so that investors can clearly understand the risk (if any) posed by off-balance-sheet companies Second, market over-reaction creates a buying opportunity. Markets always overreact, causing panic in the Street. Uncertainty created by the loss of faith in financial disclosures could even cause more damage to the market than extreme events like September 11th.

    Bob Jensen's threads on VIE's (SPEs) are at http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm



    Uncovering Hidden Debt - Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.

    Is the company whose stock you own carrying more debt than the balance sheet is showing? Most of the information about debt can be found on the balance sheet--but many debt obligations are not disclosed there. Here is a review of some off-balance-sheet transactions and what they mean for investors.

    The term "off-balance-sheet" debt has recently come under the spotlight. The reason, of course, is Enron, which used underhanded techniques to shift debt off its balance sheet, making the company's fundamentals look far stronger than they were. That said, not all off–balance-sheet finance is shady. In fact, it can be a useful tool that all sorts of companies can use for a variety of legitimate purposes--such as tapping into extra sources of financing and reducing liability risk that could hurt earnings.

    As an investor, it's your job to understand the differences between various off-balance-sheet transactions. Has the company really reduced its risk by shifting the burden of debt to another company, or has it simply come up with a devious way of eliminating a liability from its balance sheet?

    Operating Leases
    A lot of investors don't know that there are two kinds of leases: capital leases, which show up on the balance sheet, and operating leases, which do not.

    Under accounting rules, a capital lease is treated like a purchase. Let's say an airline company buying an airplane sets up a long-term payment lease plan and pays for the airplane over time. Since the airline will ultimately own the plane, it shows up on its books as an asset, and the lease obligations show up as liabilities.

    If the airline sets up an operating lease, the leasing group retains ownership of the plane; therefore, the transaction does not appear on the airline's balance sheet. The lease payments appear as operating expenses instead. Operating leases, which are popular in industries that use expensive equipment, are disclosed in the footnotes of the company's published financial statements.

    Consider Federal Express Corp. In its 2004 annual report, the balance sheet shows liabilities totaling $11.1 billion. But dig deeper, and you will notice in the footnotes that Federal Express discloses $XX worth of non-cancelable operating leases. So, the company's total debt is clearly much higher than what's listed on the balance sheet. Since operating leases keep substantial liabilities away from plain sight, they have the added benefit of boosting--artificially, critics say--key performance measures such as return-on-assets and debt-to-capital ratios.

    The accounting differences between capital and operating leases impact the cash flow statement as well as the balance sheet. Payments for operating leases show up as cash outflows from operations. Capital lease payments, by contrast, are divided between operating activities and financing activities. Therefore, firms that use capital leases will typically report higher cash flows from operations than those that rely on operating leases.

    Synthetic Leases
    Building or buying an office building can load up a company's debt on the balance sheet. A lot of businesses therefore avoid the liability by using synthetic leases to finance their property: a bank or other third party purchases the property and rents it to the company. For accounting purposes, the company is treated like a tenant in a traditional operating lease. So, neither the building asset nor the lease liability appears on the firm's balance sheet. However, a synthetic lease, unlike a traditional lease, gives the company some benefits of ownership, including the right to deduct interest payments and the depreciation of the property from its tax bill.

    Details about synthetic leases normally appear in the footnotes of financial statements, where investors can determine their impact on debt. Synthetic leases can become a big worry for investors when the footnotes reveal that the company is responsible for not only making lease payments but also guaranteeing property values. If property prices fall, those guarantees represent a big source of liability risk.

    Securitizations
    Banks and other financial organizations often hold assets--like credit card receivables--that third parties might be willing to buy. To distinguish the assets it sells from the ones it keeps, the company creates a special purpose entity (SPE). The SPE purchases the credit card receivables from the company with the proceeds from a bond offering backed by the receivables themselves. The SPE then uses the money received from cardholders to repay the bond investors. Since much of the credit risk gets offloaded along with the assets, these liabilities are taken off the company's balance sheet.

    Capital One is just one of many credit card issuers that securitize loans. In its 2004 first quarter report, the bank highlights results of its credit card operations on a so-called managed basis, which includes $38.4 billion worth of off-balance-sheet securitized loans. The performance of Capital One's entire portfolio, including the securitized loans, is an important indicator of how well or poorly the overall business is being run.

    Conclusion
    Companies argue that off-balance-sheet techniques benefit investors because they allow management to tap extra sources of financing and reduce liability risk that could hurt earnings. That's true, but off-balance-sheet finance also has the power to make companies and their management teams look better than they are. Although most examples of off-balance sheet debt are far removed from the shadowy world of Enron's books, there are nonetheless billions of dollars worth of real financial liabilities that are not immediately apparent in companies' financial reports. It's important for investors to get the full story on company liabilities.



    Show and Tell: The Importance of Transparency  - Clear and honest financial statements not only reflect value, they also help ensure it.

    Ask investors what kind of financial information they want companies to publish and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

    But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with inscrutable financials and complex business structures are riskier and less valuable investments.

    Transparency Is Assurance The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are "easily understood", "very clear", "frank", and "candid".

    Consider two companies with the same market capitalization, same overall market-risk exposure, and the same financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company A is a single-business company with easy-to-understand financial statements. Company B, by contrast, has numerous businesses and subsidiaries with complex financials.

    Which one will have more value? Odds are good the market will value Company A more highly. Because of its complex and opaque financial statements, Company B's value will be discounted.

    The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult if not impossible to evaluate a company's investment performance if its investments are funneled through holding companies, making them hidden from view. Lack of transparency may also obscure the company's level of debt. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.

    High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers employ fuzzy financials and complex business structures to hide unpleasant news. Lack of transparency can mean nasty surprises to come.

    Blurry Vision The reasons for inaccurate financial reporting are varied: a small but dangerous minority of companies actively intends to defraud investors; other companies may release information that is misleading but technically conforms to legal standards.

    The rise of stock option compensation has increased the incentives for companies to misreport key information. Companies have increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.

    Furthermore, some firms are simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric - an enormous conglomerate with dozens of businesses, from GE Plastics to NBC - is more challenging than examining the financials of a firm like Amazon.com, a pure play online retailer.

    When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. For instance, a firm that keeps each business separate will be easier to value than one that squeezes all the businesses into a single entity. Meanwhile, the increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can befuddle investors.

    The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.

    Transparency Pays
    Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Transparency pays, according to Robert Eccles, author of "Building Public Trust – The Value Reporting Revolution". Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

    Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information, so that the market can upgrade their fair value.

    Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure play firms, conglomerates are discounted by as much as 20%. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

    Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

    It's worth noting that, even if a company's financial statements are totally transparent, investors may still not understand them. If biotech specialist Amgen and semiconductor maker Intel were totally forthcoming about their R&D spending, investors might still lack the knowledge to properly value these companies.

    Conclusion
    Investors should seek disclosure and simplicity. The more companies say about where they are making money and how they are spending their resources, the more confident investors can be about the companies' fundamentals.

    It's even better when financial reports provide a line-of-sight view into the company's growth drivers. Transparency makes analysis easier and thus lowers an investor's risk when investing in stocks. That way you, the investor, are less likely to face unpleasant surprises.


    FASB Issues FAS 163 "Accounting for Financial Guarantee Insurance Contracts"--- http://www.fasb.org/pdf/fas163.pdf

    From the AccountingWeb on May 27, 2008 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=105224

    Last week The Financial Accounting Standards Board (FASB) issued FASB Statement No. 163, Accounting for Financial Guarantee Insurance Contracts. The new standard clarifies how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. It also requires expanded disclosures about financial guarantee insurance contracts. The Statement is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise's risk-management activities. Disclosures about the insurance enterprise's risk-management activities are effective the first period beginning after issuance of the Statement. "By issuing Statement 163, the FASB has taken a major step toward ending inconsistencies in practice that have made it difficult for investors to receive comparable information about an insurance enterprise's claim liabilities," stated FASB Project Manager Mark Trench. "Its issuance is particularly timely in light of recent concerns about the financial health of financial guarantee insurers, and will help bring about much needed transparency and comparability to financial statements."

    The accounting and disclosure requirements of Statement 163 are intended to improve the comparability and quality of information provided to users of financial statements by creating consistency, for example, in the measurement and recognition of claim liabilities. Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. It also requires disclosure about (a) the risk-management activities used by an insurance enterprise to evaluate credit deterioration in its insured financial obligations and (b) the insurance enterprise's surveillance or watch list.




    Warranty Accounting

    Teaching Case on Warranty Accounting
    From The Wall Street Journal Weekly Accounting Review on February 6, 2015

    Beazer Homes Loss Widens Amid Warranty Charge
    by: Chelsey Dulaney
    Jan 31, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Warranty Expenses

    SUMMARY: Beazer Homes USA Inc.'s loss widened in its December 2012 quarter as home closings fell and the company was hit by unexpected warranty costs that eroded profitability. Chief Executive Allan Merrill said that the quarter's results were weighed by a low backlog conversion rate and an unexpected $13.6 million charge stemming from stucco installation issues in some of its Florida homes that resulted in water intrusion. Shares were down 2.3% at $16.85 in premarket trading.

    CLASSROOM APPLICATION: This article could be used when discussing financial reporting related to warranty expenses.

    QUESTIONS: 
    1. (Introductory) What facts did the article report regarding Beazer Homes December quarter's results? What impact have warranty costs had on Beazer Homes?

    2. (Advanced) How are warranty expenses usually booked? When are those expenses accrued? What accounts are increased or decreased?

    3. (Advanced) What should a company do if it unexpectedly experiences an unusually large number of warranty claims or a large dollar amount? How would that be recorded in journal entries? How would it affect the financial statements?

    4. (Advanced) What has been the impact of the warranty expense information on the market price of the company's shares? Why did that happen?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    "Beazer Homes Loss Widens Amid Warranty Charge," Chelsey Dulaney, The Wall Street Journal, January 31, 2015 ---
    http://www.wsj.com/articles/beazer-homes-loss-widens-amid-warranty-charge-1422627932?mod=djem_jiewr_AC_domainid

    Beazer Homes USA Inc. ’s loss widened in its December quarter as home closings fell and the company was hit by unexpected warranty costs that eroded profitability.

    Chief Executive Allan Merrill said Friday that the quarter’s results were weighed by a low backlog conversion rate and an unexpected $13.6 million charge stemming from stucco installation issues in some of its Florida homes that resulted in water intrusion.

    Shares were down 2.3% at $16.85 in premarket trading.

    Mr. Merrill said Friday that an improving sales environment and a higher backlog should help boost the company’s future performance.

    At the end of the quarter ended Dec. 31, Beazer’s backlog was up 1.2% to 1,771 homes, with a sales value of $560.5 million.

    Overall, Beazer reported a loss of $22.3 million, or 84 cents a share, compared with a loss of $5.14 million, or 21 cents a share, a year earlier.

    Revenue fell 9.3% to $265.8 million.

    Analysts polled by Thomson Reuters had expected a per-share loss of 12 cents on revenue of $296.4 million.

    Total home closings fell 14.7% in the quarter, as the average sales price from closings grew 5.8%.

    The home-building gross margin, excluding impairments and abandonments, and interest, fell to 16.6% from 21.2%. Excluding the aforementioned items and the Florida warranty costs, margins would have edged up to 21.8% from 21.2%.

    New home orders increased 7.9% in the quarter.

    Bob Jensen's threads on warranty accounting
    http://faculty.trinity.edu/rjensen/Theory02.htm#LifetimeWarranties

     


    Question
    How would you account for warranty obligations of Tesla electric automobiles?

    "Tesla's Earnings Quality Is Sketchy, But Its Stock Keeps Soaring," by Herb Greenberg, Business Insider, May 16, 2013 ---
    http://www.businessinsider.com/teslas-stocks-keep-soaring-2013-5

    If profits matter going forward, so does earnings quality. And according to Gradient Analytics, the earnings quality gets a grade of 'F."

    What stands out the most?

    "So many things," says Gradient research director Donn Vickrey. "By declaring themselves profitable, I said there is just no way. How can this be at this point in the cycle? It has to be purely a paper profit and at that some elements of the paper may be lower quality than usual."

    Paper or not, Vickrey believes whatever Tesla's profitability, it isn't sustainable.

    Rather than go through all of his points, let's focus on just one: warranty accruals. This is the amount the company puts aside for expected warranty expenses — a non-cash charge that hits earnings as a cost of goods sold. The lower the provision, the less of a hit to earnings.

    It's highly subjective, and Tesla current reserves at a rate, relative to sales, in-line with Ford and General Motors. But its warranty is longer than mainstream auto companies and "its product is based on new technology with unproven reliability," according to Gradient's report on Tesla." Of particular concern: The firm's eight-year, 100,000 mile battery warranty could prove to be extremely costly."

    But what if the company is so new it simply doesn't know — so uses existing auto companies as a benchmark?

    Under accounting rules, Vickrey says, if you don't know what they'll be "they should be higher, not lower."

    Continued in article

    Bob Jensen's threads on warranty accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#LifetimeWarranties


    How do we account for “lifetime warranties” that are not backed by the Federal government?
    How do we account for “lifetime warranties” that are backed by the Federal government?

    Actually if we assume “going concern” accounting, the accountants and auditors can probably ignore the government backing of warranties as defined at http://wheels.blogs.nytimes.com/2009/03/30/understanding-obamas-auto-warranty-plan/ 

    But there’s still a question of how to estimate warranty reserves for “lifetime warranties?” Do auditors now have to factor in actuarial life expectancies of buyers of new Chrysler vehicles?

    July 9, 2009 message from XXXXX

    Bob,

    One issue that was brought up earlier was the risk of not being able to collect on a warranty for a new car purchased from GM or Chrysler. I'm looking at new cars. Do you have any idea whether GM will deliver on warranty repairs for a car purchased now?

    July 9, 2009 reply from Bob Jensen

    Hi XXXXX,

    The thing to do is read the fine print in the Federal government's so-called guarantee to make good on Chrysler and GM warranties if the companies default.

    First take a look at http://wheels.blogs.nytimes.com/2009/03/30/understanding-obamas-auto-warranty-plan/

    On Monday morning, President Obama announced that the Treasury Department would back the warranties of new General Motors and Chrysler vehicles.

    “If you buy a car from Chrysler or General Motors, you will be able to get your car serviced and repaired, just like always,” President Obama said during a speech from the White House. “Your warranty will be safe. In fact, it will be safer than it’s ever been, because starting today, the United States government will stand behind your warranty.”

    The administration’s plan to stand behind new-car warranties for G.M. and Chrysler is intended to reassure consumers worried about buying domestic vehicles. And to a large extent, the plan should do exactly that. But people who already own a G.M. or Chrysler vehicle are not covered by this program and it also does not cover safety recalls, which can occur years after the warranty expires.

    In a nutshell: The Obama warranty commitment program sets up special warranty accounts that will be used only if the automaker runs out of money. If that happens, the government will “appoint a program administrator who, together with the U.S. Government, will identify an auto service provider to supply warranty services.” Those accounts will be funded with 125 percent of the expected warranty cost. The automaker will contribute 15 percent and the government 110 percent. The federal funds will come from the Troubled Asset Relief Program.

    That could be a lot of money (except, perhaps, by the government’s current standards). For example, G.M. paid $4.5 billion worldwide in 2007 on warranties and $3.9 billion during the first nine months of last year, according to a filing with the Securities and Exchange Commission.

    A Treasury spokesman said the warranties would cover all vehicles, even those sold overseas. And although the program does not cover safety recalls, he said even an automaker in Chapter 11 bankruptcy would be required to pay for them.

    In the case of a defect, an automaker is typically on the hook for a safety recall for a decade. A major recall could easily cost an automaker $50 million or more, said Clarence Ditlow, the executive director of the Center for Auto Safety.

    General Motors has promised it will stand behind its warranty, although it is not clear how that would happen should it simply lack the funds. Chrysler’s statement –- issued last month and not revised — simply says: “We are committed to serving our customers.”

    The government backing should reassure consumers, but there are plenty of questions, said Jon Linkov, managing editor of the automobile section at Consumer Reports magazine.

    For example, he said, if an automaker goes out of business, how well and how quickly would the new-vehicle warranty program work and who would do more sophisticated repairs? “I guess there are more questions out there than answers,” Mr. Linkov said.

    Jeremy Anwyl, the chief executive of Edmunds.com, said he didn’t think there was much risk over the warranty anyway. “This statement from the government makes the risk even less,” he said. “There is probably more risk for consumers around resale value.”

     

    One risk is that if GM or Chrysler should fail, parts will become harder and harder to find for cars, especially models that may only have been available for a short time so that there are very few used cars to cannibalize for parts. If both your Chrysler company and your Chrysler transmission (with that dubious "life-time" Chrysler power train warranty) should fail, what happens if there are no longer any needed transmission parts? Ask the dealer to explain this scenario before you buy a Chrysler or a GM car!

    It's also not clear whether the Government's warranty backup plan will cover Fiats when Chrysler begins to sell Fiats. Wouldn't that be a kick in the butt when our Federal government backs up Italian car warranties but not Ford Motor Company warranties?

     Bob Jensen

    A15. Lifetime means lifetime
    This is put in writing by Chrysler at http://www.chrysler.com/en/lifetime_powertrain_warranty/faq.html
    Jensen Comment
    I'm not certain President Obama really understands that he is now backing up each new Chrylser's powertrain for a "lifetime" which attorneys can claim provides coverage until the buyer dies. Do you want to buy each of your newborns a new Chrysler? What a bummer if this also includes Fiats.

    How anxiously are you awaiting a FIAT with a Chrysler boilerplate?
    When FIAT entered the U.S. market and failed in the 1970s it was called "Fix It Again, Tony"
    Why does the Second Italian Navy use glass bottom boats? To look for the first Italian Navy.
    Who put the seven bullets into Benito Mussolini? Three hundred Italian marksmen.

    Among the 38 automobile models tested for reliability in 2008 ---
    http://www.which.co.uk/reviews/cars-and-motoring/index.jsp
    Honda and Toyota at the top of the 2008 reliability list, followed closely by Daihatsu, Lexus, Mazda, and Subaru. This largely mirrors the latest Consumer Reports predicted reliability ranking, though there Scion was at the top and Mazda placed 12th with Consumer Reports due to a different model line-up. Fiat ranked 35th (out of 38), followed by Renault, Land Rover, and Chrysler/Dodge. Jeep is the highest-rated brand from Chrysler, with its 29th place just barely keeping it in the “Poor” category. Fiat, Chrysler, and Dodge are categorized as “Very poor.” In total, Fiat, Chrysler, and Dodge provide similar reliability, and it isn’t good.
    Consumer Reports, May 5, 2009 ---
    http://blogs.consumerreports.org/cars/2009/05/chrysler-and-fiat-reliability-merger-of-equals.html
    Consumer Reports online subscribers can see how brands compare.--- Click Here
    Jensen Comment
    My 1989 Cadillac is ten times more reliable than my 1999 Jeep Cherokee. I don't plan to shift gears into a FIAT. My next car up in these mountains will probably be a Subaru station wagon (with all-wheel drive).

    Answer to a question from Pat Walters

    I’m curious if cars die for reasons other than powertrain failures or being totaled in collisions?

    It would seem that most anything on a car that declines due to wear and tear can be replaced. It’s the powertrain replacements that usually make it not worthwhile to make repairs (due to the cost of making powertrain repairs).

    There’s also a Catch 22 in Chrysler’s lifetime powertrain warranty. The car has to be taken regularly to a Chrysler dealer for powertrain inspection and maintenance. What if Chrysler fails and there are no more Chrysler dealers to do the powertrain inspections and maintenance? Does this get Obama’s powertrain backup off the hook?

    If Maxwell had a lifetime powertrain warranty on the car that Jack Benny purchased, he undoubtedly would have driven that Maxwell right up to the day he died --- http://www.youtube.com/watch?v=U-z7t5Fkg3o

    A picture of a Maxwell automobile like Jack owned is available at http://en.wikipedia.org/wiki/Maxwell_automobile

    Mel Blanc's classic routine --- Click Here
    http://www.youtube.com/watch?v=O9s8U0O0XPE&feature=PlayList&p=3C493293CF8D2819&playnext=1&playnext_from=PL&index=36

    In the 1970s, K-Mart offered an insane warranty that would replace a battery with no replacement cost for as long as you owned the car. Little did K-Mart realize that people like me drive cars for 20 or 30 years. I think I had eight totally free battery replacements. Once I even wore a Jack Benny nametag into the K-mart service center. They did seem to appreciate my humor.

    If Plymouth had a given me a lifetime powertrain warranty on by 1970 stationwagon, I would still be driving a 1970 Plymouth stationwagon with new fenders, doors, seats, radiator, muffler, exhaust pipes, and of course a new battery from K-Mart (those lifetime battery warranties are still good).

    Alas, in 1998 my Plymouth stationwagon transmission failed (the car would only go in reverse). At that time I decided that replacing this component of the powertrain did not meet the benefit-cost test without having a lifetime powertrain warranty from Plymouth. The saddest part was having to give up the lifetime battery replacement from K-Mart.

     Bob Jensen

    Tips on Personal Finance --- http://twitter.com/EverydayFinance

    Bob Jensen's threads on personal finance --- http://faculty.trinity.edu/rjensen/bookbob1.htm#InvestmentHelpers


    Disclosure Issues Regarding Materiality

    Illustration of the Use of Materiality Guidelines to Commit Accounting Fraud

    Swisher Hygiene --- http://www.charlotteobserver.com/news/business/article40301211.html

    As long as the changes aren’t material, I wouldn’t need to disclose.
    "Former Swisher CFO, accountant charged in fraud case," The Charlotte Observer, October 19, 2015 ---
    http://www.charlotteobserver.com/news/business/article40301211.html

    . . .

    Kipp, the former CFO, was fired in 2012 as part of the probe, Swisher said. According to the federal indictment, Kipp, Viard, Pierrard and other employees who haven’t been charged used a variety of tricks to juice the company’s earnings in order to hit predetermined target numbers.

    For example, the company allegedly used “cookie jar” accounting, inflating reserves of other companies it acquired and then drawing those reserves down to inflate earnings. Prosecutors say the company also took expenses that should have been booked on the profit-and-loss sheet and moved them to Swisher’s balance sheet, fraudulently reducing its reported expenses.

    According to prosecutors, Kipp emailed Viard on Oct. 15, 2011, and said “I need to get about $300k in expense reductions.”

    Viard responded with ideas of accounting items they could adjust, prosecutors said, and wrote back that “As long as the changes aren’t material, I wouldn’t need to disclose.” They reduced an accounting charge by $500,000, prosecutors charge, inflating earnings by the same amount.

    Later that same day, Kipp emailed Viard again, prosecutors said, to tell her they would be able to make their earnings target.

    “Here is the sum of my handy work for the day. I think if we can make all these stick, we can make it to the forecast of $3.5 million,” prosecutors say Kipp wrote.


    Read more here: http://www.charlotteobserver.com/news/business/article40301211.html#storylink=cpy

    In 2015 after a critical audit Swisher fired the audit firm of BDO ---
    http://www.sec.gov/Archives/edgar/data/1504747/000135448815001539/swsh_10k.htm
    In 2014 BDO reported concerns that Swisher had going concern issues.

    Bob Jensen's Fraud Updates --- http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on November 6, 2015

    Firms, Regulators Try to Sort Out What's Worth Disclosing to Investors
    by: Emily Chasen and Samuel Rubenfeld
    Nov 03, 2015
    Click here to view the full article on WSJ.com

    TOPICS: FASB, Financial Accounting, IASB, Materiality

    SUMMARY: Finance chiefs are preparing for changes in one of their most fundamental tasks: figuring out what's important enough to tell shareholders. Regulators in the U.S. and abroad are tinkering with the concept of "materiality," or how to determine what information is necessary for companies to disclose publicly. For companies, the sorting process is costly and complex, partly because what's considered "material" varies from regulator to regulator. Congress and the Supreme Court also have their own ideas.

    CLASSROOM APPLICATION: This article offers an excellent look at the different definitions of materiality and the challenges associated with determining what is material.

    QUESTIONS: 
    1. (Introductory) What is materiality? What are some examples of situations in which materiality would apply?

    2. (Advanced) Why is materiality important in accounting? How does it help accountants? How does it affect users of the financial statements?

    3. (Advanced) Why are companies so challenged in determining what is material? What parties or organizations have determined a definition of materiality and what are the various definitions in each of those cases? How do the definitions differ?

    4. (Advanced) Why have so many parties defined materiality? Why do those definitions vary?

    5. (Advanced) What could be done to create more consistency between the materiality definitions? What party or parties could work to unify the definition?

    6. (Advanced) What is the IASB? What is its area of responsibility? What is FASB? What is its purpose? What are its areas of authority? Why are these parties involved in the defining materiality?

    7. (Advanced) How has preparation of financial statements changed in recent years? How has the use of financial statements by outside parties changed? How does this affect materiality?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    RELATED ARTICLES: 
    Definition of Materiality Depends Who You Ask
    by Emily Chasan
    Nov 03, 2015
    Online Exclusive

    International Accounting Regulator Offers New Guidance on Materiality
    by James Willhite
    Oct 28, 2015
    Online Exclusive

    FASB Proposes Changes to 'Materiality'
    by Emily Chasan
    Sep 24, 2015
    Online Exclusive

    "Firms, Regulators Try to Sort Out What's Worth Disclosing to Investors," by Emily Chasen and Samuel Rubenfeld, The Wall Street Journal, November 3, 2015 ---
    http://www.wsj.com/articles/firms-regulators-try-to-sort-out-whats-worth-disclosing-to-investors-1446511890?mod=djem_jiewr_AC_domainid

    Finance chiefs are preparing for changes in one of their most fundamental tasks: figuring out what’s important enough to tell shareholders.

    Regulators in the U.S. and abroad are tinkering with the concept of “materiality,” or how to determine what information is necessary for companies to disclose publicly.

    For companies, the sorting process is costly and complex, partly because what’s considered “material” varies from regulator to regulator. Congress and the Supreme Court also have their own ideas.

    “A lot of [companies] find it difficult to work with the concept of materiality,” said Hans Hoogervorst, chairman of the London-based International Accounting Standards Board. Last week the board proposed allowing corporate executives to exercise more of their own judgment on what’s crucial to include in public filings.

    At least a half-dozen standard setters, including accounting rule makers, the Securities and Exchange Commission and various stock exchanges, have guidelines on the subject. Some of them want companies to sharpen their focus to avoid overwhelming investors with useless information.

    The U.S. Financial Accounting Standards Board announced plans in September to do away with its own standard and instead defer to one set by the U.S. Supreme Court in 1976. The board said it wanted to clarify that “materiality is a legal concept.” The SEC is also working on its own project to improve the usefulness of corporate disclosures and is seeking input from the public through the end of November.

    Business groups including the U.S. Chamber of Commerce say they plan to press the issue this year because of the growing complexity of deciding what information is crucial to keeping shareholders in the loop.

    “Disclosure may be straying from its core purpose,” said John Hayes, chief executive of packaging company Ball Corp, who heads the Business Roundtable’s corporate governance group. “If we thought these things were material to having our investors make informed decisions, we’d be talking about them already. But it actually gets in the way.”

    Continued in article


    From the CFO Journal's Morning Ledger on October 1, 2015

    CEOs ask Congress to return “materiality” to securities laws
    http://blogs.wsj.com/cfo/2015/09/30/business-roundtable-asks-congress-to-put-materiality-back-into-securities-laws/?mod=djemCFO_h
     Legislators should allow regulators to refocus their efforts on material issues in financial statements, instead of aiming to solve social problems through such documents, according to a new report by The Business Roundtable. Emily Chasan reports that the group, which represents CEOs, takes issue with new rules mandated by Dodd-Frank that demand disclosures on conflict minerals and payments to foreign governments without regard to materiality.

    Jensen Comment
    Materiality might be less relevant here than in financial reporting. For example, inadvertently capitalizing $1 million of transactions that should have been expensed for a company having $60 billion in net earnings is not material in terms of earnings reporting. Nor is a foreign bribe that impacts the bottom line by $1 million material in terms of earnings. However, the same bribe in a small company having less than $2 million in earnings is material in terms of earnings. The issue in these two cases, however, is the issue of being inadvertent versus deliberate.

    Should deliberate violations of regulations be treated differently in large versus small companies? Perhaps we should add criteria regarding deliberate intent to materiality considerations.

     

    FASB writes two new exposure drafts on materiality concept ---
    http://www.journalofaccountancy.com/news/2015/sep/fasb-proposal-what-materiality-means-201513079.html

    Deloitte:  FASB Modifies View on Immaterial Disclosure Omissions --- http://deloitte.wsj.com/cfo/

    The FASB has issued a proposed standard indicating that the omission of disclosures about immaterial information in the notes is not an accounting error. Additionally, the board noted that materiality is a legal concept that shall be applied to assess quantitative and qualitative disclosures individually and in the aggregate in the context of the financial statements taken as a whole. Currently, failure to provide required disclosures on the basis of materiality concerns is considered an accounting error.

    October 1, 2015 reply from Dennis Beresford

    Bob,

     

    The 18 page white paper on this topic published by the Business Roundtable can be accessed at:
    http://businessroundtable.org/sites/default/files/reports/Materiality White Paper FINAL 09-29-15.pdf

     Denny

    October 1, 2015 reply from Bob Jensen

    Thank you Denny,

     

    That is a value-added link. But I think it still is somewhat vague. Consider the following quotation:

     

     

    Court then articulated the standard for materiality that is still widely used today: 
       
    “An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote… . It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder. Put another way , there must be a substantial likelihood that the disclosure of the
    omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information available. ”

     

    Jensen Comment
    There are really two types of omitted facts that arise in this situation and in nearly every situation where a parent learns about something bad done by a teenage child. Firstly, there's the fact that concerning the deed and how bad the deed is from a materiality standpoint no matter who did the deed. For example, if $5 in merchandise is shoplifted the materiality can be judged on the value of the amount stolen.

     

    Then there's the fact that your child felt an need or an urge to shoplift at all, thereby violating your trust in the child.

     

    Thus we have two possibly omitted facts that were learned. One is that $5-value fact. The other is that it was your child.

     

    Some investors may not be concerned about small-valued improprieties per se. But they may be concerned that management would commit the impropriety irrespective of the value involved.

     

    My point is that some investors may overlook improprieties that are not material in value. Other investors, perhaps more religious investors, may find it hard to forgive no matter what the materiality of the sin involved. Thus my point is that materiality alone does not determine how an investor will react.

     

    We encounter similar situations with faculty or student cheating all the time. On the Trinity University campus officials are finding that a scheduled lecture for the largest auditorium by Jane Goodall is the becoming one of the most wildly popular lectures ever scheduled on campus (and a wealthy school like Trinity pays hundreds of thousands of dollars to a number of outside speakers every year). But a few in the audience will find it hard to forget than Jane once confessed to plagiarizing from Wikipedia. To most this one-time cheating is immaterial. To a few, however, the mere fact that she confessed to ever plagiarizing says something "material" about her character.

     

    What is a "reasonable investor" versus an "unreasonable investor" with respect to materiality?

     

    Thanks,
    Bob

    Additional Reply to Tom Selling

    I viewed your new Onion postings:

    On Reconciliations and Financial Analysis ---
    http://accountingonion.com/2015/10/materiality-the-fasb-is-shrinking-the-envelope.html

    Materiality: The FASB is Shrinking the Envelope ---
    http://accountingonion.com/2015/10/on-reconciliations-and-financial-analysis.html

    Camfferman and Zeff on the IASB --- http://accountingonion.com/2015/10/camfferman-and-zeff-on-the-iasb.html

    Jensen Comment

    This is a very nice posting that you entitled Camfferman and Zeff on the IASB. I've not yet delved into these additions to our historical literature and thus do not feel qualified to add to your comments.


    I do not agree with you that the FASB "the FASB has never needed the concept of materiality to promulgate its standards." The FASB makes statements that provisions of a standard generally do not apply if they do not meet the FASB concept on "immaterial items." For example, Paragraph 56 of the original SFAS 133 in part reads as follows:

    . . .

    The provisions of this Statement (SFAS 133) need
    not be applied to immaterial items.


    This Statement was adopted by the unanimous vote of the seven
    members of the Financial Accounting Standards Board:

    Thus the FASB needs a concept or standard for preparers and auditors to rely upon for determining when items in financial statements are "immaterial," but beyond that the issue of materiality is based upon judgment regarding materiality. To my knowledge there are no white lines to apply in this regard in either the FASB or IASB standards.

     

    Materiality is more of an issue in auditing standards. Financial statement auditors historically emphasize over and over that they are not responsible for fraud detect6ion unless that fraud materially affects the financial statements. There are numerous instances of audit failures in this regard where fraud materially affected the financial statements ranging all the way from

     

    McKesson & Robbins
    Allied Crude Vegetable Oil Refining
    ZZZZ Best
    Crazy Eddie
    Phar-Mor
    Foundation for New Era Philanthropy
    Waste Management
    Enron
    Worldcom
    Sunbeam
    Toshiba
    ETC --- http://faculty.trinity.edu/rjensen/Fraud001.htm

     

    The Koss Case is Becoming a Classic Example
    The problem these days is that users of financial statements and the courts are thinking that financial statement auditors should do more in the area of detection of management fraudsters even when their frauds are in the gray zone of lesser impact on the financial statements.

    "Koss Sues Grant Thornton, Blames Firm’s Assignment of Newbie Auditors," by Caleb Newquist , Going Concern, June 25, 2010 ---
    http://goingconcern.com/2010/06/koss-sues-grant-thornton-blames-firms-assignment-of-newbie-auditors/

    Koss hired one of the best accounting firms in the world, Grant Thornton, and should have been able to rely on Thornton’s audits to uncover wrongdoing, Avenatti said. The suit against the auditing firm says auditors assigned to Koss were not properly trained.

    The lawsuit lists hundreds of checks that Sachdeva ordered drawn on company accounts to pay for her personal expenses. She disguised the recipients — upscale retailers such as Neiman Marcus, Saks Fifth Avenue and Marshall Fields — by using just the initials. But the suit says Grant Thornton could have ascertained the true identity of the recipients by inspecting the reverse side of the checks, which showed the full name.

    Continued in article

    July 3, 2013 ---
    http://www.theflyonthewall.com/permalinks/entry.php/KOSSid1854256/KOSS-Koss-Corp-receives-M-in-settlement-with-former-auditor

    Koss Corp. receives $8.5M in settlement with former auditor Koss Corporation announced it has settled the claims between Koss and its former auditor, Grant Thornton, in the lawsuit pending in the Circuit Court of Cook County, Illinois. As part of the settlement, the parties provided mutual releases that resolved all claims involved in the litigation between Koss and its directors against Grant Thornton. Pursuant to the settlement, Koss received gross proceeds of $8.5M on July 3.

    Jensen Comment
    Grant Thornton failed to detect former Koss Corp. executive's $34 million embezzlement. Normally external auditors rested easy when such frauds did not materially affect the financial statements or they had strong cases that they were deceived by the client in a way that they were not responsible to detect such fraud in a financial statement audit.

    Both the SEC and the PCAOB are beginning to make waves about having audit firms more responsible for detecting major frauds like the SAC fraud. If one of the Big Four had been the auditor of the Madoff Fund I think the audit firm probably would not have gotten off with zero liability for negligence. Times are changing since Andy Fastow pilfered around $60 million from his employer (Enron).

     

    "Defending Koss And Their Auditors: Just Loopy Distorted Feedback," by Francine McKenna, re: TheAuditors, January 16, 2010 ---
    http://retheauditors.com/2010/01/16/defending-koss-and-their-auditors-just-loopy-distorted-feedback/

    My objective in writing this story was to handily contradict Grant Thornton’s self-serving defense to the Koss fraud.

    The defense supported by some commentators:

    Audits are not designed to uncover fraud and Koss did not pay for a separate opinion on internal controls because they are exempt from that Sarbanes-Oxley requirement.

    But punching holes in that Swiss-cheese defense is like shooting fish in a barrel.  Leading that horse to water is like feeding him candy taken from a baby. The reasons why someone other than American Express should have caught this sooner are as numerous as the acorns you can steal from a blind pig

    Ok, you get the gist.

    Listing standards for the NYSE require an internal audit function.  NASDAQ, where Koss was listed, does not.  Back in 2003, the Institute of Internal Auditors (IIA) made recommendations post- Sarbanes-Oxley that were adopted for the most part by NYSE, but not completely by NASDAQ. And both the NYSE and NASD left a few key recommendations hanging.

    In addition, the IIA has never mandated, under its own standards for the internal audit profession, a direct reporting of the internal audit function to the independent Audit Committee. The SEC did not adopt this requirement in their final rules, either.

    However, Generally Accepted Auditing Standards (GAAS), the standards an external auditor such as Grant Thornton operates under when preparing an opinion on a company’s financial statements – whether a public company or not, listed on NYSE or NASDAQ, whether exempt or not from Sarbanes-Oxley – do require the assessment of the internal audit function when planning an audit.

    Grant Thornton was required to adjust their substantive testing given the number of risk factors presented by Koss, based on SAS 109 (AU 314), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement.  If they had understood the entity and assessed the risk of material misstatement fully, they would have been all over those transactions like _______. (Fill in the blank)

    If they had performed a proper SAS 99 review (AU 316), Consideration of Fraud in a Financial Statement Audit, it would have hit’em smack in the face like a _______ . (Fill in the blank.) Management oversight of the financial reporting process is severely limited by Mr. Koss Jr.’s lack of interest, aptitude, and appreciation for accounting and finance. Koss Jr., the CEO and son of the founder, held the titles of COO and CFO, also.  Ms. Sachdeva, the Vice President of Finance and Corporate Secretary who is accused of the fraud, has been in the same job since 1992 and during one ten year period worked remotely from Houston!

    When they finished their review according to SAS 65 (AU 322), The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements, it should have dawned on them: There is no internal audit function and the flunky-filled Audit Committee is a sham.  I can see it now. The Grant Thornton Milwaukee OMP smacks head with open palm in a “I could have had a V-8,” moment but more like, “Holy cheesehead, we’re indigestible gristle-laden, greasy bratwurst here! We’ll never be able issue an opinion on these financial statements unless we take these journal entries apart, one-by-one, and re-verify every stinkin’ last number.”

    But I dug in and did some additional research – at first I was just working the “no internal auditors” line – and I found a few more interesting things.  And now I have no sympathy for Koss management and, therefore, its largest shareholder, the Koss family.  Granted there is plenty of basis, in my opinion, for any and all enforcement actions against Grant Thornton and its audit partners.  And depending on how far back the acts of deliciously deceptive defalcation go, PricewaterhouseCoopers may also be dragged through the mud.

    Yes.

    I can not make this stuff up and have it come out more music to my ears. PricewaterhouseCoopers was Koss’s auditor prior to Grant Thornton. In March of 2004, the Milwaukee Business Journal reported, “Koss Corp. has fired the certified public accounting firm of PricewaterhouseCoopers L.L.P. as its independent auditors March 15 and retained Grant Thornton L.L.P. in its place.” The article was short with the standard disclaimer of no disputes about accounting policies and practices.  But it pointedly pointed out that PwC’s fees for the audit had increased by almost 50% from 2001 to 2003, to $90,000 and the selection of the new auditor was made after a competitive bidding process.  PwC had been Koss’s auditor since 1992!

       

    The focus on audit fees by Koss’s CEO should have been no surprise to PwC.  Post-Sarbanes-Oxley, Michael J. Koss the son of the founder, was quoted extensively as part of the very vocal cadre of CEOs who complained vociferously about paying their auditors one more red cent. Koss Jr. minced no words regarding PwC in the Wall Street Journal in August 2002, a month after the law was passed:

    “…Sure, analysts had predicted a modest fee increase from the smaller pool of accounting firms left after Arthur Andersen LLP’s collapse following its June conviction on a criminal-obstruction charge. But a range of other factors are helping to drive auditing fees higher — to as much as 25% — with smaller companies bearing the brunt of the rise.

    “The auditors are making money hand over fist,” says Koss Corp. Chief Executive Officer Michael Koss. “It’s going to cost shareholders in the long run.”

    He should know. Auditing fees are up nearly 10% in the past two years at his Milwaukee-based maker of headphones. The increase has come primarily from auditors spending more time combing over financial statements as part of compliance with new disclosure requirements by the Securities and Exchange Commission. Koss’s accounting firm, PricewaterhouseCoopers LLP, now shows up at corporate offices for “mini audits” every quarter, rather than just once at year-end.”

     

    A year later, still irate, Mr. Koss Jr. was quoted in USA Today:

    “Jeffrey Sonnenfeld, associate dean of the Yale School of Management, said he recently spoke to six CEO conferences over 10 days. When he asked for a show of hands, 80% said they thought the law was bad for the U.S. economy.

    When pressed individually, CEOs don’t object to the law or its intentions, such as forcing executives to refund ill-gotten gains. But confusion over what the law requires has left companies vulnerable to experts and consultants, who “frighten boards and managers” into spending unnecessarily, Sonnenfeld says.

    Michael Koss, CEO of stereo headphones maker Koss, says it’s all but impossible to know what the law requires, so it has become a black hole where frightened companies throw endless amounts of money.

    Companies are spending way too much to comply, but the cost is due to “bad advice, not a bad law,” Sonnenfeld says.”

    It’s interesting that Koss Jr. has such minimal appreciation for the work of the external auditor or an internal audit function. By virtue, I suppose, of his esteemed status as CEO, COO and CFO of Koss and notwithstanding an undergraduate degree in anthropology, according to Business Week, Mr. Koss Jr. has twice served other Boards as their “financial expert” and Chairman of their Audit Committees.  At Genius Products, founded by the Baby Genius DVDs creator, Mr. Koss served in this capacity from 2004 to 2005. Mr. Koss Jr. has also been a Director, Chairman of Audit Committee, Member of Compensation Committee and Member of Nominating & Corporate Governance Committee at Strattec Security Corp. since 1995.

    If I were the SEC, I might take a look at those two companies…Because I warned you about the CEOs and CFOs who are pushing back on Sarbanes-Oxley and every other regulation intended to shine a light on them as public company executives.

    No good will come of this.

    I don’t want you to shed crocodile tears or pity poor PwC for their long-term, close relationship with another blockbuster Indian fraudster. Nor should you pat them on the back for not being the auditor now. PwC never really left Koss after they were “fired” as auditor in 2004.  They continued until today to be the trusted “Tax and All Other” advisor, making good money filing Koss’s now totally bogus tax returns.

    Continued in article


     

    Bob Jensen's threads on fees and fraud detection performance of other large auditing firms
    http://faculty.trinity.edu/rjensen/fraud001.htm


     

    Jensen Comment
    You may want to compare Francine's above discussion of audit fees with the following analytical research study:

    In most instances the defense of underlying assumptions is based upon assumptions passed down from previous analytical studies rather than empirical or even case study evidence. An example is the following conclusion:

    We find that audit quality and audit fees both increase with the auditor’s expected litigation losses from audit failures. However, when considering the auditor’s acceptance decision, we show that it is important to carefully identify the component of the litigation environment that is being investigated. We decompose the liability environment into three components: (1) the strictness of the legal regime, defined as the probability that the auditor is sued and found liable in case of an audit failure, (2) potential damage payments from the auditor to investors and (3) other litigation costs incurred by the auditor, labeled litigation frictions, such as attorneys’ fees or loss of reputation. We show that, in equilibrium, an increase in the potential damage payment actually leads to a reduction in the client rejection rate. This effect arises because the resulting higher audit quality increases the value of the entrepreneur’s investment opportunity, which makes it optimal for the entrepreneur to increase the audit fee by an amount that is larger than the increase in the auditor’s expected damage payment. However, for this result to hold, it is crucial that damage payments be fully recovered by the investors. We show that an increase in litigation frictions leads to the opposite result—client rejection rates increase. Finally, since a shift in the strength of the legal regime affects both the expected damage payments to investors as well as litigation frictions, the relationship between the legal regime and rejection rates is nonmonotonic. Specifically, we show that the relationship is U-shaped, which implies that for both weak and strong legal liability regimes, rejection rates are higher than those characterizing more moderate legal liability regimes.
    Volker Laux  and D. Paul Newman, "Auditor Liability and Client Acceptance Decisions," The Accounting Review, Vol. 85, No. 1, 2010 pp. 261–285
    http://faculty.trinity.edu/rjensen/TheoryTAR.htm#Analytics

     

    Added Jensen Comment
    I'm inclined to agree with you, Tom, on the following:

    Why wouldn’t the FASB simply remind these respondents that there is nothing in current GAAP, the PCAOB’s auditing standards or the securities laws, that bars an issuer from omitting immaterial disclosures.

    Perhaps the FASB is bothered by the need for more disclosures in the gray zone of immaterial fraud that is nevertheless management fraud.

    As to reconciliations and roll forwards what I would really like to see are new rules from somebody requiring roll forwards on the change in retained earnings that provides details regarding components of net earnings for the year.

    Thanks,
    Bob

    October 12, 2015 reply from Tom Selling

    Bob, my point is that even though there are some words in CON 8,  they do not constitute a genuine definition of materiality.  Since financial reporting and standard setting has functioned without one, evidently one is not needed.

     
    I should have been more clear on this in my post, and may follow up later: What is driving the FASB’s proposal is the requirement in the PCAOB’s AS14 for auditors to accumulate errors , unless clearly trivial (an amount well below immaterial) and evaluate the accumulated errors (whether an B/S or P&L amount, or a disclosure) and to share the schedule of unadjusted differences with management and the audit committee. The FASB proposal would take the audit committee out of the equation in evaluating aggregated immaterial disclosures if they are specifically designated as not accounting errors because they are immaterial.  For the life of me, I have no idea why the FASB is sticking its nose in this.  Surely, GAAP is clearly that If an item is not material, then a company can do what it wants.  But, if a fix is needed (which I question), it is a matter for the PCAOB to discuss.  

     
    Jagdish, you stated:

     
     “all promulgated accounting standards are fair except that one can violate one standard if in following another standard such violation does not make financial standards misleading” 

     
    This presumes that all accounting standards are “fair” as written.  Did you intend to imply that if something is GAAP, it is by definition “fair”?  Prior to the Codification, that was indeed the definition of “fair” in the AICPA’s auditing standards.

     
    As one example of many, but one that I think is close to the problem of materiality being  solely a legal standard, the SEC used to have the position that revenue could not be recognized on the sale of goods until legal title has transferred.  Since some non-US jurisdictions kept legal title with the seller until payment occurred, this was seen to be unfair, and the SEC modified its position.  So, what was “fair” yesterday became foul the next day. 

     
    If “fair” is defined as following the rules, and materiality is specified as a legal concept, then the standard auditor report should read “…complies with applicable laws” instead of “is fairly presented.”  

     
    Best,
    Tom
     

    Thomas I. Selling PhD, CPA

    Weblog: www.accountingonion.com

    Website: www.tomselling.com

    Email: tom.selling@grovesite.com

     

     


    Teaching Case from The Wall Street Journal Weekly Accounting Review on October 31, 2014

    SEC Staff Suggests Ingredients for Effective Disclosures

    by: Tim Kolber and Joe DiLeo
    Oct 24, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Disclosures, Materiality, Relevance, SEC

    SUMMARY: Over the past 18 months, the SEC and accounting standard setters have frequently questioned whether registrants are using the "right recipe" for effective disclosures - that is, whether their compliance with disclosure requirements and their disclosures of material and relevant information are optimally balanced. To help registrants refine their recipes, the SEC has embarked on a disclosure effectiveness project. While the SEC seeks to reduce or eliminate outdated, redundant, and overlapping disclosures, reducing the volume of disclosure is not the objective - the SEC wants to put better disclosure into the hands of investors. Although it believe that these efforts can reduce the costs and burdens on companies, updating the requirements may very well result in additional disclosures.

    CLASSROOM APPLICATION: This article updates students on the current SEC rules regarding disclosure requirements.

    QUESTIONS: 
    1. (Introductory) What is the SEC? What is its area of authority?

    2. (Introductory) What set of rules is the SEC updating? Why does the SEC have concerns? What areas is the SEC addressing? What is the current status of the project?

    3. (Advanced) What is materiality? How is it determined? Why is it important in accounting? How is materiality reported in SEC disclosures? Why?

    4. (Advanced) What are redundant disclosures? What are the potential problems caused by redundant disclosures? What guidance does the SEC offer on this topic?

    5. (Advanced) What is a "boilerplate" disclosure? Why is the SEC concerned about it? Why would corporations use them? What guidance is the SEC offering?

    6. (Advanced) What is "relevance" in financial reporting? Why is it important? What is ongoing relevance? What is the SEC guidance regarding ongoing relevance?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

     

    "SEC Staff Suggests Ingredients for Effective Disclosures," by Tim Kolber and Joe DiLeo, The Wall Street Journal, October 24, 2014 ---
    http://deloitte.wsj.com/riskandcompliance/2014/10/24/sec-staff-suggests-ingredients-for-effective-disclosures/?mod=djem_jiewr_AC_domainid

    Over the past 18 months, the SEC and accounting standard setters have frequently questioned whether registrants are using the “right recipe” for effective disclosures—that is, whether their compliance with disclosure requirements and their disclosures of material and relevant information are optimally balanced.

    To help registrants refine their recipes, the SEC has embarked on a disclosure effectiveness project.¹ While the SEC seeks to reduce or eliminate outdated, redundant, and overlapping disclosures, Keith Higgins, director of the Division of Corporation Finance, recently emphasized that “reducing the volume of disclosure is not our objective—we want to put better disclosure into the hands of investors. Although we believe that these efforts can reduce the costs and burdens on companies, updating the requirements may very well result in additional disclosures.”²

    The project is in its initial stages, and amendments to rules may ultimately be required. However, the SEC staff has emphasized that rather than waiting for changes in rules or interpretive guidance, registrants can take steps now to improve the effectiveness of their disclosures. For example, in his April 2014 “call to action,” Mr. Higgins informed registrants that “[t]here is a lot that you . . . can do to improve the focus and navigability of disclosure documents in the absence of rule changes. You can step up your game right now.”

    This Heads Up discusses the SEC staff’s views and recommendations about steps registrants can take today to improve their disclosures. The appendix outlines various types of disclosures and the SEC’s suggestions for improving them.

    Elements of Effective Disclosure

    The SEC staff has stated that effective disclosures are those that are clear and concise and focus on matters that are both material and specific to the registrant. Appropriate emphasis is also critical. Effective disclosures emphasize matters the registrant believes to be the most relevant and material, and they deemphasize—or exclude entirely—matters that are not. Consequently, registrants are encouraged to continually reevaluate their disclosures and modify them when the nature or relevance of information has changed.

    Mr. Higgins suggested that in their reevaluation of current disclosures, registrants focus on:

    Materiality

    In recent speeches, SEC staff members have questioned whether registrants are truly concentrating on disclosing material matters. Acknowledging that “materiality is not an easily applied litmus test,” Mr. Higgins stated in his April 2014 speech, “If there are any gray areas . . . the company is likely to include the disclosure in its filing” and asked whether registrants are therefore including “too many items in the obviously immaterial category.” In an October 2013 speech, SEC Chair Mary Jo White reminded registrants that the Supreme Court addressed the problem of disclosure overload and materiality approximately 35 years ago. She noted that the Court rejected the notion that “a fact is ‘material’ if an investor ‘might’ find it important” and instead “held that a fact is ‘material’ if ‘there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.’”

    Eliminating or Reducing Redundant Disclosures

    The SEC staff is also encouraging registrants to improve the quality and overall effectiveness of their disclosures by reducing or eliminating redundancies in their filings. For example, in his April 2014 speech, Mr. Higgins noted that registrants often repeat the significant accounting policy disclosures from their financial statement footnotes verbatim in their MD&A discussions of critical accounting estimates. He stated that “if there were ever a place in a report that cried out for a cross reference — and there are likely plenty of them — this is near the top of the list.” While the SEC’s call to action does not relieve registrants from complying with disclosure requirements under U.S. GAAP and SEC rules and regulations (e.g., Regulations S-K and S-X), Mr. Higgins encourages them to “[t]hink twice before repeating something.”

    Tailoring Disclosures

    The SEC staff often objects to “boilerplate” or general disclosures that could apply to any registrant. Disclosures about risk factors are a prime example. Whether the result of Congressional actions or, as Ms. White noted in her October 2013 speech, the “safe harbors [that] encouraged companies to share more ‘soft’ information with investors,” there has been a marked increase in the amount of non-registrant-specific risk-factor disclosures, which often span several pages in registrants’ filings. Mr. Higgins suggested that rather than viewing risk-factor disclosures as “insurance policies,” registrants could work to limit such disclosures to those that are the most relevant to their operations and be specific in detailing how the risk factors “would affect the company if they came to pass.”

    Ongoing Relevance

    Effective disclosures are not static but change over time. Registrants are encouraged to continually reevaluate their facts and circumstances to determine whether the information they are disclosing is material and relevant, including information originally disclosed as a result of an SEC staff comment. For example, a registrant may no longer need to disclose a material risk or an uncertainty related to a contingency that was subsequently resolved or became immaterial. Conversely, a registrant would need to disclose any additional information it has gained about a material contingency.

    Editor’s Note: In speeches, Mr. Higgins and other SEC staff members have asked registrants to carefully consider whether their decisions to disclose information are based solely on industry-specific or other SEC comment trends that are identified as “hot button” issues. Moreover, an SEC comment letter can be viewed as the “beginning of . . . a dialogue” rather than as an indication that the staff has “concluded the requested information is material” and should therefore be disclosed. Mr. Higgins reminded registrants to consider relevance, applicability, and materiality before adding (or agreeing to add) disclosures to their filings.

    Next Steps

    Instead of waiting for the SEC’s comprehensive list of ingredients for effective disclosures, registrants are encouraged to start testing their own recipes. In his October 3, 2014, speech, Mr. Higgins noted that the SEC staff wants “to encourage companies to . . . experiment with the presentation [in their periodic reports], reduce duplication and eliminate stale information that is both outdated and not required.” He stated that if “companies have ideas to improve their disclosures and want to talk with us about them, although we won’t pre-clear specific disclosures we are certainly happy to discuss potential changes.”


    Teaching Case on Going Concern Accounting
    From The Wall Street Journal Accounting Weekly Review on September 5, 2014

    Executive Responsibility For 'Going Concern' Disclosures Increases
    by: Emily Chasan and Maxwell Murphy
    Aug 28, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Deficiency

    SUMMARY: Corporate managers will have to make more uniform disclosures when there is substantial doubt about their business' ability to survive, according to the Financial Accounting Standards Board. The FASB updated U.S. accounting rules, effective by the end of 2016, to define management's responsibility to evaluate whether their business will be able to continue operating as a "going concern," and make relevant disclosures in financial statement footnotes. Previously, there were no specific rules under U.S. Generally Accepted Accounting Principles and disclosures were largely up to auditors. Corporate executives had the option to make any voluntary disclosures they felt relevant.

    CLASSROOM APPLICATION: This is a good article to discuss going concern, notes to the financial statements, and FASB, as well as management's responsibility in financial reporting.

    QUESTIONS: 
    1. (Introductory) What is FASB? What is its function? What is GAAP? Why is GAAP used in accounting?

    2. (Advanced) What does the concept "going concern" mean? Why is it important? What kind of disclosures is FASB requiring? Who is required to make the disclosures? Why are these parties included in the requirement?

    3. (Advanced) In general, what is included in the notes to financial statements? Why are notes required? Who uses the notes and how are they used? Please give some examples of information regularly included in the notes.

    4. (Advanced) What is the benefit of this new rule? How can this information be used? Are there other ways besides a note that someone could access this information?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Going Concern Opinions on Life Support With Investors
    by Emily Chasan
    Sep 12, 2014
    Online Exclusive

    "Executive Responsibility For 'Going Concern' Disclosures Increases," by Emily Chasan and Maxwell Murphy, The Wall Street Journal, August 27, 2014 ---
    http://blogs.wsj.com/cfo/2014/08/27/executive-responsibility-for-going-concern-disclosures-increases/?mod=djem_jiewr_AC_domainid

    Corporate managers will have to make more uniform disclosures when there is substantial doubt about their business’ ability to survive, the Financial Accounting Standards Board said Wednesday.

    The FASB updated U.S. accounting rules, effective by the end of 2016, to define management’s responsibility to evaluate whether their business will be able to continue operating as a “going concern,” and make relevant disclosures in financial statement footnotes. Previously, there were no specific rules under U.S. Generally Accepted Accounting Principles and disclosures were largely up to auditors. Corporate executives had the option to make any voluntary disclosures they felt relevant.

    Investors, however, have grown frustrated with a lack of going concern opinions during the financial crisis that failed to warn them of impending bankruptcies.

    The FASB first issued a proposal at the peak of the financial crisis in 2008, but debate and revisions delayed the final standard, which didn’t go up for a vote until May.

    Supporters of the changes have argued that corporate managers have better information about a company’s ability to continue financing their operations than auditors. The updated rule will force executives to disclose serious risks even if management has a credible plan to alleviate them, for example.

    Information currently disclosed by companies can vary significantly. Only about 40% of companies that filed for bankruptcy in the past two decades have explicitly disclosed the possibility that they could cease to operate before running into trouble, according to a study this month from Duke University’s Fuqua School of Business.


    Teaching Case on Analysis of Financial Statements
    From The Wall Street Journal Accounting Weekly Review on September 12, 2014

    Investing Tips from Warren Buffett? Try Writing Tips Instead
    by: Michael Rapoport
    Sep 08, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Annual Report, Disclosures, Financial Accounting

    SUMMARY: Regulators have been concerned that the volume of disclosures required of public companies has made their financial reports so lengthy it's become harder for investors to find the most relevant information. To address that problem, a committee of the Association of the Bar of the City of New York is proposing yet another required disclosure for companies: A short, plain-English overview, at the start of a company's annual report, that would describe what happened at the company over the past year and management's expectations and concerns for the year to come.

    CLASSROOM APPLICATION: This is a good article to share with students as we discuss annual reports and required disclosures.

    QUESTIONS: 
    1. (Introductory) What is an annual report? What are its components? What is the purpose of an annual report?

    2. (Advanced) Who are the users of the annual report? How is this information used? Why is accurate information and full disclosure important?

    3. (Advanced) What has a group of lawyers proposed regarding the requirements for annual reports? What is the reasoning behind this proposal? What are the benefits of this proposal? Are there any drawbacks?

    4. (Advanced) Should this proposal be implemented? Why or why not?
     

    SMALL GROUP ASSIGNMENT: 
    Find the annual report for a large public company (either a physical copy or online). Do you find that the critiques detailed in the article apply to the financial information you are reviewing? Is information organized well? Are the disclosures easy to find, read, and understand? Would the proposal presented in the article be an improvement for the annual report you are reviewing? Do you have other ideas for improvements to presentation?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Investing Tips from Warren Buffett? Try Writing Tips Instead," by Michael Rapoport, The Wall Street Journal, September 8, 2014 ---
    http://blogs.wsj.com/moneybeat/2014/09/08/investing-tips-from-warren-buffett-try-writing-tips-instead/?mod=djem_jiewr_AC_domainid

    A prominent lawyers’ group has an idea for how companies can improve annual reports: write a letter explaining the results in plain English, as Warren Buffett often does it.

    Regulators have been concerned that the volume of disclosures required of public companies has made their financial reports so lengthy it’s become harder for investors to find the most relevant information.

    To address that problem, a committee of the Association of the Bar of the City of New York is proposing yet another required disclosure for companies: A short, plain-English overview, at the start of a company’s annual report, that would describe what happened at the company over the past year and management’s expectations and concerns for the year to come.

    “Business disclosure should not be akin to a game of ‘Where’s Waldo’ in which a reader is left suspecting that critical information is buried somewhere in the document but good luck finding it,” Michael R. Young, who chairs the bar association’s financial-reporting committee, wrote in a letter last week to Keith Higgins, the Securities and Exchange Commission’s director of corporation finance. “Rather, the most important information is best volunteered, up front, by management in a way that is both understandable and provides context.”

    The committee plans to announce its proposal Monday. In an interview, Mr. Young called the proposal “a rule to cut through the rules” and said it wouldn’t replace any of the existing, more-detailed disclosures that the SEC requires of public companies. “The goal is to encourage companies and executives to report on what’s going on [to investors] much as they would to the board of directors,” he said.

    The model, Mr. Young said, is the widely read, plain-spoken Berkshire Hathaway Inc. shareholder letter that Mr. Buffett writes each year. That “was sort of looked to as the platonic ideal” in developing the new proposal, he said.

    The SEC would be the agency to ultimately decide whether to propose and implement such a move. The SEC’s Mr. Higgins said he didn’t have any reaction to the committee’s proposal itself, but he likes the idea in principle. “We encourage companies to make it easier to understand what management thought for the prior year and what’s up for the future,” he said.

    According to 2012 research from accounting firm Ernst & Young LLP, the average number of pages in annual reports devoted to footnotes and management’s discussion and analysis has quadrupled over the last two decades. In recent months, SEC officials have said they will look at possible steps to make disclosure more effective, such as weeding out outdated and redundant disclosure requirements.

    “As the number of pages in annual reports has steadily increased, it may become more difficult for investors to find the most salient information,” Mr. Higgins said in an April speech to business lawyers, in which he invited their suggestions.

    Mr. Young says he “appreciates the irony” of fighting disclosure overload by proposing another disclosure requirement. But enacting such requirements is “the main tool regulators have to work with” in solving the problem, he said.

    Accounting rule Warren Buffett loathes boosts Berkshire's bottom line to $81B ---
    https://www.foxbusiness.com/money/accounting-rule-warren-buffett-loathes-boosts-berkshires-bottom-line-to-81b

    Jensen Comment
    The accounting rule is controversial in that net earnings and portfolio values are subject to short-term transitory variations in security prices that may have little to do with long-term earnings and value. For example, Tesla share prices are subject to huge day-by-day volatility caused news events that usually do not reflect changes future cash flows of the company.

    Reporting of a portfolio's value becomes highly dependent upon what day the reporting takes place.

    Also there's a difference in value based upon such factors as control. For example, if Buffett's firm only owns a few shares of Company X the price of $100 per share means something different than if his firm owns 51% of the voting shares. That $100 per share represents the liquidity value of one share of stock. It does not reflect the possibly enormous value of having control of the management of the company.

    The same rule could be a stock market and real estate disaster for any tax (think a wealth or income tax)  that forces investors to liquidate portfolios to pay the tax. At the moment tax accounting rules do not generally require liquidation for value appreciation alone.

    It's a little like reporting the number of birds to be served for dinner while they are still in the bush and can fly away before dinner time.

    Bob Jensen's threads on value accounting theory ---
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValueFails

    Also see
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting

     

    Bob Jensen's threads on financial statement analysis are at
    http://faculty.trinity.edu/rjensen/roi.htm


     

    "FASB proposes a bevy of new disclosure provisions aimed at financing receivables: Will companies balk at the rules, despite already having most of the information on hand? by Robert Willens, CFO.com, July 20, 2009 --- http://www.cfo.com/article.cfm/14070524/c_2984368/?f=archives

    The Financial Accounting Standards Board has issued an ambitious new plan that will dramatically increase the volume and quality of the disclosures creditors will be asked to provide with respect "financing receivables." The plan takes the form of a rule exposure draft, and according to the proposal creditors will have to disclose their allowance for credit losses associated with the financing receivables. These rules are scheduled to become effective with respect to interim and annual periods ending after December 15, 2009.

    The proposed rule is entitled Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. It applies to all financing receivables held by creditors, both public and private, that prepare financial statements in accordance with generally accepted accounting principles.

    For the purpose of the draft statement, financing receivables include "loans" defined as a contractual right to receive money either on demand or on fixed or determinable dates, and that are recognized as an asset regardless of whether the receivable was originated by the creditor or acquired by the creditor. The term loan, however, excludes accounts receivable with contractual maturities of one year or less that arise from the sale of goods or services. Further, there is an exception for credit card receivables, as well, and the draft rule also excludes debt securities as defined in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

    The proposal contains several other key terms worth noting. For example, a portfolio segment is the level at which a creditor develops and documents a systematic methodology to determine its allowance for credit losses. For disclosure purposes, portfolio segments are disaggregated in the following way: (1) financing receivables within a portfolio segment that are evaluated collectively for impairment, and (2) financing receivables within a portfolio segment that are evaluated individually for such impairment.

    Another term defined in the drat rule is, class of financing receivable, described as a level of information that enables users of financial statements to understand the nature and extent of exposure to credit risk arising from financing receivables. Finally, a credit quality indicator is a statistic about the credit quality of a portfolio of financing receivables.

    Types of Disclosures The proposal also suggests a variety of disclosures that affected creditors will be called upon to provide. For instance, a creditor is required to disclose four key pieces of information related to the financing receivable: (1) a description, by portfolio segment, of the accounting policies and methodology used to estimate the allowance for credit losses; (2) a description, once again by portfolio segment, of management's policy for charging off uncollectible financing receivables; (3) the activity in the total allowance for credit losses by portfolio segment; and (4) the activity in the financing receivables related to the allowance for credit losses by portfolio segment.

    Moreover, a creditor will be expected to disclose information by portfolio segment that enables users of its financial statements to assess the fair value of loans at the end of the reporting period.

    There is still more work for creditors, in that they must again disclose management's policy for determining past-due or delinquency status, this time by class of financing receivable. For financing receivables carried at "amortized cost" that are neither past-due nor impaired, creditors will be asked to disclose quantitative and qualitative information about the credit quality of financing receivables. That includes a description of the credit quality indicator and the carrying amount of the financing receivables by credit quality indicator.

    For financing receivables carried at a measurement other than amortized cost, that are neither past-due nor impaired, a creditor will have to provide quantitative information about credit quality at the end of the reporting period.

    With respect to financing receivables that are past-due, but not impaired, the creditor will be asked to provide an analysis of the age of the carrying amount of the financing receivables at the end of the reporting period. The creditor will also have to disclose the carrying amount — again at the end of the reporting period — of financing receivables which are 90 days or more past-due, but not impaired, for which interest is still accruing. Moreover, disclosures will be required with respect to the carrying amount of financing receivables at the end of the reporting period that are now considered "current," but have been modified in the current year subsequent to being past-due.

    Continued in article

     


    the information on hand? by Robert Willens, CFO.com, July 20, 2009 --- http://www.cfo.com/article.cfm/14070524/c_2984368/?f=archives

    The Financial Accounting Standards Board has issued an ambitious new plan that will dramatically increase the volume and quality of the disclosures creditors will be asked to provide with respect "financing receivables." The plan takes the form of a rule exposure draft, and according to the proposal creditors will have to disclose their allowance for credit losses associated with the financing receivables. These rules are scheduled to become effective with respect to interim and annual periods ending after December 15, 2009.

    The proposed rule is entitled Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. It applies to all financing receivables held by creditors, both public and private, that prepare financial statements in accordance with generally accepted accounting principles.

    For the purpose of the draft statement, financing receivables include "loans" defined as a contractual right to receive money either on demand or on fixed or determinable dates, and that are recognized as an asset regardless of whether the receivable was originated by the creditor or acquired by the creditor. The term loan, however, excludes accounts receivable with contractual maturities of one year or less that arise from the sale of goods or services. Further, there is an exception for credit card receivables, as well, and the draft rule also excludes debt securities as defined in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

    The proposal contains several other key terms worth noting. For example, a portfolio segment is the level at which a creditor develops and documents a systematic methodology to determine its allowance for credit losses. For disclosure purposes, portfolio segments are disaggregated in the following way: (1) financing receivables within a portfolio segment that are evaluated collectively for impairment, and (2) financing receivables within a portfolio segment that are evaluated individually for such impairment.

    Another term defined in the drat rule is, class of financing receivable, described as a level of information that enables users of financial statements to understand the nature and extent of exposure to credit risk arising from financing receivables. Finally, a credit quality indicator is a statistic about the credit quality of a portfolio of financing receivables.

    Types of Disclosures The proposal also suggests a variety of disclosures that affected creditors will be called upon to provide. For instance, a creditor is required to disclose four key pieces of information related to the financing receivable: (1) a description, by portfolio segment, of the accounting policies and methodology used to estimate the allowance for credit losses; (2) a description, once again by portfolio segment, of management's policy for charging off uncollectible financing receivables; (3) the activity in the total allowance for credit losses by portfolio segment; and (4) the activity in the financing receivables related to the allowance for credit losses by portfolio segment.

    Moreover, a creditor will be expected to disclose information by portfolio segment that enables users of its financial statements to assess the fair value of loans at the end of the reporting period.

    There is still more work for creditors, in that they must again disclose management's policy for determining past-due or delinquency status, this time by class of financing receivable. For financing receivables carried at "amortized cost" that are neither past-due nor impaired, creditors will be asked to disclose quantitative and qualitative information about the credit quality of financing receivables. That includes a description of the credit quality indicator and the carrying amount of the financing receivables by credit quality indicator.

    For financing receivables carried at a measurement other than amortized cost, that are neither past-due nor impaired, a creditor will have to provide quantitative information about credit quality at the end of the reporting period.

    With respect to financing receivables that are past-due, but not impaired, the creditor will be asked to provide an analysis of the age of the carrying amount of the financing receivables at the end of the reporting period. The creditor will also have to disclose the carrying amount — again at the end of the reporting period — of financing receivables which are 90 days or more past-due, but not impaired, for which interest is still accruing. Moreover, disclosures will be required with respect to the carrying amount of financing receivables at the end of the reporting period that are now considered "current," but have been modified in the current year subsequent to being past-due.

    Continued in article

    "FASB proposes a bevy of new disclosure provisions aimed at financing receivables: Will companies balk at the rules, despite already having most of the information on hand? by Robert Willens, CFO.com, July 20, 2009 --- http://www.cfo.com/article.cfm/14070524/c_2984368/?f=archives

    The Financial Accounting Standards Board has issued an ambitious new plan that will dramatically increase the volume and quality of the disclosures creditors will be asked to provide with respect "financing receivables." The plan takes the form of a rule exposure draft, and according to the proposal creditors will have to disclose their allowance for credit losses associated with the financing receivables. These rules are scheduled to become effective with respect to interim and annual periods ending after December 15, 2009.

    The proposed rule is entitled Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. It applies to all financing receivables held by creditors, both public and private, that prepare financial statements in accordance with generally accepted accounting principles.

    For the purpose of the draft statement, financing receivables include "loans" defined as a contractual right to receive money either on demand or on fixed or determinable dates, and that are recognized as an asset regardless of whether the receivable was originated by the creditor or acquired by the creditor. The term loan, however, excludes accounts receivable with contractual maturities of one year or less that arise from the sale of goods or services. Further, there is an exception for credit card receivables, as well, and the draft rule also excludes debt securities as defined in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

    The proposal contains several other key terms worth noting. For example, a portfolio segment is the level at which a creditor develops and documents a systematic methodology to determine its allowance for credit losses. For disclosure purposes, portfolio segments are disaggregated in the following way: (1) financing receivables within a portfolio segment that are evaluated collectively for impairment, and (2) financing receivables within a portfolio segment that are evaluated individually for such impairment.

    Another term defined in the drat rule is, class of financing receivable, described as a level of information that enables users of financial statements to understand the nature and extent of exposure to credit risk arising from financing receivables. Finally, a credit quality indicator is a statistic about the credit quality of a portfolio of financing receivables.

    Types of Disclosures The proposal also suggests a variety of disclosures that affected creditors will be called upon to provide. For instance, a creditor is required to disclose four key pieces of information related to the financing receivable: (1) a description, by portfolio segment, of the accounting policies and methodology used to estimate the allowance for credit losses; (2) a description, once again by portfolio segment, of management's policy for charging off uncollectible financing receivables; (3) the activity in the total allowance for credit losses by portfolio segment; and (4) the activity in the financing receivables related to the allowance for credit losses by portfolio segment.

    Moreover, a creditor will be expected to disclose information by portfolio segment that enables users of its financial statements to assess the fair value of loans at the end of the reporting period.

    There is still more work for creditors, in that they must again disclose management's policy for determining past-due or delinquency status, this time by class of financing receivable. For financing receivables carried at "amortized cost" that are neither past-due nor impaired, creditors will be asked to disclose quantitative and qualitative information about the credit quality of financing receivables. That includes a description of the credit quality indicator and the carrying amount of the financing receivables by credit quality indicator.

    For financing receivables carried at a measurement other than amortized cost, that are neither past-due nor impaired, a creditor will have to provide quantitative information about credit quality at the end of the reporting period.

    With respect to financing receivables that are past-due, but not impaired, the creditor will be asked to provide an analysis of the age of the carrying amount of the financing receivables at the end of the reporting period. The creditor will also have to disclose the carrying amount — again at the end of the reporting period — of financing receivables which are 90 days or more past-due, but not impaired, for which interest is still accruing. Moreover, disclosures will be required with respect to the carrying amount of financing receivables at the end of the reporting period that are now considered "current," but have been modified in the current year subsequent to being past-due.

    Continued in article

    Bob Jensen's threads on the failure of auditors to warn of loan losses in the collapse of the banking system are at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms


    The analogy would be proposing to your sweetheart in June without revealing your previous marital record  until the day of the wedding in December. Why should your new bride know early on that you had five previous wives and eight children about to be released from reform school? The same goes for your own secret prison record for two statutory rapes.
    From the CFO Journal's Morning Ledger on September 13, 2013

    Twitter is putting the JOBS Act to work
    The company fittingly
    used a Tweet to announce that it has filed confidential paperwork to begin the process for its highly anticipated IPO, the WSJ reports. As MoneyBeat’s Telis Demos notes, the JOBS Act allows companies with less than $1 billion in revenue or  nonconvertible debt (known as emerging growth companies) to make an initial confidential filing that only the SEC can see. Since the law was implemented last April, the number of companies making confidential IPO filings has outpaced those submitting public filings, CFOJ noted back in May. But Twitter is the highest-profile name to do so.

    The NYT’s Steven M. Davidoff says that the situation with Twitter is exactly the kind of thing opponents of the JOBS Act had warned about: A prominent company, known around the world, has filed for what will most likely be the most anticipated stock offering since Facebook—and we know precious little about its business. “No selected financial data, no information about capitalization or operations, no ‘risk factors’” or anything else you typically find in a company’s S-1. Under the Act, companies don’t have to make their public filing until 21 days before they launch a “roadshow,” and the filing doesn’t obligate Twitter to set a timeline for selling its shares, the Journal notes.

    Twitter is already valued at more than $9 billion, as judged by private sales by employees of their stock to BlackRock earlier this year, people familiar with that transaction tell the WSJ. And if it goes public soon, it could reap rewards from a buoyant market and a hot period for IPOs.

     

     


    Questions
    Why might Perry Corp. want to avoid filing a Form 13-D?
    Why should individual investors want to know the information provided on such a form?

    SEC Halts A Strategy on Merger Disclosures
    by Jenny Strasburg
    The Wall Street Journal

    Jul 22, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Disclosure, Disclosure Requirements, Financial Reporting, Hedge Funds, SEC, Securities and Exchange Commission

    SUMMARY: "Perry Corp., a well-known hedge fund, will pay $150,000 to settle allegations brought by the Securities and Exchange Commission that it improperly withheld details about a large investment in an effort to profit."

    CLASSROOM APPLICATION: The article can be used in covering investments or business combinations to help students understand the financial reporting and SEC filings associated with these activities-and the possibilities that some will try to avoid disclosure and transparency.

    QUESTIONS: 
    1. (Introductory) What is the purpose of a SEC filing on Form 13-D? (Hint: You may investigate this question at www.sec.gov under "Description of SEC Forms" Look for Table 3-4.)

    2. (Introductory) What is the SEC's accusation, brought as a civil suit against Perry Corp. about its trading activities in 2004?

    3. (Advanced) Why might Perry Corp. want to avoid filing a Form 13-D? Why should individual investors want to know the information provided on such a form?

    4. (Introductory) The Perry case highlights continuing tensions over how much transparency private funds provide to the public. What is transparency? According to the author of the article, how do hedge funds profit in part by avoiding transparency?

    5. (Advanced) The SEC "has been revamping its enforcement division, in part, by trying to ensure that deep-pocketed investors make mandatory public disclosures" How do these disclosures help with the SEC's monitoring efforts?

    Reviewed By: Judy Beckman, University of Rhode Island

    "SEC Halts a Strategy on Merger Disclosures," by Jenny Strasburg, The Wall Street Journal, July 22, 2009 ---
    http://online.wsj.com/article/SB124822107142070361.html?mod=djem_jiewr_AC

    Federal securities regulators are taking a shot at a high-profile trading strategy that triggered controversy on Wall Street a few years back.

    Perry Corp., a well-known hedge fund, will pay $150,000 to settle allegations brought by the Securities and Exchange Commission that it improperly withheld details about a large investment in an effort to profit.

    The move followed a nearly four-year investigation by the SEC into trades during 2004 that involved merger discussions between two pharmaceutical companies, the regulatory agency said on Tuesday.

    Perry neither admitted nor denied wrongdoing. The firm, run by former Goldman Sachs Group Inc. trader Richard Perry and which at its peak controlled $15 billion, called the settlement a "satisfactory conclusion."

    At issue is the broad requirement that investors fully disclose their large stakes in companies in a timely fashion. The SEC accused Perry of failing to file a regulatory document known as a 13(d) that would alert the market it had built up a stake of more than 5% in a public company, according to the agency's administrative proceeding.

    The $150,000 settlement amount is small, given the stakes at play in the hedge-fund world. At the same time, not many SEC actions are solely focused on the failure to file a 13(d).

    "This case shows that institutional investors need to take very seriously their disclosure obligations," said David Rosenfeld, associate director of the SEC's New York regional office, who oversaw the case. The case "hopefully will deter others from engaging in this type of conduct."

    Perry was represented in the case by securities lawyer William McLucas, who ran the SEC's enforcement division for eight years before leaving the agency in 1998.

    The case centered on a series of trades Perry made beginning in 2004 involving Mylan Inc. and King Pharmaceuticals Inc. The SEC said Perry should have disclosed publicly that it had amassed a nearly 10% stake in Mylan as the two companies were contemplating a merger.

    Perry maintained that the stock purchases fell under the category of investments made "in the ordinary course of business" and weren't done to exert control over the company, and therefore Perry didn't have to make the filing by a certain time.

    The SEC disagreed, saying Perry's Mylan stake was linked to its desire to gain shareholder clout so Mylan would go through with the merger, and therefore the filing needed to be made within 10 days of the acquisition of the securities.

    Ultimately, the merger fell through, diminishing the profit Perry hoped to make. At the time, Perry and billionaire investor Carl Icahn, who opposed the deal, became embroiled in a legal battle that brought the merger bid further attention.

    The Perry case highlights continuing tensions over how much transparency private funds provide to the public. Hedge funds generally try to gain and retain an information edge wherever they can, in part by keeping as much of their holdings as veiled from outsiders as possible.

    Hedge funds are currently fighting government efforts on several fronts to require deeper disclosure of their positions in public companies, exotic derivatives and other holdings.

    The SEC lately has been revamping its enforcement division amid a rash of big frauds. As part of that effort, the agency is trying to ensure that deep-pocketed investors make mandatory public disclosures designed to prevent unfair profits at the expense of smaller investors.

    Mr. Perry, 54 years old, and his firm now oversee $6.6 billion in assets. The firm lost about 28% on investment declines in 2008 and, like many hedge funds, has experienced client withdrawals, according to investor documents. During 2004, the firm notched a gain of 20%, a return that helped it become one of the biggest U.S. hedge funds.


    Teaching Case from The Wall Street Journal Accounting Weekly Review on April 27, 2012

    MetLife Reports Loss After Website Snafu
    by: Lauren Pollock and Leslie Scism
    Apr 21, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Operating Income, Regulation, SEC, Securities and Exchange Commission, Segment Analysis

    SUMMARY: "MetLife Inc. posted a first-quarter shortfall on steeper derivatives losses...Operating earnings...climbed in the period and topped estimates, though operating revenue...grew more slowly than expected." The operating results were disclosed two weeks earlier than MetLife had intended because the company "...inadvertently post[ed] some of the data on its website....The technological foul-up stemmed from an effort by the insurer to get revamped historical data into investors' hands in advance of MetLife's previously planned May 2 earnings release date..." because the company reorganized its segments into six units within 3 broad geographic regions.

    CLASSROOM APPLICATION: The article covers basic quarterly reporting and market reactions to earnings releases, segment reporting and the effect of a business reorganization on that reporting, and Regulation Fair Disclosure (Reg FD). Under this regulation, the company had to release first quarter earnings information to all parties once the inadvertent disclosure to some analysts was discovered.

    QUESTIONS: 
    1. (Introductory) Define operating revenues and operating earnings and highlight what generates the difference between the two. How did MetLife perform on each of these measures in the first quarter of 2012?

    2. (Introductory) How did the market react to these results? What information in the article do you think generated that market reaction, the operating revenues, the operating earnings, the "snafu" in posting earnings, or something else?

    3. (Advanced) Access the announcement about these first quarter results in the SEC filing of Form 8-K on April 24, 2012, available at http://www.sec.gov/Archives/edgar/data/1099219/000119312512168620/0001193125-12-168620-index.htm, by clicking on the link to the Form 8-K document. What business organizational change did the company undertake? In your answer, include an explanation of how the company's business was organized before the organizational change.

    4. (Advanced) What authoritative accounting guidance requires companies to provide information according to how the business is organized? Provide specific reference to promulgated accounting standards.

    5. (Advanced) Refer again to the MetLife SEC filing. Click on the link to the "Historical Results Financial Supplement" below the Form 8-K filing link. Summarize how the information is presented and what benefit MetLife hoped to provide its investors and other financial statement users.

    6. (Introductory) What is Regulation Fair Disclosure? Search on the SEC web site to find this answer and provide a reference to your source.

    7. (Advanced) Refer again to the MetLife SEC filing of Form 8-K. Why does the Metlife filing indicate in item 7.01 that the company is complying with Regulation FD by providing the earnings release covering results of operations and financial condition?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "MetLife Reports Loss After Website Snafu," by: Lauren Pollock and Leslie Scism, The Wall Street Journal, April 21, 2012 ---
    http://online.wsj.com/article/SB10001424052702303425504577355563837307548.html?mod=djem_jiewr_AC_domainid

    MetLife Inc. MET +1.39% posted a first-quarter shortfall on steeper derivatives losses, in results the life insurer released two weeks ahead of schedule after inadvertently posting some of the data on its website.

    Operating earnings, which exclude investment gains and losses, climbed in the period and topped estimates, though operating revenue, which also strips out some investment effects, grew more slowly than expected.

    MetLife, the biggest U.S. life insurer, reported its results earlier than planned after the company had learned that historical data posted Wednesday on the investor-relations section of its website "could be accessed in ways to make visible" the preliminary quarterly results. It discovered the snafu on Thursday.

    The company's shares fell 1.2% to $34.96 Friday. They have climbed 12% this year.

    MetLife posted a loss of $64 million, compared with a year-earlier profit of $877 million. On a per-share basis, which reflects the payment of preferred dividends, the company posted a loss of 9 cents, versus a profit of 66 cents. Operating earnings rose to $1.37 a share from $1.23. Operating revenue climbed 6.9% to $16.69 billion.

    Analysts polled by Thomson Reuters were looking for operating earnings of $1.25 a share and operating revenue of $16.72 billion. The better-than-expected operating results were aided by the stock market's strong showing, which lifted products such as variable annuities, said Morgan Stanley analyst Nigel Dally. International earnings were at "the upper-end" of the prior guidance range provided by the company, he said, mostly attributable to MetLife's Asian operations.

    Like its fellow insurers, MetLife uses derivatives to hedge a number of risks, including changes in interest rates and fluctuations in foreign currencies. Certain derivatives tend to produce losses in quarters when shares of MetLife and the broader market are rallying, and vice versa. In the most recent period, the company booked net derivative losses of $1.98 billion compared with a year-earlier derivative loss of $315 million.

    Analysts also applauded a sharp drop in MetLife's sales of variable annuities. While the investment products can be lucrative to insurers, they can be costly to hedge when interest rates are low and markets are volatile.

    John Nadel, an analyst at Sterne Agee, said MetLife seems to have its variable-annuity sales "under control."

    MetLife executives, led by chief executive Steven Kandarian, have said profits were likely to rise in 2012, as better results at its U.S. retirement-products business and its international operations offset the effects of sluggish economic growth.

    Continued in article

     


    Collateralized Debt Obligation --- http://en.wikipedia.org/wiki/Collateralized_debt_obligation

    New Rules for CDOs
    "Statement at Open Meeting: Asset-Backed Securities Disclosure and Registration," by Commissioner Kara M. Stein, SEC, August 27, 2014 ---
    http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370542772431#.VBgvYBZS7rx

    I begin my remarks by echoing others and commending the work of the team that has been working on this rule, including Rolaine Bancroft, Hughes Bates, Michelle Stasny, Kayla Florio, Heather Mackintosh, Silvia Pilkerton, Robert Errett, Max Rumyantsev, and Kathy Hsu. 

    Heather and Sylvia have been working on the data tagging and preparing EDGAR to accept this new data.  This is no small endeavor. 

    I want to give a special thank you to Paula Dubberly, who retired last year from the SEC and is in the audience today.  She has been a champion for investors through her leadership on asset-backed securities regulation from the development of the initial Reg AB proposal through the rules that are being considered today.

    This rule is an important step forward in completing the mandated Dodd-Frank Act rulemakings.[1]  The financial crisis revealed investors’ inability to actually assess pools of loans that had been sliced and diced, sometimes multiple times, by being securitized, re-securitized, or combined in a dizzying array of complex financial instruments.  The securitization market was at the center of the financial crisis.  While securitization structures provided liquidity to nearly every sector in the U.S. economy, they also exposed investors to significant and non-transparent risks due to poor lending practices and poor disclosure practices. 

    As we now know, offering documents failed to provide timely and complete information for investors to assess the underlying risks of the pool of assets.[2]   Without sufficient and accurate loan level details, analysts and investors could not gauge the quality of the loans – and without an ability to distinguish the good from the bad, the secondary market collapsed.

    Congress responded and required the Commission to promulgate rules to address a number of weaknesses in the securitization process.[3]

    Six years after the financial crisis, the securitization markets continue to recover.  While certain asset classes have rebounded, others continue to struggle.

    The rule the Commission issues today partially addresses the Congressional mandate.  In effect, today’s rules provide investors with better information on what is inside the securitization package.  The rules today do for investors what food and drug labeling does for consumers – provide a list of ingredients.

    This rule also addresses certain critical flaws that became apparent in the securitization process, including a dearth of quality information and insufficient time to make informed assessments of the underlying investments.  This rule is an important step toward providing investors with tools and data to better understand the underlying risks and appropriately price the securities. 

    There are several important and laudable aspects of today’s rule that merit specific mentioning.

    First, the rule requires the underlying loan information to be standardized and available in a tagged XML format to ensure maximum utility in analysis.[4]   As noted in the Commission’s 2010 Proxy Plumbing Release: “If issuers provided reportable items in interactive data format, shareholders may be able to more easily obtain information about issuers, compare information across different issuers, and observe how issuer-specific information changes over time as the same issuer continues to file in an interactive format.”[5]  The same is true for underlying loan information.  Investors can unlock the value and efficiency that standardized, machine readable data allows. 

    Today’s rule also improves disclosures regarding the initial offering of securities and significantly, for the first time, requires periodic updating regarding the loans as they perform over time.  This information will provide a more nuanced and evolving picture of the underlying assets in a portfolio to investors.

    The rule also requires that the principal executive officer of the ABS issuer certify that the information in the prospectus or report is accurate.  These kinds of certifications provide a key control to help ensure more oversight and accountability.

    As for the privacy concerns that prompted a re-proposal, the staff has worked hard to balance investor needs for loan level data with concerns that the data could lead to identification of individual borrowers.   I believe the rule achieves a workable balance between these two competing needs, while still providing invaluable public disclosure.

    Finally, I believe that the new disclosure rule will provide investors with the necessary tools to see what is “under the hood” on auto loan securitizations.  In its latest report on consumer debt and credit, the Federal Reserve Bank of New York noted a recent spike in subprime auto lending.  As the report shows, although consumer auto debt balances have risen across the board, the real growth has been in riskier loans.[6] The disclosure and reporting changes that the Commission is adopting today will help investors see the quality of the loans in a portfolio and the performance of those loans over time. 

    While today’s rules are an important step forward, more work needs to be done regarding conflicts of interest.   We now know that many firms who were structuring securitizations before the financial crisis were also betting against those same securitizations. 

    In April 2010, the Commission charged the U.S broker-dealer of a large financial services firm for its role in failing to disclose that it allowed a client to select assets for an investment portfolio while betting that the portfolio would ultimately lose its value.  Investors in the portfolio lost more than $1 billion.[7]  

    In October 2011, the Commission sued the U.S broker-dealer of a large financial services firm for among other things, selling investment products tied to the housing market and then, for their own trading, betting that those assets would lose money.  In effect, the firm bet against the very investors it had solicited.  An experienced collateral manager commented internally that a particular portfolio was “horrible.”  While investors lost virtually all of their investments in the portfolio, the firm pocketed over $160 million from bets it made against the securitization it created.[8]

    The Dodd-Frank Act directed the Commission to adopt rules prohibiting placement agents, underwriters, and sponsors from engaging in a material conflict of interest for one year following the closing of a securitization transaction. Those rules were required to be issued by April 2011.[9]   The Commission initially proposed these rules in September 2011, and still has not completed them.[10]  We need to complete these rules as soon as possible, hopefully, by the end of this year.  These rules will provide investors with additional confidence that they are not being hoodwinked by those packaging and selling those financial instruments. 

    Unfortunately, the Commission has put on hold its work to provide investors with a software engine to aid in the calculation of waterfall models.  Although the final rule provides for a preliminary prospectus at least three business days before the first sale, this is reduced from the proposal, which provided for a five-day period.   With only three days to conduct due diligence and make an investment determination, such a software engine could be an important and much needed tool for investors to use in analyzing the flow of funds.  Such waterfall models can help investors assess the cash flows from the loan level data.  We should return to this important initiative to provide investors with the mathematical logic that forms the basis for the narrative disclosure within the prospectus. 

    The rule today impacts some significant sectors of the securitization market, however, the Commission should continue to work in making improvements that will provide investors with the disclosures they need regarding other asset classes, such as student loans, equipment loans and leases, and others as appropriate.      

    Finally, it is vitally important that the Commission continue to work with our fellow regulators to establish important provisions for risk retention, also required by the Dodd-Frank Act. 

    In conclusion, I appreciate the staff’s hard work both with me and my staff over these past several months.  But much work remains to be done.  I am committed to working with the staff and my fellow Commissioners to continue to move forward with Dodd-Frank rulemakings and specifically rulemakings to improve the strength and resiliency of securitization markets. 

    A stable securitization market efficiently brings investors and issuers together.  Thus far, the return of capital to securitization markets has been disappointing, and I am hopeful that this rule and others that will follow will provide incentives for both issuers and investors to return with confidence to this once vibrant marketplace.     

    The new tools and protections provided in today’s rule should help restore trust in a market that was at the heart of the worst financial crisis since the Great Depression.  But removing this black cloud is going to require continuing focus and effort from all of us. 

    Thank you.  I
     


     

    [1]           The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010). 

     

    [2]           See Sheila Bair, Bull by The Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself at 52 (2012) (investors in asset-backed securities lacked detailed loan level information and adequate time to analyze the information before making an investment decision). 
    [3]           The Dodd-Frank Wall Street Reform and Consumer Protection Act imposed new requirements on the ABS process and required the Commission to promulgate rules in a number of areas.  Section 621 prohibits an underwriter, placement agent, initial purchaser, sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity for a period of one year after the date of the first closing of the sale of the asset-backed security.  Section 941 requires the Commission, the Federal banking agencies, and, with respect residential mortgages, the Secretary of Housing and Urban Development and the Federal Housing Finance Agency to prescribe rules to require that a securitizer retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells, or conveys to a third party. The chairperson of the Financial Stability Oversight Council is tasked with coordinating this regulatory effort.  Section 942 contains disclosure and Exchange Act reporting requirements for ABS issuers.  Section 943 requires the Commission to prescribe regulations on the use of representations and warranties in the ABS market.  Section 945 requires the Commission to issue rules requiring an asset-backed issuer in a Securities Act registered transaction to perform a review of the assets underlying the ABS, and disclose the nature of such review.   See also H.R. Rep. No. 4173 (2010) (Dodd-Frank Conference Report)

     

    [4]           See Statement of Former Federal Reserve Governor Randall S. Kroszner at the Federal Reserve System Conference on Housing and Mortgage Markets, Washington, DC, December 4, 2008, available at  http://www.federalreserve.gov/newsevents/speech/kroszner20081204a.htm.

     

    [5]           See Concept Release on the U.S. Proxy System, Exchange Act Release No. 62495 (July 14, 2010), available at http://www.sec.gov/rules/concept/2010/34-62495.pdf.

     

     

    [6]           See Quarterly Report on Household Debt and Credit, August 14, 2014, Federal Reserve Bank of New York, available at http://www.newyorkfed.org/microeconomics/hhdc.html#/2014/q2.

      

    [7]           See SEC v. Goldman, Sachs & Co. and Fabrice Tourre, 10 Civ. 3229 (BJ) (S.D.N.Y. filed April 16, 2010) available at http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf.

     

    [8]           See SEC v. Citigroup Global Markets, 11 Civ. 7387. (Rakoff, J.) (S.D.N.Y. filed Oct. 19, 2011)., available at http://www.sec.gov/litigation/complaints/2011/comp-pr2011-214.pdf.

     

     

    [9]           Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, § 621, 124 Stat. 1376, 1632 (2010).

     

    [10]          See SEC Release No. 34-65355, Prohibition against Conflicts of Interest in Certain Securitizations, September 19, 2011; SEC Release No. 34-65545, October 12, 2011 (extending the comment period from December 19, 2011 to January 13, 2012); and SEC Release No. 34-66058, October 12, 2011 (extending the comment period end date from January 13, 2012 to February 13, 2012).

     

    Bob Jensen's threads on bad debts and loan losses ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#LoanLosses


    CDO --- https://en.wikipedia.org/wiki/Collateralized_debt_obligation

    "Goldman Reaches $5 Billion Settlement Over Mortgage-Backed Securities:  Pact marks largest settlement in history of Wall Street firm," by Justin Baer and Chelsey Dulaney, The Wall Street Journal, January 14, 2016 ---
    http://www.wsj.com/articles/goldman-reaches-5-billion-settlement-over-mortgage-backed-securities-1452808185?mod=djemCFO_h

    Goldman Sachs Group Inc. agreed to the largest regulatory penalty in its history, resolving U.S. and state claims stemming from the Wall Street firm’s sale of mortgage bonds heading into the financial crisis.

    In settling with the Justice Department and a collection of other state and federal entities for more than $5 billion, Goldman will join a list of other big banks in moving past one of the biggest, and most costly, legal headaches of the crisis era.

    Goldman said litigation legal expenses stemming from the accord would trim its fourth-quarter earnings by about $1.5 billion, after taxes. The firm is scheduled to report results Wednesday.

    “We are pleased to have reached an agreement in principle to resolve these matters,” Lloyd Blankfein, Goldman’s chief executive, said in a statement.

    Government officials previously won multibillion-dollar settlements from J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc. The probes examined how Wall Street sold bonds tied to residential mortgages, and whether banks deceived investors by misrepresenting the quality of underlying loans.

    The government’s inquiry into Goldman related to mortgage-backed securities the firm packaged and sold between 2005 and 2007, the years when the housing market was soaring and investor demand for related bonds was still strong.

    Continued in article


    The Hazards of Financial Contract Creativity
    Keywords
    Financial Innovation; Raghuram Rajan; Junk Bonds; Credit-Default Swaps; Securitization; Index Funds; Currency Swaps
    Read more: http://www.newyorker.com/talk/financial/2010/05/17/100517ta_talk_surowiecki#ixzz0o7msp3sa

    Structured Financing Contracts --- http://en.wikipedia.org/wiki/Structured_finance

    Securitization (remember the CDO disasters where bonds were secured by both legitimate and poisonous mortgages) ---
    http://en.wikipedia.org/wiki/Securitization

    Securitization and Structured Finance Post Credit Crunch: A Best Practice Deal Lifecycle Guide
    Edition 1
    by Markus Krebsz
    http://www.barnesandnoble.com/w/securitization-and-structured-finance-post-credit-crunch-markus-krebsz/1101212381?ean=9780470713914&itm=1&usri=markus%2bkrebsz

    Product Details

    • Pub. Date: June 2011
    • Publisher: Wiley, John & Sons, Incorporated

    Synopsis

    Structured bonds are often viewed as complex and opaque, and participants in the securitization and structured finance markets have traditionally had a narrow focus on a specific part of the securitization value chain. However, in the post credit crunch environment, the market is more regulated, standardized, transparent, and better structured with closer-aligned and more balanced incentives for all participants, more focus on investors and improved comprehension of these bond instruments. In order for the market to succeed, it is vital that all participants take a broader view and understand every part of the transaction lifecycle.

    In Securitization and Structured Finance Post Credit Crunch: A Best Practice Deal Lifecycle Guide, Markus Krebsz draws on his years of experience in the global finance markets to provide a jargon-free guide to the entire lifecycle of securitization and structured finance deals. The book:

    • Introduces much needed sound practice principles, based on lessons learnt post credit crisis
    • Takes the reader through a generic deal's typical lifecycle stages
    • Discusses each stage of the deal in detail, from 'Pre-Close' (strategic aims, feasibility studies, deal economic analysis and transaction documentation) through 'Close' (credit ratings, investor appetite/marketability, legal considerations) and 'Aftercare' (reporting, surveillance and performance analysis, and ordinary and extraordinary repayment)
    • Opens up the author's personal 'tool box' and provides the reader with a comprehensive selection of references, tables, a glossary and other useful resources. Electronic versions of these tools are available from the book's companion website at www.structuredfinanceguide.com

    This unique, holistic and pragmatic insight into all deal life cycle stages makes Securitization and Structured Finance Post Credit Crunch an invaluable reference for all market participants in their efforts to get this important and - if used properly - hugely beneficial part of the capital markets back up and running.

    Jensen Comment
    There's not much in this book regarding accounting rules or illustrations of measurement and disclosures in financial statements. However, the book us up-to-date in lending insight into the types of contracts that must bye accounted for in structured financing and securitization.


    Accounting Standards Update (ASU) on reclassification of collateralized mortgage loans to foreclosed residential real estate property
    From EY:  Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40), January 2014 --- Click Here
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175828206382&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=2287159&blobheadervalue1=filename%3DASU_2014-04.pdf&blobcol=urldata&blobtable=MungoBlobs

  • Summary
    Why Is the FASB Issuing This Accounting Standards Update (Update)? In recent years, the rate of default on loans collateralized by residential real estate properties resulting from general economic conditions, including weakness in the housing market, has affected the rate of residential real estate foreclosures and the levels of foreclosed real estate owned by banks or similar lenders (creditors). U.S. generally accepted ac counting principles on troubled debt restructurings include guidance on situations in which a creditor obtains one or more collateral assets in satisfaction of all or part of the receivable. That guidance indicates that a creditor should reclassify a collateralized mortgage loan such that the loan should be derecognized and the collateral asset recognized when it determines that there has been in substance a repossession or foreclosure by the creditor, that is, the creditor receives physical possession of the debtor’s assets regardless of whether formal foreclosure proceedings take place . However, the terms in substance a repossession or foreclosure and physical possession are not defined in the accounting literature and there is diversity about when a creditor should derecognize the loan receivable and recognize the real estate property. That diversity has been highlighted by recent extended foreclosure timelines and processes related to residential real estate properties.

  • The objective of the amendments in this Update is to reduce diversity by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized.

  • Who Is Affected by the Amendments in This Update?
    The amendments in this Update apply to all creditors who obtain physical possession (resulting from an in substance repossession or foreclosure) of residential real estate property collateralizing a consumer mortgage loan in satisfaction of a receivable.

  • What Are the Main Provisions?
    The amendments in this Update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical properties existing as of the beginning of the annual period for which the amendments are effective. Assets reclassified from real estate to loans as a result of adopting the amendments in th is Update should be measured at the carrying value of the real estate at the date of adoption. Assets reclassified from loans to real estate as a result of adopting the amendments in this Update should be measured at the lower of the net amount of loan receivable or the real estate’s fair value less costs to sell at the time of adoption. For prospective transition, an entity should apply the amendments in this Update to all instances of an entity receiving physical possession of residential real estate property collateralized by consumer mortgage loans that occur after the date of adoption. Early adoption is permitted.

  • How Do the Provisions Compare with International Financial Reporting Standards (IFRS)?
    IFRS does not contain any guidance specific to the reclassification of collateralized mortgage loans to foreclosed residential real estate property.

  • Continued in article

  •  


    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:

    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

     

     


     

    29 April 2011


    To the Point: Repo accounting amendments finalized

    The Financial Accounting Standards Board (FASB) today amended its guidance on accounting for repurchase agreements. The amendments simplify the accounting by eliminating the requirement that the transferor demonstrate it has adequate collateral to fund substantially all the cost of purchasing replacement assets. As a result, more arrangements could be accounted for as secured borrowings rather than sales.

    The attached To the Point summarizes what you need to know about the new guidance. It is also available online.

     


    "Fatal Risk: The Must-Read Story Of AIG's Downfall," by John Hemton, Business Insider, April 18, 2011 ---
    http://www.businessinsider.com/fatal-risk-the-must-read-story-of-aigs-downfall-2011-4

    There are dozens of books on the financial crisis: I have read many of them and the Kindle samples for just about all of them. There are only two I would recommend: those are Bethany McLean and Joe Nocera’s excellent All the Devils are Here and the much more specifically detailed Fatal Risk from Roddy Boyd. Roddy's book is solely concerned with the failure of AIG.

    Both books start without any strong ideological preconceptions and let the facts woven into a good story do the talking - and both wind up ambivalent about many of the major players - with many players having human weaknesses (gullibility, delusion, arrogance etc) but committing nothing that looks like a strong case for criminal prosecution. Reading these you can see why there are so few criminal prosecutions from the crisis. And you will also see just how extreme the human failings that caused the crisis are.

    Continued in article
     

    Bob Jensen's threads on the credit derivative disaster are at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#IgnobleAgendas

    Bob Jensen's Primer on Derivatives ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Primer

     

     


    "Too Clever by Half?" by James Surowiecki, The New Yorker, May 17, 2010 ---
    http://www.newyorker.com/talk/financial/2010/05/17/100517ta_talk_surowiecki

    Innovate or die. The phrase, popularized in Silicon Valley in the nineteen-nineties, has since become a mantra throughout the business world, and nowhere has it been more popular than on Wall Street, which in recent years has churned out a seemingly endless stream of new ways to manage capital and slice and dice risk. But, while Silicon Valley’s innovations have brought enormous benefits to society, the value of Wall Street’s innovations seems a lot less clear. (The former Fed chair Paul Volcker has said, for instance, that the last valuable new product in banking was the A.T.M.) The Valley gave us the microprocessor, Google, and the iPod. The Street gave us the C.D.O., the A.B.S., and the C.D.S.—not to mention the kind of computerized trading that enabled last week’s stock-market nosedive. Not surprisingly, then, the whole notion of “financial innovation” is being looked at with a gimlet eye, and Congress is now considering various ways to rein in the banking industry’s excesses. Given the tumult of the past few years, the barter system is starting to look good.

    Not all of Wall Street’s concoctions have been pointless or destructive, of course. Take junk bonds, whose use Michael Milken pioneered in the nineteen-eighties. They got a bad name when Milken went to prison for securities fraud. But his insight that high-yield bonds could be a good investment—that, historically, the rewards outweighed the risks—allowed new companies, including eventual giants like Turner Broadcasting and M.C.I., as well as countless smaller businesses, to raise billions in capital that previously would have been out of their reach. Today, almost two hundred billion dollars’ worth of junk bonds is sold every year; they’re an integral part of the way Wall Street does what it’s supposed to do: channel money from investors to productive enterprises.

    There are plenty of comparable examples, as Robert Litan, a scholar at the Brookings Institution, showed in a recent essay. Currency and interest-rate swaps, for instance, allow global corporations to focus on their businesses without having to worry about wild swings in currency values. Index funds have given individual investors a low-cost way of putting their money to work. Venture capital provides startups with access to tens of billions of dollars every year. Raghuram Rajan, a former chief economist at the I.M.F. and a finance professor at the University of Chicago, says, “There’s a lot of stuff that does a lot of good that we take for granted, because it’s just become part of our everyday financial lives.”

    Unfortunately, the benefits of good financial innovations have, of late, been swamped by the costs of the ones that went bad. Things like “structured investment vehicles,” for instance, were designed to evade regulations and make bank balance sheets look safer than they were. Subprime loans, which offered lower-income Americans a rare chance to accumulate wealth, ended up inflating the housing bubble and leaving these same people with debts they couldn’t pay. Credit-default swaps, which are a useful way for investors to protect themselves against unavoidable risks, became a way for institutions like A.I.G. to make easy money in the short term while piling up billions of dollars in potential obligations that taxpayers ended up paying for. And securitization—the packaging of many loans into a single complex financial product—led investors to neglect the quality of the actual loans that were being made.

    Some of these ideas, as it happens, were reasonable ones, within limits. But limits aren’t something that Wall Street knows much about: in recent years, it has shown an uncanny knack for taking reasonable ideas to unreasonable extremes. The economists Nicola Gennaioli, Andrei Shleifer, and Robert Vishny argue in a recent paper that financial innovation often leads to financial instability: investors get interested in a new product that seems to offer high returns, and, precisely because it’s new, underestimate the chance that this product will eventually blow up. They pour more and more money into the market, until things start to go wrong, at which point they panic en masse. The complex financial engineering that went into creating products like C.D.O.s exacerbated the problem by making the risks of those investments opaque. If investors had known the risks they were taking in the pursuit of greater returns, they would have been more prepared for failure—and would presumably have put less money into the housing market. Instead, they thought that financial wizardry had engineered all the danger out of the system. As Rajan argued in a prescient 2005 paper, financial development, which was supposed to make the system safer, could in fact make it riskier. The fundamental problem with innovation was that it made investors and executives forget the need to think for themselves.

    Read more: http://www.newyorker.com/talk/financial/2010/05/17/100517ta_talk_surowiecki#ixzz0o7nchYvD


    2001
    Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets
      (Henry Holt and Company, 2003, Pages 385 &389, ISBN 0-8050-7510-0)

    The second type of credit derivative --- the Collateralized Debt Obligation  (CDO) --- posed even greater dangers to the global economy. In a standard CDO, a financial institution sold debt (loans or bonds) to a Special Purpose Entity, which then split the debt into p9ces by issuing new securities linked to each piece. Some of the pieces were of higher quality; some were of lower quality. The credit-rating agencies gave investment-grade ratings to all except the lowest-quality piece. By 2002, there were more than a half a trillion dollars of CDOs.

    . . .

    .No one had paid much attention to the first warning that CDOs threatened the health of the global economy. In July 2001 --- two months before Jeff Slilling had resigned from Enron, and long before investors learned about the accounting problems at Global Crossing and WorldCom --- American Express, the U.S. financial services conglomerate had calmly announced that it would take an $825 million pretax charge to write down the value of investments in high-yield bonds and Collateralized Debt Obligations. It all sounded much too esoteric to matter to average investors. The media brushed off the details by focusing on the junk bonds involved in the various deals, and commentators seem to agree that theese losses were just a minor consequence of the explosion of financial innovation.

    . . .

    Then there was the stunning public admission by the chairman of American Express, Kenneth Cheault, that his firm "did not comprehend the risk" of these investments.  What?

     

     

    Question
    What are CDOs?
    Should they be booked?
    Why were they particularly troublesome in the Year 2007?

    CDO --- Click Here

    Accounting for Collateralized Debt Obligations (CDOs)

    As to CDOs in VIEs, you might take a look at
    http://www.mayerbrown.com/public_docs/cdo_heartland2004_FIN46R.pdf

    Evergreen Investment Management case at
    http://www.sec.gov/litigation/admin/2009/34-60059.pdf

    Accounting for CDOs (including journal entries) under U.S. and Foreign GAAP --- http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm

    Bob Jensen's threads on SPEs, SPVs, and VIEs ---
    http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

     

    Why were CDOs particularly troublesome in the Year 2007?
    The accounting standards are not resolved on whether or not CDOs should be booked.
    From The Wall Street Journal Accounting Weekly Review on November 30, 2007

    Citi's $41 Billion Issue: Should It Put CDOs On the Balance Sheet?
    by David Reilly
    The Wall Street Journal
    Nov 26, 2007
    Page: C1
    Click here to view the full article on WSJ.com
    ---
    http://online.wsj.com/article/SB119604238679603556.html?mod=djem_jiewr_ac

     

    TOPICS: Accounting, CDO, Collateralized Debt Obligations, Consolidated Financial Statements, Consolidations, Financial Accounting, Reconsideration Events

    SUMMARY: Does Citigroup need to bring $41 billion in potentially shaky securities onto its balance sheet? Opinions are divided, reflecting a wider debate over how to interpret accounting rules on off-balance-sheet treatment for some financing vehicles.

    CLASSROOM APPLICATION: This article offers a good basis for discussion of CDOs, possible consolidation of CDOs, and the balance sheet presentation of CDOs based on the rules related to "reconsideration events."

    QUESTIONS: 
    1.) What are CDOs? What are the recent problems connected with CDOs? What is the cause of these problems? In general, why are they especially a concern for Citigroup?

    2.) What is the specific issue facing Citigroup, as detailed in the article?

    3.) What are the accounting rules regarding consolidation of CDOs? How do banks avoid having to consolidate?

    4.) Why is there controversy over the how the losses should be booked by the bank? What is the potentially vague part of the rules?

    5.) What position does Citigroup take? What position are some accounting experts taking? Is either side getting support from other parties? If so, from whom?

    6.) With what position do you agree? How did you reach this conclusion? Please offer support from your answer.
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Why Citi Struggles to Tally Losses
    by Carrick Mollenkamp and David Reilly
    Nov 05, 2007
    Page: C1

    The Nine Lives of CDOs
    by
    Nov 26, 2007
    Page: C10

    Goldman Says Citigroup Faces $15 Billion CDO Write-Downs
    by Kimberly A. Vlach
    Nov 20, 2007
    Online Exclusive
     

    "Citi's $41 Billion Issue: Should It Put CDOs On the Balance Sheet?" by David Reilly, The Wall Street Journal, November 26, 2007; Page C1 --- http://online.wsj.com/article/SB119604238679603556.html?mod=djem_jiewr_ac

    A $41 billion question mark is hanging over Citigroup Inc.

    That is the amount, in a worst-case scenario, of potentially shaky securities the bank would need to bring onto its balance sheet. Citi has already taken billions of dollars of such securities onto its balance sheet and expects to take big write-downs on those holdings.

    The fate of the $41 billion rests on the outcome of a debate going on in accounting circles over what constitutes a "reconsideration event." Those who say Citi needs to put these securities, known as collateralized debt obligations, onto its balance sheet argue that because Citi acted over the summer to backstop some of them, its relationship with them changed, prompting a reconsideration event.

    At the moment, it seems unlikely Citigroup will be forced to bring the assets onto its books. The bank doesn't believe such a reconsideration event is in order. A spokeswoman says Citigroup is confident its "financial statements fully comply with all applicable rules and regulations."

    But the division of opinion reflects debate within accounting circles over just how to interpret rules that govern off-balance-sheet treatment for some financing vehicles. That, in turn, underscores what many consider to be a failure of these rules to ensure that investors in the companies that create these vehicles are adequately informed of the risks posed by them.

    In recent months, investors have been shocked to learn that many banks were exposed to big losses because of their involvement with vehicles that issued commercial paper and purchased risky assets such as mortgage securities. The troubles facing one kind of off-balance-sheet entity, known as structured investment vehicles, have even prompted Citigroup and other major banks to organize a rescue fund.

    But CDO vehicles created by Citigroup have proved to be a more immediate threat. The bank's announcement this month that it expects to take $8 billion to $11 billion in write-downs in the fourth quarter largely stems from its exposure to CDO assets. Citigroup was one of the biggest arrangers of CDOs -- products that pool debt, often mortgage securities, and then sell slices with varying degrees of risk.

    If Citigroup had to include an additional $41 billion in CDO assets on its books, that could potentially spur a further $8 billion in write-downs, above and beyond those already signaled, according to a report earlier this month by Howard Mason, an analyst at Sanford C. Bernstein. Such losses could further weaken Citigroup's capital position, threatening its dividend or forcing the bank to raise money.

    The issue for Citigroup is when, and if, it has to reconsider consolidation of the CDO vehicles it sponsors.

    Like other banks, Citigroup structured these vehicles so they wouldn't be included on its books. The vehicles are created as corporate zombies that ostensibly aren't owned or controlled by anyone. In that case, accounting rules say consolidation of such vehicles is determined by who holds the majority of risks and rewards connected to them.

    To deal with that, banks sell off the riskiest pieces of the vehicles. This ensures they don't shoulder a majority of the risk and so don't have to consolidate the vehicles. The assessment of who absorbs the majority of losses is made when the vehicles are created.

    Over time, though, rising losses within a vehicle can lead a sponsor to shoulder more risk, or even a majority of it. That can also happen if a sponsor takes on additional interests in the vehicle by buying up the short-term IOUs it issues.

    That is what happened to Citigroup. Over the summer, the bank was forced to buy $25 billion in commercial paper issued by its CDO vehicles because investors were no longer interested in the paper. Citigroup already had an $18 billion exposure to these vehicles through other funding it had provided.

    This combined $43 billion exposure means that if CDO losses climb high enough, the bank could be exposed to more than half the losses, according to Bernstein's Mr. Mason. That would seem to argue for Citigroup's consolidating all $84 billion of its CDO assets originally held in off-balance-sheet vehicles.

    But the accounting rules don't say that sponsors of these vehicles have to reassess on any regular basis the question of who bears the majority of risk of loss. Such "reconsideration events" occur when there is a change in the "governing documents or contractual arrangements" related to these vehicles, the rules say.

    Citigroup believes that because it hasn't changed the documents or contracts related to the vehicles, it shouldn't have to reconsider its relationship to them, according to people familiar with the bank's thinking.

    But some accounting experts point out that the rule also says a reconsideration event occurs when an institution acquires additional interests in the vehicle. "If a bank is being forced to step in and be a bigger holder of the commercial paper, to me that's pretty black and white that it's a reconsideration event," says Ed Trott, a retired member of the Financial Accounting Standards Board, the body that wrote the accounting rule.

    An influential accounting-industry group, the Center for Audit Quality, also seems to lean toward this view. In a paper issued last month, the center said the purchase of commercial paper is an example of a change in the contractual arrangements governing these vehicles. This "may also result in a reconsideration event," the paper said.

    But Citigroup believes its purchase of the CDO vehicles' commercial paper is different, because it had taken on the obligation to provide such assistance when the vehicles were created. This means the bank was acting within the contractual arrangements governing the vehicles, not changing them, according to the people familiar with Citigroup's thinking.

    Some accounting experts agree. "If all that's happening is one set of [paper holders] is going out and another is coming in, that's not a reconsideration event," says Stephen Ryan, an accounting professor at New York University. "I don't think you reconsider moment by moment; an event is not just bad luck happening."


    Question
    To what extent should the FASB and the IASB modify accounting standards for new theories of structured finance and securitization?

    "The Economics of Structured Finance," by Joshua D. Coval,  Jakub Jurek, and  Erik Stafford, Working Paper 09-060, Harvard Business School, 2008 ---
    http://www.hbs.edu/research/pdf/09-060.pdf

    The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

    We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. First, we show that most securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities’ default risks, and how likely defaults were to be correlated. Using the prototypical structured finance security – the collateralized debt obligation (CDO) – as an example, we illustrate that issuing a capital structure amplifies errors in evaluating the risk of the underlying securities. In particular, we show how modest imprecision in the parameter estimates can lead to variation in the default risk of the structured finance securities which is sufficient, for example, to cause a security rated AAA to default with reasonable likelihood.

    A second, equally neglected feature of the securitization process is that it substitutes risks that are largely diversifiable for risks that are highly systematic. As a result, securities produced by structured finance activities have far less chance of surviving a severe economic downturn than traditional corporate securities of equal rating. Moreover, because the default risk of senior tranches is concentrated in systematically adverse economic states, investors should demand far larger risk premia for holding structured claims than for holding comparably rated corporate bonds. We argue that both of these features of structured finance products – the extreme fragility of their ratings to modest imprecision in evaluating underlying risks and their exposure to systematic risks – go a long way in explaining the spectacular rise and fall of structured finance.

    For over a century, agencies such as Moody’s, Standard and Poor’s and Fitch have gathered and analyzed a wide range of financial, industry, and economic information to arrive at independent assessments on the creditworthiness of various entities, giving rise to the now widely popular rating scales (AAA, AA, A, BBB and so on). Until recently, the agencies focused the majority of their business on single-name corporate finance—that is, issues of creditworthiness of financial instruments that can be clearly ascribed to a single company. In recent years, the business model of credit rating agencies has expanded beyond their historical role to include the nascent field of structured finance.

    From its beginnings, the market for structured securities evolved as a “rated” market, in which the risk of tranches was assessed by credit rating agencies. Issuers of structured finance products were eager to have their new products rated on the same scale as bonds so that investors subject to ratings-based constraints would be able to purchase the securities. By having these new securities rated, the issuers created an illusion of comparability with existing “single-name” securities. This provided access to a large pool of potential buyers for what otherwise would have been perceived as very complex derivative securities.

    During the past decade, risks of all kinds have been repackaged to create vast quantities of triple-A rated securities with competitive yields. By mid-2007, there were 37,000 structured finance issues in the U.S. alone with the top rating (Scholtes and Beales, 2007). According to Fitch Ratings (2007), roughly 60 percent of all global structured products were AAA-rated, in contrast to less than 1 percent of the corporate issues. By offering AAA-ratings along with attractive yields during a period of relatively low interest rates, these products were eagerly bought up by investors around the world. In turn, structured finance activities grew to represent a large fraction of Wall Street and rating agency revenues in a relatively short period of time. By 2006, structured finance issuance led Wall Street to record revenue and compensation levels. The same year, Moody’s Corporation reported that 44 percent of its revenues came from rating structured finance products, surpassing the 32 percent of revenues from their traditional business of rating corporate bonds.

    By 2008, everything had changed. Global issuance of collateralized debt obligations slowed to a crawl. Wall Street banks were forced to incur massive write-downs. Rating agency revenues from rating structured finance products disappeared virtually overnight and the stock prices of these companies fell by 50 percent, suggesting the market viewed the revenue declines as permanent. A huge fraction of existing products saw their ratings downgraded, with the downgrades being particularly widespread among what are called “asset-backed security” collateralized debt obligations—which are comprised of pools of mortgage, credit card, and auto loan securities. For example, 27 of the 30 tranches of asset-backed collateralized debt obligations underwritten by Merrill Lynch in 2007, saw their triple-A ratings downgraded to “junk” (Craig, Smith, and Ng, 2008). Overall, in 2007, Moody’s downgraded 31 percent of all tranches for asset-backed collateralized debt obligations it had rated and 14 percent of those nitially rated AAA (Bank of International Settlements, 2008). By mid-2008, structured finance activity was effectively shut down, and the president of Standard & Poor’s, Deven Sharma, expected it to remain so for “years” (“S&P President,” 2008).

    This paper investigates the spectacular rise and fall of structured finance. We begin by examining how the structured finance machinery works. We construct some simple examples of collateralized debt obligations that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. We then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. We then conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.

    Manufacturing AAA-rated Securities

    Manufacturing securities of a given credit rating requires tailoring the cash-flow risk of these securities – as measured by the likelihood of default and the magnitude of loss incurred in the event of a default – to satisfy the guidelines set forth by the credit rating agencies. Structured finance allows originators to accomplish this goal by means of a two-step procedure involving pooling and tranching.

    In the first step, a large collection of credit sensitive assets is assembled in a portfolio, which is typically referred to as a special purpose vehicle. The special purpose vehicle is separate from the originator’s balance sheet to isolate the credit risk of its liabilities – the tranches – from the balance sheet of the originator. If the special purpose vehicle issued claims that were not prioritized and were simply fractional claims to the payoff on the underlying portfolio, the structure would be known as a pass-through securitization. At this stage, since the expected portfolio loss is equal to the mean expected loss on the underlying securities, the portfolio’s credit rating would be given by the average rating of the securities in the underlying pool. The pass-through securitization claims would inherit this rating, thus achieving no credit enhancement.

    By contrast, to manufacture a range of securities with different cash flow risks, structured finance issues a capital structure of prioritized claims, known as tranches, against the underlying collateral pool. The tranches are prioritized in how they absorb losses from the underlying portfolio. For example, senior tranches only absorb losses after the junior claims have been exhausted, which allows senior tranches to obtain credit ratings in excess of the average rating on the average for the collateral pool as a whole. The degree of protection offered by the junior claims, or overcollateralization, plays a crucial role in determining the credit rating for a more senior tranche, because it determines the largest portfolio loss that can be sustained before the senior claim is impaired.

    Continued in article

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    When will auditors learn about complexities of financial risk?

    "Did Wells Fargo's Auditors Miss Repurchase Risk?" by Francine McKenna, ClusterStock, September 20, 2009 --- http://www.businessinsider.com/john-carney-did-wells-fargos-auditors-miss-repurchase-risk-2009-9

    On Friday, the Business Insider worried that Wells Fargo may be making the same fatal mistake AIG did underestimating, or worse, naively ignoring Collateral Call Risk. 

    The concern was focused on potential exposure from the credit default swaps portfolio they inherited from Wachovia. In WFC's annual report the Buiness Insider saw limited discussion of this risk and no details of the reserves for it.

    There are two possible ways to account for the lack of discussion of Collateral Call Risk.  Either Wachovia wrote its derivative contracts in ways that don’t permit buyers to demand more collateral or Wells Fargo is not disclosing this risk. (A third possibility—that they don't even seem aware that they have this risk — seems remote after AIG.)

    When I read that, I saw eerie parallels with New Century, all the more so because of the auditor connection – both Wells Fargo and Wachovia and New Century (now in Chapter 11) are audited by KPMG.  New Century was not too transparent either and, as a result, many people, including some very sophisticated investors were caught with their pants down. KPMG is accused in a $1 billion dollar lawsuit of not just being incompetent, but of aiding, abetting, and covering up New Century’s fraudulent loan loss reserve calculations just so they could keep their lucrative client happy and viable.

    From the lawsuit:

    KPMG’s audit and review failures concerning New Century’s reserves highlights KPMG’s gross negligence, and its calamitous effect — including the bankruptcy of New Century.  New Century engaged in admittedly high risk lending.  Its public filings contained pages of risk factors…New Century’s calculations for required reserves were wrong and violated GAAP. For example, if New Century sold a mortgage loan that did not meet certain conditions, New Century was required to repurchase that loan.  New Century’s loan repurchase reserve calculation assumed that all such repurchases occur within 90 days of when New Century sold the loan, when in fact that assumption was false.

    In 2005 New Century informed KPMG that the total outstanding loan repurchase requests were $188 million.  If KPMG only considered the loans sold within the prior 90 days, the potential liability shrank to $70 million.  Despite the fact that KPMG knew the 90 day look-back period excluded over $100 million in repurchase requests, KPMG nonetheless still accepted the flawed $70 million measure used by New Century to calculate the repurchase reserve.  The obvious result was that New Century significantly under reserved for its risks.

    How does the New Century situation and KPMG’s role in it remind me of Wells Fargo now?  Well, in both cases, there’s no disclosure of the quantity and quality of the repurchase risk to the organization. Back in March of 2007, I wrote about the lack of disclosure of this repurchase risk in New Century’s 2005 annual report:

    There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements….it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans. Did the lenders have the right to call the loans unilaterally? It does say that if one called the loans it is likely that all would. Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened.

    Some have been writing since 2005 about the elephant in the room that is mortgage loan repurchase risk:

    Even if a lender sells most of the loans it originates, and, theoretically, passes the risk of default on to the buyer of the loan, there remains an elephant lurking in the room: the risk posed to mortgage bankers from the representations and warranties made by them when they sell loans in the secondary market… in bad times, the holders of the loans have been known to require a second "scrubbing" of the loan files, looking for breaches of representations and warranties that will justify requiring the originator to repurchase the loan. …A "pure" mortgage banker, who holds and services few loans, may think he's passed on the risk (absent outright fraud). Sophisticated originators know better…When the cycle turns (as it always does) and defaults rise, those originating lenders who sacrificed sound underwriting in return for fee income will find the grim reaper knocking at their door once again, whether or not they own the loan.

    Clusterstock quoted Wells Fargo from page 127 of their 2008 Annual Report (emphasis added):

    In certain loan sales or securitizations, we provide recourse to the buyer whereby we are required to repurchase loans at par value plus accrued interest on the occurrence of certain credit-related events within a certain period of time. The maximum risk of loss…In 2008 and in 2007, we did not repurchase a significant amount of loans associated with these agreements.

    But earlier, on page 114, there is a footnote to a chart representing loans in their balance sheet that have been securitized--including residential mortgages and securitzations sold to FNMA and FHLMC--where servicing is their only form of continuing involvement. 

    However, the delinquencies and charge off figures do not include sold loans. Wells Fargo tells us these numbers do not represent their potential obligations for repurchase if FNMA and FHLMC decide their underwriting standards were not up to par.

    Delinquent loans and net charge-offs exclude loans sold to FNMA and FHLMC. We continue to service the loans and would only experience a loss if required to repurchasea delinquent loan due to a breach in original representations and warranties associated with our underwriting standards.

    So where are those numbers?  Where is the number that correlates to the $8.4 billion dollar exposure that brought down New Century?  Wells Fargo saw an almost 300% increase from 2007 to 2008 in delinquencies and 200% increase in charge offs from commercial loans and a 300% increase in delinquencies and 350% increase in charge offs on residential loans they still hold. Can anyone say with certainty that we won’t see FNMA and FHLMC come back and force some repurchases on Wells Fargo for lax underwriting standards?

    This is all we get from Wells Fargo in the 2008 Annual Report:  

    During 2008, noninterest income was affected by changes in interest rates, widening credit spreads, and other credit and housing market conditions, including… 

    The lack of disclosure of this issue here mirrors the lack of disclosure in New Century and perhaps in other KPMG clients such at Citigroup, Countrywide ( now inside Bank of America) and others.  How do I know there could be a pattern? Because the inspections of KPMG by the PCAOB, their regulator, tell us they have been called on auditing deficiencies just like this.  Do we have to wait for a post-failure lawsuit to bring some sense, and some sunshine, to the system?

    Francine McKenna is Editor of Re: The Auditors.

    Will auditors survive the huge lawsuits concerning their negligence in estimating loan losses in the subprime mortgage and CDO crisis --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#Auditors

    Bob Jensen's threads on auditing firm lawsuits --- http://faculty.trinity.edu/rjensen/Fraud001.htm

     


    Question
    Securitization entails lending with collateral that, in the subprime crisis, was highly (and often fraudulently) overstated in value to outside investors in that collateralized debt. What can be done to save securitization in capital markets?

    "Coming Soon ... Securitization with a New, Improved (and Perhaps Safer) Face,   Knowledge@Wharton, April 2, 2008 ---
    http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=a83051431af9532a7261?articleid=1933

    For generations, the strength of the U.S. housing market was due, in part, to securitization of mortgages with guarantees from the government-sponsored companies, Fannie Mae and Freddie Mac. Following the savings and loan debacle of the late 1980s, securitization -- which has been defined as "pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors" -- helped bring capital back to battered real estate markets.

    Today, securitization of subprime real estate loans is blamed for the global liquidity crisis, but Wharton faculty say securitization itself is not at fault. Poor underwriting and other weaknesses in the market for mortgage-backed securities led to the current problems. Securitization, they say, will remain an important part of the way real estate is funded, although it is likely to undergo significant change.

    "Securitization, in the long run, is a good thing," says Wharton finance professor Franklin Allen. "We didn't have much experience with falling real estate prices in recent years. The mechanisms weren't designed for that." He explains that economists were concerned about the incentives and accounting that shaped the private mortgage securitization market in recent years, but as long as real estate prices kept rising, the weaknesses in the system did not become clear. Now, after credit markets seized up and prices have declined sharply, those problems have been exposed.

    Allen believes financial markets will get back into the business of securitizing mortgage debt, but only after making some major changes. One new feature of future securitization deals, he says, could be a requirement that loan originators hold at least part of the loans they write on their books. Before the current crisis, loans were bundled into complex tranches that were passed through the financial system and onto buyers with little ability to assess the real value of the individual assets.

    "The way the collateralized debt obligations (CDOs) and other vehicles are structured will change. They are too complicated," says Allen. "I'm sure the industry will figure out how to do it. There will be a lot of industry-generated reform and the industry will prosper. This is not, in my view, something that should be regulated."

    Privatizing Securitization

    According to Wharton finance professor Richard J. Herring, for decades, mortgage securitization was backed by government guarantees through Fannie Mae and Freddie Mac, and it worked well. Of course, these agencies were regulated and bound by less-risky underwriting standards than those that ultimately prevailed in the subprime market which was also, potentially, more profitable. Indeed, default rates were so low in the mortgage-based securities market that banks and other private financial institutions were eager to take a piece of the residential business.

    At first, the transition to private securitization worked, because investors were willing to rely on three substitutes for the government guarantees. These included ratings agencies, new business models and monoline insurance designed to guarantee specialized mortgage-backed bonds. "Positive experience with private securitization led to an alphabet soup of innovations that sliced and diced the cash flows from pools of mortgages in increasingly complex ways," says Herring.

    Now, the subprime crisis has undermined confidence in all three pillars of private securitization. Ratings proved unreliable as even highly rated tranches experienced sudden, multiple-notch downgrades that were unknown in corporate bonds. Models developed by the most sophisticated firms selling mortgage-backed securities, including Bear Stearns, Merrill Lynch, Citigroup and UBS, failed. Monoline insurers, it turned out, were not adequately capitalized.

    "There has been a highly rational flight to simplicity," says Herring. Over time, he believes, the real estate securitization market will reemerge as investors regain confidence in the ratings agencies, new models evolve, and monoline insurers are able to increase their capital. "But I think that it will be a long time before the market will be willing to accept the complex, opaque structures that failed," continues Herring. He adds that recovery will be delayed until investors are confident that the fall in house prices has reached the bottom.

    Wharton real estate professor Susan M. Wachter points out that many recent -- and historic -- international financial problems originated in real estate. The nature of real estate finance and incentive structures is more to blame than securitization this time around. "The most recent crisis is coming through the securitization market, but this isn't the only real estate crisis," Wachter notes, adding that the fundamental problem in real estate finance is that there is no way to bet against the industry. Real estate is essentially priced by optimists, and rising prices themselves justify even higher values as assets are marked to market, creating new incentives for investors to overpay.

    Wachter points to real estate investment trusts (REITS), publicly traded bundles of real estate assets, as an example of how securitization can help provide liquidity, but also a chance for short-sellers to correct against overly optimistic pricing. Research indicates that REIT prices may not have increased as much as other sectors of real estate finance because the industry has at least 200 analysts looking at the underlying assets in each REIT with the ability to point out faulty pricing to investors. "REITS have performed fluidly relative to the overall market, and that is a good thing," says Wachter.

    Fee-driven Lending

    Another problem was that much of the subprime lending was fee-driven, giving banks incentives to write loans to earn the fees because they could then pass the risky assets along to securitized bondholders. And even bank shareholders had no way to limit their real estate exposure because banks invest in various kinds of economic activity and not just in real estate. Biased pricing and bubbles also arise because the supply of real estate is not elastic. By the time the market recognizes supply has outstripped demand, construction has already begun on many more projects that will continue to be built out; this tends to exacerbate oversupply and create downward pressure on prices for years.

    In a research paper titled, "Incentives for Mortgage Lending in Asia," Wachter and her co-authors write: "With [the] forbearance of regulatory authorities and the intervention of governments, banks may be bailed out, mitigating the consequences for shareholders. Nonetheless, the fundamental factor which explains why episodes of bank under-pricing of risk are likely to occur is the inability of banking shareholders to identify these episodes promptly and incentivize correct pricing."

    Wharton real estate professor Joseph Gyourko notes that significant differences exist in the performance of commercial and residential real estate securities. "Securitized commercial property debt will come back once the market calms down," he says, adding that there has been very little default in commercial real estate finance. "You'll be able to pool mortgages and securitize them, but almost certainly won't be able to leverage them as much as you did in the past."

    The residential side, where there is significant default, is more problematic. Gyourko believes the residential market will go back to what it was in the mid-1990s and most borrowers will have to put down at least 10% of the sales price. "We will get rid of the exotic, highly leveraged loans," he says. "That will lead to lower homeownership, but it should. We put a lot of people into homeownership that we shouldn't have."

    Wharton emeritus finance professor Jack Guttentag, who runs a web site called mtgprofessor.com, says the short-term future for residential real estate is "bleak."

    "Secured bondholders have been badly burned. They discovered to their dismay that all kinds of problems are connected to mortgage-backed securities, which they hadn't anticipated." Guttentag also points to the failure of ratings agencies, which are already being revamped. The methodologies used to determine ratings were flawed, he says. "They used historic performance over a period that simply wasn't representative."

    "CDOs are Doomed"

    In the future, ratings agencies will need to operate on the assumption that a security rated AAA should be able to withstand a shock as great as the current crisis.

    "That will mean that under the best of circumstances, it will be harder to get a triple-A rating, which will reduce the profitability of securities," Guttentag says. Some forms of securities will die. CDOs are doomed, he adds, because the market has seen they are extremely difficult to value. "In the short term, the prospects are dismal. The market will recover, but I don't think we'll ever see CDOs again and the standards will be tougher, so the comeback will be gradual."

    Gyourko notes that the crisis is playing out in a presidential election year, complicating the response. "I think this is the worst time to have this happen. It's never a good time, but in an election year, you're more likely to get a bad policy response," he says. According to Guttentag, while Republican presidential candidate John McCain is taking a laissez-faire stance, the Democratic presidential candidates have focused on using the Federal Housing Administration (FHA) to refinance loans that are in default. The idea is similar to what happened during the Great Depression of the 1930s with another agency called the Home Owners' Loan Corp. which was created specifically for that purpose.

    The problem, says Guttentag, is that FHA is not designed as a bailout agency. "The FHA's core mission is predicated on it being a solvent operation, actuarially sound, charging an insurance premium large enough only to cover losses. How they would reconcile that is not clear."

    Guttentag says attempts may be made to create a separate bailout agency within the FHA with different accountability. "But the devil is in the details," he warns, "and the details have to do with exactly who is going to be helped, what the requirements are, what the nature of the assistance is going to be, and myriad other factors that have to be worked out." The Bush administration has taken some steps to ease the crisis, including encouraging lenders to modify contracts to avoid foreclosure. A strong case can be made for these measures, Guttentag adds. "The cost of foreclosure is often greater than the cost of modifying the contract and keeping the borrower in the house." One downside is that once some loans are modified for those truly on the brink of foreclosure, other borrowers who could somehow manage to avoid foreclosure may demand the same modifications, shortchanging investors.

    In testimony before the U.S. House of Representatives' Committee on Oversight and Government Reform, Wachter laid out a proposal developed with the Center for American Progress to resolve the current crisis. Under the so-called SAFE loan plan, the U.S. treasury and the Federal Reserve would run auctions, in which FHA originators, as well as Fannie Mae and Freddie Mac and their servicers, would purchase mortgages from current investors at a discount determined at the auction.

    Investors would take a reduction in asset value and yield in exchange for liquidity and certainty and the auction process would price pools and bring transparency back to the market. The FHA, Fannie Mae, and Freddie Mac could then arrange for restructuring of loans.

    Meanwhile, Allen notes the Federal Reserve has taken some dramatic steps with interest rate policy to resolve the current economic crisis, but that could lead to tension with Europe and Japan over currency valuations. As the dollar continues to fall, U.S. companies are increasingly more competitive overseas. "The Fed cut the rate at the beginning, and that was fine, but now things are getting way out of line," he says.

    Furthermore, it is not clear that cutting rates is going to solve the basic problem. As rates continues to drop, foreigners may begin withdrawing their money from dollar-denominated investments, driving rates up. "What the Fed is doing is unprecedented," says Allen. "It is laudable that it is trying to stop a recession, but how many risks should you take to do that? We're now moving into an area where the Fed is probably taking too many risks. If inflation picks up and long-term rates go up, we'll be in a situation where we have to raise short-term rates as we go into recession, which is not a happy thing to."

    Vulture Capital

    The private sector has begun to show signs of willingness to get back into the fray. A number of vulture funds have begun to form to take advantage of distressed real estate prices. BlackRock and Highfields Capital Management have announced they will raise $2 billion to buy delinquent residential mortgages. The companies have hired Sanford Kurland, the former president of Countrywide Financial, to run the new venture called Private National Mortgage Acceptance, or PennyMac. "Many distressed funds will come in to discover prices," says Gyourko.

    Wharton real estate professor Peter Linneman offers an intriguing prescription to bring prices down to the point where the industry can start to rebuild. He suggests that the government tell banks that if they want to maintain their federal insurance, they should fire their CEO by the end of the day, and the government will pay the CEO $10 million in severance. Ousting the former CEOs gives the new bank CEOs an incentive to write down all the bad assets immediately, so that any improvement will make them look good going forward. That would speed the painful process of gradual price declines.

    "There's plenty of money out there waiting for these assets to be written down to bargain prices," says Linneman. In another quarter or two, the lenders would have new cash and be ready to lend again. Meanwhile, he says, the government should tell bankers it will keep interest rates down but raise them after the end of the year. "That says, 'Get your house in order in the next nine months because the subsidy ends at the end of the year.'" Linneman figures that 1,000 CEOs are accountable for about 80% of the current lending mess. If the government were to spend $10 billion to restore liquidity to the market in nine months with only 1,000 people losing their jobs, it would be the best investment it could make to restore the economy. "I'm only half-kidding," he quips.

    Linneman also argues that concerns about moral hazard -- or the tendency to take greater risks because of the presence of a safety net -- because of a bailout are not valid. Those concerns, he says, already exist and have been in place since the U.S. government agreed to insure bank deposits. "The minute you say to somebody, 'No matter what you do I'll give your people their money back,' you've created moral hazard," he says. "Now it's only a matter of how often and how much they will have to spend to settle up. If you go through our history, every eight years to 15 years we have had an episode."

    Continued in article


    Fighting the Battle Against Off-Balance-Sheet Financing"  Winning a Battle Does Not Mean Winning a War
    But it's better than losing the battle

    "FASB Issues New Standards for Securitizations and Special Purpose Entities," SmartPros, June 15, 2009 --- http://accounting.smartpros.com/x66815.xml 

    The FASB has published Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities.

    The new standards will impact financial institution balance sheets beginning in 2010. The impact of both new standards has been taken into account by regulators in the recent “stress tests.”

    These projects were initiated at the request of investors, the SEC, and The President’s Working Group on Financial Markets. Copies of the new standards are available at the FASB’s website, along with a concise briefing document.

    Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures.

    Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

    Robert Herz, chairman of the FASB, said:

    “These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitizations and special-purpose entities, and enhance disclosure requirements.  They’ll provide better transparency for investors about a company’s activities and risks in these areas.”

    Both new standards will require a number of new disclosures. Statement 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement.   A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements.   Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets. 

    Both Statements 166 and 167 will be effective at the start of a company’s first fiscal year beginning after November 15, 2009, or January 1, 2010 for companies reporting earnings on a calendar-year basis.

    Hiding Debt in VIEs (read that QSPEs) No Longer So Simple
    "FASB Tightens Off-Balance-Sheet Loan Rule," SmartPros, May 18, 2009 ---
    http://accounting.smartpros.com/x66572.xml

    The board that sets U.S. accounting standards on Monday moved to end companies' use of a device that allowed them to park hundreds of billions of dollars in loans off their balance sheets without capital cushions and has been blamed for helping stoke banks' losses in the housing boom.

    The change will tighten the use of so-called "qualifying special purpose entities" by requiring companies to report to regulators the loans contained in them and to increase their capital reserves in proportion as a cushion against potential losses.

    It was the lack of disclosure and absence of capital supporting ballooning subprime mortgage loans in these special entities that aggravated the massive losses sustained by banks, regulators say.

    The change by the Financial Accounting Standards Board could result in about $900 billion in assets being brought onto the balance sheets of the nation's 19 largest banks, according to federal regulators. The information was provided by Citigroup Inc., JPMorgan Chase & Co. and 17 other institutions during the government's recent "stress tests," an analysis designed to determine which banks would need more capital if the economy worsened.

    In its quarterly regulatory filing earlier this month, Citigroup said the rule change could have "a significant impact" on its financial statements. Citigroup estimated it would result in the recognition of $165.8 billion in additional assets, including $90.5 billion in credit card loans.

    JPMorgan estimated in its quarterly filing that the impact of consolidation of the bank's qualifying special purpose entities and variable interest entities could be up to $145 billion.

    In general, companies transfer assets from balance sheets to special purpose entities to insulate themselves from risk or to finance a large project. Under the change by the FASB, many qualifying special purpose entities will have to be moved back to a company's main balance sheet.

    Outside investors often take interests in those entities, for example, making an investment in a bank's holdings of mortgage loans in exchange for payments from borrowers. Under the new standard, companies must bring back any entity in which they hold an interest that gives them "control over the most significant activities," according to FASB. Companies must perform analyses to determine that.

    In cases where companies have "continuing involvements" with off-balance-sheet entities, they will have to provide new disclosures.

    "That's a step in the right direction," said Edward Ketz, an associate professor of accounting at Pennsylvania State University. He cited estimates that U.S. banks will need to report up to $1 trillion in loans due to the rule change.

    The FASB said the rule change was intended "to improve consistency and transparency in financial reporting." The FASB voted 5-0 to adopt it at a public meeting of its board at its headquarters in Norwalk, Conn. A revised proposal had been opened to a public comment period that ended in November.

    The rule change, which applies both to public and privately held companies, takes effect for companies' annual reporting periods starting after Nov. 15.

    "It's great to see that they didn't defer it," said Jack Ciesielski, a Baltimore-based accounting expert who writes a financial newsletter. Investors finally "will get an idea of how leveraged these things really are," he said.

    The change by FASB cuts in the opposite direction of its move last month - surrounded by controversy and with some dissension by board members - giving companies more leeway in valuing assets and reporting losses. That revision in the so-called "mark-to-market" accounting rules was expected to help boost battered banks' balance sheets, while the new rule change likely will result in financial institutions recognizing on their books billions in high-risk loans that may default.

    FASB acted on the mark-to-market rules amid intense pressure from Congress, which threatened legislation. The board received hundreds of comment letters opposing the move from mutual funds, accounting firms and others contending that it would damage honest financial reckoning by masking the deficiencies and risks lurking within the system.

    Question
    Would you like to see (AIG) Special Purpose Vehicles pull away from the loading ($25 billion) dock?

    "AIG Sells Shares to Fed: Papa's Little Dividend? The New York Fed has agreed to get involved in the life insurance business by investing $25 billion in two special-purpose vehicles," by David M. Katz, CFO.com, June 25, 2009 --- http://www.cfo.com/article.cfm/13932672/c_2984368/?f=archives

    In a move aimed at cutting American International Group's $40 billion debt to the Federal Reserve Bank of New York by $25 billion and setting up two AIG life insurance giants as initial public offerings, the N.Y. Fed has agreed to a debt-for-equity swap done via special-purpose vehicles.

    Under the agreement announced today, AIG will place the equity of American International Assurance Company and American Life Insurance Company in separate SPVs in exchange for preferred and common shares of the vehicles. The New York Fed will get all the preferred shares in the two SPVs, amounting to $16 billion in the AIA unit and $9 billion in the ALICO vehicle.

    The New York Fed will be paid a 5 percent dividend on its shares, which it will get at a fairly hefty discount, until September 2013. For shares that aren't redeemed by that date, the SPVs would start paying a 9 percent dividend.

    The face value of the preferred shares represents a percentage of the estimated fair-market value of AIA and ALICO. With the IPOs looming, the parties aren't saying what that value is. But the New York Fed, which will hold all the preferred shares, will get a majority stake in the economic value of the companies.

    For its part, AIG will hold all the common equity in the two SPVs and "will benefit from the fair market value of AIA and ALICO in excess of the value of the preferred interests as the SPVs monetize their stakes in these companies in the future," AIG said in a release issued today.

    The dates of the closing of the deal and the IPOs aren't tied to each other. The AIG-New York Fed transaction is expected to close late in the third quarter of this year. AIA, which has already launched its IPO process, is expected to start the offering in 2010. While ALICO hasn't started the process of its offering just yet, it has announced its attention to do so.

    As for the SPVs, they will structured as limited-liability companies in Delaware. Until they're spun off, AIA and ALICO will remain wholly owned subsidiaries of AIG, consolidated in the company's reported financial statements.

    "Placing AIA and ALICO into SPVs represents a major step toward repaying taxpayers and preserving the value of AIA and ALICO, two terrific life insurance businesses with great futures," said Edward Liddy, AIG's chairman and chief executive officer said in the release. "Operating AIA's and ALICO's successful business models in the SPV format will enhance the value of these franchises as we move forward with our global restructuring."

    Asked why the company chose to structure the arrangement by means of the much stigmatized method of setting up SPVs, AIG spokesperson Christina Pretto told CFO that since the vehicles were on-balance-sheet entities they wouldn't be the target of disapproval.

    AIA has one of the biggest books of life insurance in Asia, and ALICO has a large presence in Japan. While both are profitable, AIG has found it impossible to achieve its goal of selling the companies-at least partly because they are so large.

    Continued in article

    Bob Jensen's threads on Off-Balance-Sheet Financing (OBSF) are at
    http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2

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

    How CDO's led to the collapse of Wall Street in 2008 ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout


    "FASB Issues FSP Requiring Enhanced Disclosure for Credit Derivative and Financial Guarantee Contracts,"  by Mark Bolton and Shahid Shah, Deloitte Heads Up, September 18, 2008 Vol. 15, Issue 35 --- http://www.iasplus.com/usa/headsup/headsup0809derivativesfsp.pdf

    September 18, 2008

    Vol. 15, Issue 35

    The FASB recently issued FSP FAS 133-1 and FIN 45-4,1 which amends and enhances the disclosure requirements for sellers of credit derivatives (including hybrid instruments that have embedded credit derivatives) and financial guarantees. The new disclosures must be provided for reporting periods (annual or interim) ending after November 15, 2008, although earlier application is encouraged. The FSP also clarifies the effective date of Statement 161.2

    The FSP defines a credit derivative as a "derivative instrument (a) in which one or more of its underlyings are related to the credit risk of a specified entity (or a group of entities) or an index based on the credit risk of a group of entities and (b) that exposes the seller to potential loss from credit-risk-related events specified in the contract." In a typical credit derivative contract, one party makes payments to the seller of the derivative and receives a promise from the seller of a payoff if a specified third party or parties default on a specific obligation. Examples of credit derivatives include credit default swaps, credit index products, and credit spread options.

    The popularity of these products, coupled with the recent market downturn and the potential liabilities that could arise from these conditions, prompted the FASB to issue this FSP to improve the transparency of disclosures provided by sellers of credit derivatives. Also, because credit derivative contracts are similar to financial guarantee contracts, the FASB decided to make certain conforming amendments to the disclosure requirements for financial guarantees within the scope of Interpretation 45.3

    Credit Derivative Disclosures

    The FSP amends Statement 1334 to require a seller of credit derivatives, including credit derivatives embedded in hybrid instruments, to provide certain disclosures for each credit derivative (or group of similar credit derivatives) for each statement of financial position presented. These disclosures must be provided even if the likelihood of having to make payments is remote. Required disclosures include:

    In This Issue:

    • Credit Derivative Disclosures

    • Financial Guarantee Disclosures

    • Effective Date and Transition

    • Effective Date of Statement 161

    1 FASB Staff Position No. FAS 133-1 and FIN 45-4, "Disclosures About Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161."

    2 FASB Statement No. 161, Disclosures About Derivative Instruments and Hedging Activities.

    3 FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.

    4 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

    • The nature of the credit derivative, including:

    o The approximate term of the derivative.

    o The reason(s) for entering into the derivative.

    o The events or circumstances that would require the seller to perform under the derivative.

    o The status of the payment/performance risk of the derivative as of the reporting date. This can be based on a recently issued external credit rating or an internal grouping used by the entity to manage risk. (If an internal grouping is used, the entity also must disclose the basis for the grouping and how it is used to manage risk.)

    • The maximum potential amount of future payments (undiscounted) the seller could be required to make under the credit derivative contract (or the fact that there is no limit to the maximum potential future payments). If a seller is unable to estimate the maximum potential amount of future payments, it also must disclose the reasons why.

    • The fair value of the derivative.

    • The nature of any recourse provisions and assets held as collateral or by third parties that the seller can obtain and liquidate to recover all or a portion of the amounts paid under the credit derivative contract.

    For hybrid instruments that have embedded credit derivatives, the required disclosures should be provided for the entire hybrid instrument, not just the embedded credit derivative.

    Financial Guarantee Disclosures

    As noted previously, the FASB did not perceive substantive differences between the risks and rewards of sellers of credit derivatives and those of financial guarantors. With one exception, the disclosures in Interpretation 45 were consistent with the disclosures that will now be required for credit derivatives. To make the disclosures consistent, the FSP amends Interpretation 45 to require guarantors to disclose "the current status of the payment/performance risk of the guarantee."

    Effective Date and Transition

    Although it is effective for reporting periods ending after November 15, 2008, the FSP requires comparative disclosures only for periods presented that ended after the effective date. Nevertheless, it encourages entities to provide comparative disclosures for earlier periods presented.

    Effective Date of Statement 161

    After the issuance of Statement 161, some questioned whether its disclosures are required in the annual financial statements for entities with noncalendar year-ends (e.g., March 31, 2009). To address this confusion, the FSP clarifies that the disclosure requirements of Statement 161 are effective for quarterly periods beginning after November 15, 2008, and fiscal years that include those periods. However, in the first fiscal year of adoption, an entity may omit disclosures related to quarterly periods that began on or before November 15, 2008. Early application is encouraged.

     

    From The Wall Street Journal Accounting Weekly Review on June 13, 2008

     
    SEC, Justice Scrutinize AIG on Swaps Accounting
    by Amir Efrati and Liam Pleven
    The Wall Street Journal

    Jun 06, 2008
    Page: C1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
     

    TOPICS: Advanced Financial Accounting, Auditing, Derivatives, Fair Value Accounting, Internal Controls, Mark-to-Market Accounting

    SUMMARY: The SEC "...is investigating whether insure American International Group Inc. overstated the value of contracts linked to subprime mortgages....At issue is the way the company valued credit default swaps, which are contracts that insure against default of securities, including those backed by subprime mortgages. In February, AIG said its auditor had found a 'material weakness' in its accounting. Largely on swap-related write-downs...AIG has recorded the two largest quarterly losses in its history."

    CLASSROOM APPLICATION: Financial reporting for derivatives is at issue in the article; related auditing issues of material weakness in accounting for these contracts also is covered in the main article and the related one.

    QUESTIONS: 
    1. (Introductory) What are collateralized debt obligations (CDOs)?

    2. (Advanced) What are credit default swaps? How are these contracts related to CDOs?

    3. (Advanced) Summarize steps in establishing fair values of CDOs and credit default swaps.

    4. (Introductory) What is a material weakness in internal control? Does reporting write-downs of such losses as AIG has shown necessarily indicate that a material weakness in internal control over financial reporting has occurred? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    AIG Posts Record Loss, As Crisis Continues Taking Toll
    by Liam Pleven
    May 09, 2008
    Page: A1
     


    "SEC, Justice Scrutinize AIG on Swaps Accounting," by Amir Efrati and Liam Pleven, The Wall Street Journal,  June 6, 2008; Page C1 ---
    http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC

    The Securities and Exchange Commission is investigating whether insurer American International Group Inc. overstated the value of contracts linked to subprime mortgages, according to people familiar with the matter.

    Criminal prosecutors from the Justice Department in Washington and the department's U.S. attorney's office in Brooklyn, New York, have told the SEC they want information the agency is gathering in its AIG investigation, these people said. That means a criminal investigation could follow.

    In 2006, AIG, the world's largest insurer, paid $1.6 billion to settle an accounting case. Its stock has been battered because of losses linked to the mortgage market. The earlier probe led to the departure of Chief Executive Officer Maurice R. "Hank" Greenberg.

    Officials for AIG, the SEC, the Justice Department and the U.S. attorney's office declined to comment on the new probe. A spokesman for AIG said the company will continue to cooperate in regulatory and governmental reviews on all matters.

    At issue is the way the company valued credit default swaps, which are contracts that insure against default of securities, including those backed by subprime mortgages. In February, AIG said its auditor had found a "material weakness" in its accounting.

    Largely on swap-related write-downs, which topped $20 billion through the first quarter, AIG has recorded the two largest quarterly losses in its history. That has turned up the heat on management, including CEO Martin Sullivan.

    AIG sold credit default swaps to holders of investments called collateralized-debt obligations, or CDOs, backed in part by subprime mortgages. The buyers were protecting their investments in the event of default on the underlying debt. In question is how the CDOs were valued, which drives both the value of the credit default swaps and the amount of collateral AIG must "post," or essentially hand over, to the buyer of the swap to offset the buyer's credit risk.

    AIG posted $9.7 billion in collateral related to its swaps, as of April 30, up from $5.3 billion about two months earlier.

    Law Blog: Difficulties in Valuation 'Best Defense'

     

    Bob Jensen's threads on CDOs are at
    http://faculty.trinity.edu/rjensen/theory01.htm#CDO

    Bob Jensen's timeline of derivative financial instruments scandals and new accounting rules ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's threads on credit derivatives are under the C-Terms at
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

     


    "The Accounting Cycle:  FASB Needs to Change Accounting for SPEs," by: J. Edward Ketz, SmartPros, January 2008 --- http://accounting.smartpros.com/x60543.xml

    The CDO imbroglio that has enveloped the financial sector created quite a stir in 2007. Mortgage foreclosures have led to losses for the banks, and investors in CDOs have been surprised by the degree of their risk exposure. "Super seniors" have not been super or senior.

    Amid this disarray, a simple question has to be asked: why are the activities and transactions of special purpose entities (SPEs), legal entities that run collateralized debt obligations (CDOs) and similar financial vehicles, not displayed on the financial reports of corporate America? These SPEs remain hidden from view and corporate disclosures about them mist like a Chicago fog.

    Recall that Enron's episodes were sprinkled with many an SPE shenanigan. The old accounting rule said that if the SPE had at least 3 percent of its total capital from some outside source, then the business enterprise did not have to consolidate the SPE with its own affairs. While EITF 90-15 originally applied to certain leasing activities, business managers quickly applied it to all sorts of SPEs, and the Financial Accounting Standards Board and the Securities and Exchange Commission allowed them to do so. The threshold was so low that managers found it easy to keep SPE debt off the balance sheet and to make few disclosures.

    Because of Enron, FASB finally updated the rules to require consolidation unless outsiders contributed at least 10 percent of the capital to the SPE and this capital is at risk. Funny, FASB sat on its collective backside for over a decade before it took action. It seems the board members are incapable of taking proactive steps in any area.

    One of the criticisms was that 3 percent equity does not really put the equity at risk. While the 10 percent cutoff remains arbitrary, it clarifies the situation -- until the board muddied this clarity with some mystical, principles-based goobledy-gook. Many managers complained because they perceived that billions of dollars would be added to the corporate balance sheet. Apparently the appeals had some effect, for FASB modified the final rule. Interpretation No. 46R now states:

    9. An equity investment at risk of less than 10 percent of the entity's total assets shall not be considered sufficient to permit the entity to finance its activities without subordinated financial support in addition to the equity investment unless the equity investment can be demonstrated to be sufficient. The demonstration that equity is sufficient may be based on either qualitative analysis or quantitative analysis or a combination of both. Qualitative assessments, including but not limited to the qualitative assessments described in paragraphs 9(a) and 9(b), will in some cases be conclusive in determining that the entity's equity at risk is sufficient. If, after diligent effort, a reasonable conclusion about the sufficiency of the entity's equity at risk cannot be reached based solely on qualitative considerations, the quantitative analyses implied by paragraph 9(c) should be made. In instances in which neither a qualitative assessment nor a quantitative assessment, taken alone, is conclusive, the determination of whether the equity at risk is sufficient shall be based on a combination of qualitative and quantitative analyses.

    a. The entity has demonstrated that it can finance its activities without additional subordinated financial support.

    b. The entity has at least as much equity invested as other entities that hold only similar assets of similar quality in similar amounts and operate with no additional subordinated financial support.

    c. The amount of equity invested in the entity exceeds the estimate of the entity's expected losses based on reasonable quantitative evidence.

    Note that the 10 percent threshold can be ignored under several scenarios using either quantitative or qualitative excuses. As I said in 2003, this rule or standard is suspect and board members are spineless. The debt of an SPE is similar to the debt of a subsidiary. If FASB thinks that SPE debt does not have to be consolidated, it might as well announce that parent companies no longer have to show the liabilities of their subsidiaries.

    We can forget substance over form. While we are at it, we might as well toss out decision usefulness and relevance because FASB really doesn't promote these ideals, despite the rhetoric in the so-called conceptual framework.

    Given the ethical failures of both managers and auditors, I predicted in Hidden Financial Risk (2003) that many SPEs would remain unconsolidated. Indeed the majority of SPEs not only remain unconsolidated, but also the sponsoring organizations provide precious little disclosures about them. With the help of investment bankers, corporate managers have been highly creative in finding rhetoric that skirts principled accounting. When the corporate executives are managers of the investment banks, well, the creativity is off the charts.

    Years ago FASB and the SEC should have required the consolidation of SPEs. The last six months or so have clearly displayed the need for improved corporate reporting. This directive applies to the sponsors of CDOs including Citicorp and Merrill Lynch: they should consolidate their special purpose vehicles.

    How many more debacles in the market place will occur before FASB and the SEC get it right? When will they have men and women of courage?

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


    "The Accounting Cycle:  Poor Performance of Credit Rating Agencies," by J. Edward Ketz, SmartPros, December 2007 --- http://lyris.smartpros.com/t/204743/5562870/4383/0/

    Soon after Merrill Lynch disclosed its $8.4 billion write-down because of problems with collateralized debt obligations (CDOs) and other financial instruments relating to subprime mortgages, the credit rating agencies started downgrading the securities. But, this is like the proverbial soldier who watches a raging battle from afar; when the war is over, he proceeds to bayonet the wounded. 

    Merrill Lynch and other banks got into the CDO business several years ago. The CDOs received an imprimatur from agencies such as Moody's, Standard & Poor's, and Fitch. Some CDOs were even evaluated as investment grade securities. The analysts at Moody's, Standard & Poor's, and Fitch apparently ignored the risks involved in the subprime mortgage market as well as the risks in real estate prices.

    This segment generated lots of money for Merrill Lynch and the other banks. The CDO business brought in millions and millions of revenues. This line of business was at least as profitable for the bond rating agencies, too, as their ratings produced massive amounts of money.

    Not surprisingly, problems developed because the financial institutions were lending funds to marginal borrowers, those with less-than-stellar credentials for loan applicants. When some of these riskier borrowers defaulted on their mortgages, the CDOs started losing value. The credit rating agencies did nothing; presumably, they felt that the CDOs still had investment grade status.

    With the losses by Merrill Lynch out in the open, everybody knows not only that the CDOs have less fair value, but also that the credit raters aren't earning their keep. Unfortunately, members of Congress believe that they should hold investigations on the matter. I say unfortunate because such a move would be a waste of time, energy, and money.

    Recall the downfall of Enron and the high credit ratings that Enron received from the credit rating agencies. These agencies did not downgrade Enron's debt until after the 2001 third quarter results became public and Enron's stock price started its nosedive. When Congress passed the Sarbanes-Oxley Act in 2002, section 702(b) required the SEC to conduct a study of credit rating agencies to determine why these credit rating agencies did not act as useful watchdogs and warn the public about Enron's true situation. It accomplished little at the time; if Congress holds hearings now, nothing new will be learned. Until policy makers focus on the institution of credit ratings and follow the cash, they waste their time with investigations.

    Moody's and the other agencies make money by charging the business entities who are issuing debt. It doesn't take a genius to see the conflict of interest. The credit agencies lean on the issuer for more money or risk receiving a poor rating. Payment not only entitles one to a good rating, but also it gives one the privilege of not receiving a downgrade unless bad news becomes public.

    The SEC barely mentions this institutional feature in its "Report on the Roles and Function of Credit Rating Agencies in the Operation of the Securities Markets."

    This essay, written in January, 2003, practically ignores the problem. On page 41, the SEC report states, "The practice of issuers paying for their own ratings creates the potential for a conflict of interest." The SEC goes on to review comments by the large rating agencies themselves on how they manage this potential conflict of interest.

    The comments are pathetic. First, the SEC and the managers at credit rating agencies mangle the English language when they refuse to identify conflicts of interest for what they are. My dictionary defines conflict of interest as "the circumstance of a public officeholder, corporate officer, etc., whose personal interests might benefit from his or her official actions or influence." The term does not mean that they actually do benefit, but calls attention to the possibility. Calling such circumstances "potential conflicts of interests" merely attempts to push ethics aside. I can understand this behavior by the managers, but I don't comprehend the words of the SEC staff.

    Second, the comments rely heavily on the assertions of the credit rating agencies themselves. Managers of these agencies claim there is no problem, and of course the SEC should listen to them and accept every word as truth. Yeah, right!

    Third, on page 42 of the report, the SEC promises to explore whether these credit rating agencies "should implement procedures to manage potential conflicts of interest that arise when issuers [pay] for ratings." Either the SEC did not keep its promise or such actions are inadequate. Clearly, the credit rating agencies have not responded any differently to the CDO problem than they did with Enron's circumstances.

    Policy makers can reduce the problems by reducing the very real conflict of interests that perniciously raises its ugly head from time to time. The solution is to prohibit credit rating agencies to receive any funds from the issuers. If the ratings have any merit, then investors will be willing to pay for them.

    This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

    Bob Jensen's threads on credit rating industry frauds are at http://faculty.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies  

    Accounting for CDOs (including journal entries) under U.S. and Foreign GAAP --- http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm


    Is it possible to teach this transaction from an IFRS perspective?

    Denny Beresford made a helpful suggestion that one way to teach IFRS is to first look at the transaction itself and then reason out how to account for it under IFRS standards and interpretations. So here's a challenge for your advanced-level accounting students:  How would you account for this one under IFRS?

    What this illustrates is the type of thing that the IASB will have to tackle all alone, without a FASB research staff, when the U.S. depends upon the IASB for its accounting standards. I don't think the IASB fully understands what it is getting into by so desperately wanting to set accounting standards for U.S. companies.

    From the financial rounds blog on December 29, 2008

    How Do You Use Credit Default Swaps (CDS) To Create "Synthetic Debt"?

    There's been a lot of talk in recent months about "synthetic debt". I just read a pretty good explanation of synthetics in Felix Salmon's column, so I thought I'd give a brief summary of what it is, how it's used, and why.

    First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of similarities to an insurance policy on a bond (it's different in that the holder of the CDS needn't own the underlying bond or even suffer a loss if the bond goes into default).

    The buyer (holder) of a CDS will make yearly payments (called the "premium"), which is stated in terms of basis points (a basis point is 1/100 of one percent of the notional amount of the underlying bond). The holder of the CDS gets paid if the bond underlying the CDS goes into default or if other stated events occur (like bankruptcy or a restructuring).

    So, how do you use a CDS to create a synthetic bond? here's the example from Salmon's column:

    Let's assume that IBM 5-year bonds were yielding 150 basis points over treasuries. In addition, Let' s assume an individual (or portfolio manager) wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread). Here's how he could use CDS to accomplish the same thing:
     
    So, what does he get from the Treasury plus writing the CDS? If there's no default, the coupons on the Treasury plus the CDS premium will give him the same yearly amount as he would have gotten if he's bought the 5-year IBM bond, And if the IBM bond goes into default, his portfolio value would be the value of the Treasury less what he would have to pay on the CDS (this amount would be the default losses on the IBM bond). So in either case (default or no default), his payoff from the portfolio would be the same payments as if he owned the IBM bond.

    So why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there might not be any bonds available in the maturity you want. The CDS market, on the other hand, is very flexible and extremely liquid.

    One thing that's interesting about CDS is that (as I mentioned above), you don't have to hold the underlying asset to either buy or write a CDS. As a result, the notional value of CDS written on a particular security can be multiple times the actual amount of the security available.

    I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks (particularly home builders). From what i know, they made a ton of money. But CDS can also be used to hedge default risk on securities you already hold in a portfolio.


    To read Salmon's column, click here, and to read more about CDS, click here

    Credit Default Swap (CDS)
    This is an insurance policy that essentially "guarantees" that if a CDO goes bad due to having turds mixed in with the chocolates, the "counterparty" who purchased the CDO will recover the value fraudulently invested in turds. On September 30, 2008 Gretchen Morgenson of The New York Times aptly explained that the huge CDO underwriter of CDOs was the insurance firm called AIG. She also explained that the first $85 billion given in bailout money by Hank Paulson to AIG was to pay the counterparties to CDS swaps. She also explained that, unlike its casualty insurance operations, AIG had no capital reserves for paying the counterparties for the turds they purchased from Wall Street investment banks.

    "Your Money at Work, Fixing Others’ Mistakes," by Gretchen Morgenson, The New York Times, September 20, 2008 --- http://www.nytimes.com/2008/09/21/business/21gret.html

    What Ms. Morgenson failed to explain, when Paulson eventually gave over $100 billion for AIG's obligations to counterparties in CDS contracts, was who were the counterparties who received those bailout funds. It turns out that most of them were wealthy Arabs and some Asians who we were getting bailed out while Paulson was telling shareholders of WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.

    You tube has a lot of videos about a CDS. Go to YouTube and read in the phrase "credit default swap" --- http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
    In particular note this video by Paddy Hirsch --- http://www.youtube.com/watch?v=kaui9e_4vXU
    Paddy has some other YouTube videos about the financial crisis.

    Bob Jensen’s threads on accounting for credit default swaps are under the C-Terms at
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

    Bob Jensen's threads on CDO accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#CDO

    Bob Jensen's threads on FIN 46 are at http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

     


    Pensions and Post-retirement Benefits: 
    Schemes for Hiding Debt

     

    Accounting for Pension Obligations in the European Union: A Case Study for EPSAS and Transnational Budgetary Supervision
    SSRN, May 27, 2016
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2785725

    Authors

    Yuri Biondi French National Center for Scientific Research (CNRS)

    Marion Boisseau Université Paris Dauphine

    Abstract

    Pension obligations constitute a critical issue for public finances and budgets. This is especially true for the European Union whose institutional mechanism aims to supervise Member States’ spending through centralised budgetary rules based upon financial covenants. In this context, accounting methods of recognition and measurement of pension obligations become an integral and critical aspect of Europe’s transnational budgetary and financial supervision. Drawing upon a comprehensive overview of pension management and regulation, this article aims to analyse the ongoing debate on accounting for pension obligations with a specific attention to the harmonization of European Public Sector Accounting Standards (EPSAS). While the European Commission has been favouring the ‘indisputable reference’ to the International Public Sector Accounting Standards (IPSAS), European Member States’ practices and views remain inconsistent with the normative solution imposed by the IPSAS 25, which favours and facilitates Definite Contribution pension schemes. In this context, we do summarise the IPSAS position mimicking the IFRS, review the pension’s accounting in national statistics and EPSAS debate, and provide some building blocks for a comprehensive model of accounting for pension obligations that admits and enables several viable modes of pension management.


    Pension Spiking --- https://en.wikipedia.org/wiki/Pension_spiking

    An August 17 California appeals court ruling rejected a public employee union's claim that its members had a right to "pension spiking," which the court described as "various stratagems and ploys to inflate their income and retirement benefits." Public employees often will pad their final salary total with vacation leave, bonuses and "special pay" categories to inflate the pension benefits they receive for the rest of their lives.
    https://reason.com/archives/2016/09/02/is-ruling-too-late-to-fix-californias-pe
    But it's probably too late to do much good.

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    "FASB proposals address retirement benefit reporting,"
    http://www.journalofaccountancy.com/news/2016/jan/retirement-benefit-financial-reporting-201613779.html#sthash.SPhtrBQy.dpuf

    FASB issued two proposals Tuesday that are designed to address financial reporting issues related to retirement benefits.

    Proposed Accounting Standards Update (ASU), Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, addresses a concern that the presentation of defined benefit cost on a net basis combines elements with different predictive values. Users of financial statements have told FASB that the service cost component of net benefit cost is analyzed differently from other components.

    Under the proposal, an employer would report the service cost component in the same line item or items as other compensation costs arising from services rendered by the affected employees during the period. The other components of net benefit cost as defined in Paragraphs 715-30-35-4 and 715-60-35-9 would be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented.

    The proposal states that if a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. In addition, the proposal would allow only the service cost to be eligible for capitalization when applicable (e.g., as a cost of internally manufactured inventory or a self-constructed asset).

    Amendments in the proposal would apply to all employers, including not-for-profits, that offer defined benefit pension plans, other post-retirement benefit plans, or other types of benefits accounted for under Topic 715.  

    See more at: http://www.journalofaccountancy.com/news/2016/jan/retirement-benefit-financial-reporting-201613779.html#sthash.SPhtrBQy.dpuf


    Pension Benefit Guaranty Corp (PGBC) --- https://en.wikipedia.org/wiki/Pension_Benefit_Guaranty_Corporation

    Central States Pension Fund (CSPF) --- https://mycentralstatespension.org/

    From the CFO Journal's Morning Ledger on May 31, 2016

    Central States could torpedo PBGC.
    One of the nation’s largest multiemployer pension funds said that it is out of ideas for ways to save itself from an impending failure. The Central States Pension Fund has little choice but to turn to a federal insurance program that is supposed to offer a lifeline to troubled pension funds, the Washington Post reports. But the strain may be more than the Pension Benefit Guaranty Corp., which insures private pensions, can bear. The fund’s deterioration could pose a threat to the 10 million people in multiemployer plans who could soon be left without a safety net for their pensions.

    Jensen Comment

    On May 6, 2016, the U.S. Department of the Treasury (Treasury) notified Central States Pension Fund that our proposed pension rescue plan was denied. A copy of the communication from Treasury is available at
    http://www.cspensionrescue.com/

    . . .

    Central States Pension Fund remains in critical and declining status, and is projected to run out of money in less than ten years. In a letter to Congressional leaders, Secretary of the Treasury Jack Lew reinforced the fact that Treasury’s denial in no way resolves the serious threat to our participants’ pension benefits. The fact that the federal government’s multiemployer pension insurance program, the Pension Benefit Guaranty Corporation (PBGC), is also running out of money means we may see our pension benefits ultimately reduced to virtually nothing when the Fund runs out of money. At this time, only government funding, either directly to our Pension Fund or through the PBGC, will prevent Central States participants from losing their benefits entirely.

    A significant number of Members of Congress were vocal in calling for Treasury to reject our pension rescue plan. It is now time for those and others who suggested that there is a better way to fix this critical problem to deliver on real solutions that will protect the retirement benefits of Central States participants.

    There is no time—or reason—to delay. With each passing month, this crisis becomes more difficult—and costly—to solve. For over ten years, we have fought to protect our participants’ hard-earned retirement benefits. This included painful benefit reductions for active members and mandatory employer contribution increases in 2004, legislative campaigns to secure additional funding in 2009 and 2010, and most recently, our pension rescue plan application under MPRA.

    In the coming months, we will do everything in our power to support a legislative solution that protects the pension benefits of the more than 400,000 Central States participants and beneficiaries, who should not have to bear the emotional trauma of waiting until the Fund is at the doorstep of insolvency before Congress acts. The moment for action and for doing the right thing is now.

    We understand the uncertainty and anxiety that our participants and beneficiaries may be experiencing as this process continues. As always, our goal is to ensure that the Fund is able to continue to pay future benefits.

    We will continue to track progress and provide updates on this website, through email for those who have registered on our website to receive such communications, and/or by U.S. postal mail. You can also call our dedicated hotline at 1-800-323-7640 to listen to a recorded message with updated information.

     

    One of the huge problems with the CSPF is the underfunding of Teamster's Union pension obligations.

     


    Teaching Case on How Longer Lives Hit Companies With Pension Plans Hard

    Longer Lives Hit Companies With Pension Plans Hard
    by: Michael Rapoport
    Feb 24, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Pension Accounting

    SUMMARY: When General Motors Co.'s pension plan took a big hit in February 2015, it joined hundreds of companies facing growing pension shortfalls as Americans keep living longer. Longevity has a downside for those paying the bills, and the higher costs now have to be reflected on corporate balance sheets because of new mortality estimates released in October 2014. The new estimates won't affect many U.S. companies, which long ago shifted their employees to defined-contribution plans like 401(k)s, which leave workers on their own after retirement. But they are hitting other big companies with defined-benefit plans that have to make payments to some former employees for as long as they live.

    CLASSROOM APPLICATION: Use this when covering pension accounting.

    QUESTIONS: 
    1. (Introductory) What are the recent changes to life-expectancy estimates? Why do those estimates affect accounting for pensions?

    2. (Advanced) How does increased longevity affect a company's income statement and balance sheet? How are those changes calculated? What are the appropriate journal entries?

    3. (Advanced) Which companies are most likely to be affected by these changes? Why? What companies will not be affected by the change?

    4. (Advanced) Do you think these changes will cause more companies to change their retirement options for employees? Why or why not? How could a company change the options to lessen the impact? What benefits would those changes bring to employers?

    5. (Advanced) How have the companies mentioned in the article dealt with the changes in life expectancy? What announcements have they made? How have some of these companies differed?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Longer Lives Hit Companies With Pension Plans Hard," by Michael Rapoport, The Wall Street Journal, February 24, 2015 ---
    http://www.wsj.com/articles/longer-lives-hit-firms-with-pension-plans-hard-1424742593?mod=djem_jiewr_AC_domainid

    When General Motors Co. ’s pension plan took a big hit earlier this month, it joined hundreds of companies facing growing pension shortfalls as Americans keep living longer.

    Longevity has a downside for those paying the bills, and the higher costs now have to be reflected on corporate balance sheets because of new mortality estimates released in October.

    In its first revision of mortality assumptions since 2000, the Society of Actuaries estimated the average 65-year-old man today will live 86.6 years, up from the 84.6 it estimated a decade and a half ago. The average 65-year-old woman will live 88.8 years, up from 86.4.

    The new estimates won’t affect many U.S. companies, which long ago shifted their employees to defined-contribution plans like 401(k)s, which leave workers on their own after retirement. But they are hitting other big companies with defined-benefit plans that have to make payments to some former employees for as long as they live. The changes may also prompt more companies to take steps to reduce the risks associated with their pension plans, experts say.

    When GM announced fourth-quarter earnings Feb. 4, it said the mortality changes had caused the funding of its U.S. pension plans to fall short by an additional $2.2 billion and contributed to significant pension losses that will be filtered into its earnings over a period of years.

    Verizon Communications Inc. and AT&T Inc. recorded big charges to earnings tied to their pension and retiree-benefit plans partly as a result of the new estimates, and the changes could have a significant impact across corporate America. Consulting firm Towers Watson estimates the funding status of 400 large U.S. companies could weaken by a total of $72 billion as a result.

    The cost is another weight on pension-plan operators already wrestling with the impact of declining interest rates. Lower rates boost the current value of the future payments the plans have promised to retirees because the value of future pension obligations isn’t discounted back to the present as dramatically. That raises the current value of pension obligations, making pension plans more underfunded.

    Continued in article

    Jensen Comment
    The biggest disaster of longevity will be on entitlement programs like Medicare and Medicaid.
    These programs are not sustainable.

    Bob Jensen's threads on pension and post-employment benefits accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    Question
    Can your students explain why outsourcing pension obligations improves balance sheets?
    Does this make sense in theory?

    From the CFO Journal's Morning Ledger on October 7, 2014

    Some large companies have been shedding their pension obligations by handing them off to insurers, a move with obvious benefits for the firms’ balance sheets.Motorola Solutions Inc. and Bristol-Myers Squibb Co. were the latest to make the move as their pension obligations were taken over by Prudential Financial Inc., CFOJ’s Vipal Monga reports. Doing so doesn’t just rid them of the need to make future contributions—it also relieves them of having to pay fees to the government’s pension insurer.

    Congress raised the mandatory insurance fees that companies must pay the Pension Benefit Guaranty Corp. for each employee, to $64 from $49. At those rates, Motorola would save over $5 million in total premium payments through 2016, and Bristol-Myers would save almost $1.5 million.

    The reduction in fees flowing to the PBGC is proving a drain on the agency’s resources, but for companies making the move, the savings are too hard to resist. Railroad operatorCSX Corp. has started offering lump-sum buyouts to some former employees, and Chief Financial Officer Fredrik Eliasson said the PBGC fee increase was a factor in that choice.


    Pension Ponzi Fraud:  Chicago = Detroit = Stockton

    "Rahm Emanuel's Chicago Nears Fiscal Free Fall," Investors Business Daily, March 2, 2015 ---
    http://news.investors.com/ibd-editorials/030215-741568-emanuels-chicago-nears-fiscal-free-fall.htm

    . . .

    Chicago's finances are staggering under the weight of an unfunded pension liability that Moody's Investors Service has estimated at $32 billion, eight times the city's operating revenue.

    Chicago has a $300 million structural deficit. And Illinois law requires the city to up its 2016 contributions to its police and fire pension funds by $550 million.

    "This is an unfortunate wake-up call for anyone still asleep over the fiscal cliff facing the city of Chicago," said Laurence Msall, president of the Chicago-based government finance watchdog, the Civic Federation.

    The steady financial decline of the nation's third-largest city prompted us recently to say that Chicago was well on its way to becoming the next Detroit.

    In other words, it's another bankrupt monument to the perils of Democratic governance: a one-party town in one of the bluest states, whose mayor, former White House Chief of Staff Rahm Emanuel, learned financial discipline at the feet of President Barack Obama.

    A large part of Chicago's problem is that the game of maintaining campaign armies by overpromising and underfunding pensions is over. Emanuel can expect little help from Illinois' new Republican governor, Bruce Rauner, who is trying to fix similar problems at the state level.

    Chicago's pension funds are only 40% funded, and prospects aren't good, as people — particularly high-income individuals and businesses — flee the city's high taxes and stiff regulations.

    Emanuel recently emerged from the Windy City's mayoral primary with just 45% of the vote against four opponents, forcing Chicago's first-ever mayoral runoff. A poll taken by local polling firm Ogden & Fry on Feb. 28 showed Emanuel leading second-place primary finisher Jesus "Chuy" Garcia, who serves on the Cook County Board of Commissioners, by a slim 42.9% to 38.5% margin. Chicago natives are clearly restless.

    As Aaron Renn has noted in City Journal, Chicago lost 7.1% of its jobs in the first decade of this century. Its famous Loop, the second-largest business district in the nation, lost 18.6% of its private-sector positions.

    Raising the city's minimum wage will not reverse that trend. People are leaving in droves, voting the only way they can in a one-party town — with their feet.

    From 2000 to 2009, Chicago's population shrank by 200,000 — the only one of the nation's 15 largest cities to lose people. The city now has 145,000 fewer school-age children than it had more than a decade ago, according to district data, forcing the closure of about 100 schools since 2001.

    Chicago may soon be forced to go to Washington for a bailout similar to New York City's 1975 rescue. The prospect of Emanuel begging his former boss, President Obama, for financial help would be ironic indeed.

    The man who once said that a crisis is a terrible thing to waste now finds his city and President Obama's home town in fiscal crisis and his own political future teetering on the brink.


    "Debt-Saddled Municipal Budgets Get a Lifeline:  A unanimous Supreme Court held that health benefits for retired workers can be renegotiated or reduced," by Robert C. Pozen And Ronald J. Gilson, The Wall Street Journal, March 1, 2015 ---
    http://www.wsj.com/articles/robert-pozen-and-ronald-gilson-debt-saddled-municipal-budgets-get-a-lifeline-1425249172?tesla=y

    While underfunded public-employee pensions capture the headlines, health-insurance benefits for retired state and local workers are also a huge problem. But a recent ruling by the Supreme Court may help state and local governments scale back these benefits.

    Unlike public pension plans, retiree health benefits aren’t funded in advance; they are typically paid out of current tax revenues, so they compete with other budget priorities like schools and police. This competition will only grow more intense, as unfunded retiree health benefits are close to $1 trillion, according to a recent study in the Journal of Health Economics.

    Several cities and states have tried to reduce the scope of retiree health-care services, or to increase the portion of the premiums paid by retired workers going forward. Public unions have frequently sued, claiming the benefits are vested for life—roughly parallel to the legal arguments the unions have made against efforts to curb future pension costs.

    In late January, however, the Supreme Court issued an unanimous decision that will increase the chances of local governments winning such lawsuits. While the case involved a private business and its union, the principles should generally apply to public-sector agreements.

    M&G Polymers vs. Tackett involved a collective-bargaining agreement that provided certain retirees, along with their surviving spouses and dependents, with a full company contribution toward the cost of their health-care benefits “for the duration of [the] Agreement.” The contract was subject to renegotiation after three years, but the critical legal question was whether the retirement health-care benefits continued even after the agreement expired—in effect whether the intent was to vest these benefits for life.

    The union argued that the contract did vest these benefits for life and the Sixth Circuit Court of Appeals agreed. The Supreme Court reversed, noting that to prevail, the plaintiffs, in this case the union, had to supply concrete evidence—“affirmative evidentiary support”—that lifetime vesting of retiree health benefits was what both parties to the agreement intended.

    Normally, the explicit terms of a contract are taken to reflect the parties’ intentions; only when a contract’s language is ambiguous does a court look to the parties’ intent. Here the Supreme Court followed a traditional rule of contract law: If a contract is ambiguous, proof requires evidence of what the parties intended, not what a court—in this case the appellate court—might infer from the ambiguous contract.

    Two principles in Tackett should be especially relevant to reductions in retiree health-care benefits where the duration of these benefits is often unclear. The court, Justice Clarence Thomas wrote, supported the “traditional principle that courts should not construe ambiguous writings to create lifetime promises.” Similarly, he wrote that the court endorsed the traditional principle that “contractual obligations will cease, in the ordinary course, upon termination of the bargaining agreement.”

    This is where the Supreme Court’s decision is particularly significant for the public sector. There must be explicit proof that a collective-bargaining agreement intended long-term commitments to bind a city or state long past the incumbency of the public officials who signed the agreement.

    Today elected officials trade generous retiree benefits in the future for current wages. By doing so, they avoid having to take responsibility for current cutbacks in state and municipal services that would accompany wage increases.

    The Supreme Court’s ruling in Tackett means that lifetime benefits cannot be inferred but must be made explicit. As a result, if public officials now attempt to revise the benefits in a current or new collective agreement, unions will doubtless demand that any long-term promises be made explicit. But public officials who make these promises explicit send a strong signal that they are putting potentially enormous burdens on future taxpayers and elected officials. This makes it harder for current officials to make such promises. That is a step forward—not just in interpreting contracts but also in enhancing political accountability.

    Mr. Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. Mr. Gilson is a professor of law at Columbia and Stanford law schools.

    "Debt-Saddled Municipal Budgets Get a Lifeline:  A unanimous Supreme Court held that health benefits for retired workers can be renegotiated or reduced," by Robert C. Pozen And Ronald J. Gilson, The Wall Street Journal, March 1, 2015 ---
    http://www.wsj.com/articles/robert-pozen-and-ronald-gilson-debt-saddled-municipal-budgets-get-a-lifeline-1425249172?tesla=y

    While underfunded public-employee pensions capture the headlines, health-insurance benefits for retired state and local workers are also a huge problem. But a recent ruling by the Supreme Court may help state and local governments scale back these benefits.

    Unlike public pension plans, retiree health benefits aren’t funded in advance; they are typically paid out of current tax revenues, so they compete with other budget priorities like schools and police. This competition will only grow more intense, as unfunded retiree health benefits are close to $1 trillion, according to a recent study in the Journal of Health Economics.

    Several cities and states have tried to reduce the scope of retiree health-care services, or to increase the portion of the premiums paid by retired workers going forward. Public unions have frequently sued, claiming the benefits are vested for life—roughly parallel to the legal arguments the unions have made against efforts to curb future pension costs.

    In late January, however, the Supreme Court issued an unanimous decision that will increase the chances of local governments winning such lawsuits. While the case involved a private business and its union, the principles should generally apply to public-sector agreements.

    M&G Polymers vs. Tackett involved a collective-bargaining agreement that provided certain retirees, along with their surviving spouses and dependents, with a full company contribution toward the cost of their health-care benefits “for the duration of [the] Agreement.” The contract was subject to renegotiation after three years, but the critical legal question was whether the retirement health-care benefits continued even after the agreement expired—in effect whether the intent was to vest these benefits for life.

    The union argued that the contract did vest these benefits for life and the Sixth Circuit Court of Appeals agreed. The Supreme Court reversed, noting that to prevail, the plaintiffs, in this case the union, had to supply concrete evidence—“affirmative evidentiary support”—that lifetime vesting of retiree health benefits was what both parties to the agreement intended.

    Normally, the explicit terms of a contract are taken to reflect the parties’ intentions; only when a contract’s language is ambiguous does a court look to the parties’ intent. Here the Supreme Court followed a traditional rule of contract law: If a contract is ambiguous, proof requires evidence of what the parties intended, not what a court—in this case the appellate court—might infer from the ambiguous contract.

    Two principles in Tackett should be especially relevant to reductions in retiree health-care benefits where the duration of these benefits is often unclear. The court, Justice Clarence Thomas wrote, supported the “traditional principle that courts should not construe ambiguous writings to create lifetime promises.” Similarly, he wrote that the court endorsed the traditional principle that “contractual obligations will cease, in the ordinary course, upon termination of the bargaining agreement.”

    This is where the Supreme Court’s decision is particularly significant for the public sector. There must be explicit proof that a collective-bargaining agreement intended long-term commitments to bind a city or state long past the incumbency of the public officials who signed the agreement.

    Today elected officials trade generous retiree benefits in the future for current wages. By doing so, they avoid having to take responsibility for current cutbacks in state and municipal services that would accompany wage increases.

    The Supreme Court’s ruling in Tackett means that lifetime benefits cannot be inferred but must be made explicit. As a result, if public officials now attempt to revise the benefits in a current or new collective agreement, unions will doubtless demand that any long-term promises be made explicit. But public officials who make these promises explicit send a strong signal that they are putting potentially enormous burdens on future taxpayers and elected officials. This makes it harder for current officials to make such promises. That is a step forward—not just in interpreting contracts but also in enhancing political accountability.

    Mr. Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. Mr. Gilson is a professor of law at Columbia and Stanford law schools.

     


    From the CFO Journal's Morning Ledger on February 24, 2015

    Longevity isn’t all it’s cracked up to be, especially if you’re trying to balance the books for a defined benefit plan. The Society of Actuaries’ revised mortality assumptions, released in October, now have to be reflected on corporate balance sheets, the WSJ’s Michael Rapoport reports. According to the new estimates, the average 65-year-old man today will live 86.6 years, up from 84.6 the Society of Actuaries estimated a decade and a half ago. The average 65-year-old woman will live 88.8 years, up from 86.4. Good news for humanity, but bad news for recent earnings reports.


    Teaching Case on Pension Write Downs
    From The Wall Street Journal Accounting Weekly Review on January 23, 2015

    AT&T to Take $7.9 Billion Pension Hit
    by: Josh Beckerman and Vipal Monga
    Jan 20, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Mark-to-Market, Pension Accounting

    SUMMARY: AT&T Inc. said it would take a $7.9 billion charge for pension-related costs at least partially because people are living longer. The telecommunications giant said the losses were in part due to "updated mortality assumptions" in addition to a decrease in the rate it uses to measure its pension obligations. AT&T, along with about 30 other companies, in the past few years has switched to mark-to-market pension accounting to make it easier for investors to gauge plan performance. With the switch, pension gains and losses flow into earnings sooner than under the old rules, which are still in effect and allow companies to smooth out the impact over several years. Companies that switch to valuing assets at up-to-date market prices may incur more volatility in their earnings, but it offers a more current picture of a pension plan's health.

    CLASSROOM APPLICATION: This is a good article to use when covering accounting for pensions.

    QUESTIONS: 
    1. (Introductory) What are the details of AT&T's announcement? What is the reason for the changes?

    2. (Advanced) Please explain how the changes will impact each of the financial statements. Will those changes be material?

    3. (Advanced) In general, what is mark-to-market? How does mark-to-market affect pension accounting? What are the benefits of mark-to-market? What are potential challenges?

    4. (Advanced) How have AT&T pensions adjustments changed from year-to-year? How does this impact financial statement analysis?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    AT&T Posts Pension Hit As Rates Fall and Mortality Increases
    by Vipal Monga
    Jun 26, 5081
    Online Exclusive

    "AT&T to Take $7.9 Billion Pension Hit," by Josh Beckerman and Vipal Monga, The Wall Street Journal, January 20, 2015 ---
    http://www.wsj.com/articles/at-t-estimates-some-fourth-quarter-charges-1421449286?tesla=y?mod=djem_jiewr_AC_domainid 

    AT&T Inc. on Friday said it would take a $7.9 billion charge for pension-related costs at least partially because people are living longer.

    The telecommunications giant said the losses were in part due to “updated mortality assumptions” in addition to a decrease in the rate it uses to measure its pension obligations.

    The nonprofit Society of Actuaries recently updated its mortality tables for the first time since 2000 to reflect the longer lifespans, estimating today’s retirees will live about two years longer than in 2000. That means companies will have to sock away more money to pay benefits for those added years.

    Mercer LLC estimates that corporate pension liabilities totaled about $2 trillion at the end of 2013. The increased life expectancy will add about 7% to the pension obligations on balance sheets, according to consulting firm Aon Hewitt. The increased costs may be enumerated in the coming weeks as companies report earnings.

    AT&T, along with about 30 other companies, in the past few years has switched to mark-to-market pension accounting to make it easier for investors to gauge plan performance.

    With the switch, pension gains and losses flow into earnings sooner than under the old rules, which are still in effect and allow companies to smooth out the impact over several years.

    Companies that switch to valuing assets at up-to-date market prices may incur more volatility in their earnings, but it offers a more current picture of a pension plan’s health.

    A year ago, AT&T posted a $7.6 billion pretax gain tied to pension accounting.

    AT&T also said it would take a $2.1 billion noncash charge in the fourth quarter after it determined that certain copper assets won’t be necessary to support future network activity, because of lower demand for legacy voice and data services and the move toward new technology. It said those copper assets will be abandoned in place.

    Continued in article

    Bob Jensen's threads on pension accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    Most, but not all, unions support these cuts because the losses to retirees will be greater if these private sector and union pensions are not reduced
    "Congress Says It Has to Cut Pensions to Save Them," by Peter Coy, Bloomberg Businessweek, December 11, 2014 ---
    http://www.businessweek.com/articles/2014-12-11/congress-says-it-has-to-cut-pensions-to-save-them?campaign_id=DN121114

    Jensen Comment

    The $1+ trillion budget is really a Nancy Pelosi budget in the sense that nobody, especially members of Congress," will know what all is in it until after it is passed" --- which is what Pelosi said about the ACA when it was passed in 2010.


    What is the incentive to manage pensions responsibly in Illinois or California?

    "Illinois’s Pension Absurdity:  A judge rules that all benefits are forever, no matter the public cost," The Wall Street Journal, November 28, 2014 ---
    http://online.wsj.com/articles/illinoiss-pension-absurdity-1417219755?tesla=y&mod=djemMER_h&mg=reno64-wsj

    Republican Bruce Rauner has his work cut out rehabilitating Illinois from years of liberal-public union misrule, but now he may also have to cope with a willful state judiciary. Consider a lower court judge’s slipshod ruling last week striking down de minimis pension reforms.

    The fiscally delinquent state has accrued a $111 billion unfunded pension liability—a 75% increase from five years ago—in addition to $56 billion in debt for retiree health benefits. Incredibly, the state is spending more of its general fund on pensions than on K-12 education. One in four tax dollars pays for retirement benefits. Last year the state had to defer $7 billion in bills to contractors. This is after Democrats in 2011 raised income and corporate taxes by 67% and 30%, respectively. Little wonder that Illinois has the nation’s worst credit rating.

    Democrats last year passed modest pension fixes conceived with the fainthearted judiciary in mind. The retirement age for younger workers increased on a graduated scale. Workers now in their 20s could still retire with pensions approximating 75% of their salaries at age 60.

    Salaries used for pension calculations were also capped at an inflation-adjusted $110,600 with a gaping carve-out for workers who collectively-bargained higher pay. Cost-of-living adjustments were tied to years of service and inflation instead of annually compounding at 3%. As a political salve, the state even cut worker pension contributions by 1%.

    Yet Sangamon County Circuit Court Judge John Belz last week rejected all pension trims as a violation of the state Constitution, which holds that “[m]embership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.” According to Judge Belz, there is “no legally cognizable affirmative defense” for impairing pensions benefit.

    Except, well, 80 years of U.S. Supreme Court precedent. Federal courts have established that states may invoke their police powers to impair contracts. In the 1934 case Home Building & Loan Association v. Blaisdell, the U.S. Supreme Court ruled that emergencies “may justify the exercise of [the State’s] continuing and dominant protective power notwithstanding interference with contracts,” which the U.S. Constitution otherwise prohibits.

    The Supreme Court has since developed a balancing test that allows states to impair contracts when it is reasonable and necessary to serve an important public purpose. The level of legal scrutiny increases with the severity of the impairment.

    Yet Judge Belz refused even to consider the state’s argument that it must tweak pensions to maintain vital public services (e.g., police, schools). The court “need not and does not reach the issue of whether the facts would justify the exercise of such a power if it existed,” the judge asserted. If the police power existed?

    Perhaps the judge assumes that the Illinois Supreme Court, based on its 6-1 decision this summer that extended constitutional protections to retiree health benefits, will strike down the pension reforms. Judge Belz teed up the high court by quoting copiously from that opinion.

    Even if they lose at the Illinois Supreme Court, Mr. Rauner and the legislature will still have options for fixing their pension mess including moving new workers to defined-contribution plans and putting a constitutional amendment before voters that affirms the ability to prospectively modify retirement benefits. Option C would be to petition Illinois’s more prudent neighbors for annexation.

    Pension Benefit Guaranty Corporation (PBGC) --- http://en.wikipedia.org/wiki/Pension_Benefit_Guaranty_Corporation

    The Pension Benefit Guaranty Corporation (PBGC) is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and uninterrupted payment of pension benefits, and keep pension insurance premiums at the lowest level necessary to carry out its operations. Subject to other statutory limitations, the PBGC insurance program pays pension benefits up to the maximum guaranteed benefit set by law to participants who retire at age 65 ($54,000 a year as of 2011).[2] The benefits payable to insured retirees who start their benefits at ages other than 65, or who elect survivor coverage, are adjusted to be equivalent in value.

    During fiscal year 2010, the PBGC paid $5.6 billion in benefits to participants of failed pension plans. That year, 147 pension plans failed, and the PBGC's deficit increased 4.5 percent to $23 billion. The PBGC has a total of $102.5 billion in obligations and $79.5 billion in assets.

    Jensen Comment
    Private sector companies can pay premiums to insure employee pension benefits will carry on when companies carrying this insurance go bankrupt. But at least those benefits are capped. For example, here on Sunset Hill Road I have a friend who is a retired United Airlines Captain. When United Airlines went bankrupt his pension benefits were cut in half because the insured benefits are capped for high-salaried employees. In terms of the public sector such caps are no longer allowed unless this court ruling is overturned by a higher court.

    Because of their skills, airline Captains are understandably paid very well with large pension benefits tied to their high salaries before retirement, pensions that they themselves contributed to out of their salaries over the years. In the public sector, salaries are generally not so high, and sometimes the high pension benefits are outright frauds such as the $500,000 annual pension of the former City Manager of tiny Bell, California. Illinois public pension plans were similarly wracked with frauds promising enormous pensions and early retirements.

    One can argue that pension contracts should not be broken, but pension contracts are commonly broken in the private sector. Employees of companies that did not pay for PGBC insurance may lose all their pensions depending upon the outcomes of the bankruptcy courts. Employees of companies that are insured by PGBC may still lose part of their pensions like my friend nearby lost half of his United Airlines pension. Then why is it that public sector pension contracts cannot be broken somewhat similar to private sector pensions?

    The main problem with this ruling is that there is moral hazard. It encourages fraud and mismanagement of pensions in the public sector. The main problem with public sector pensions in Illinois that they were enormously mismanaged and underfunded. What is the incentive to manage pensions responsibly in Illinois?


    Vernon's former city manager, for example, was receiving more than $500,000 in annual pension payments. Most public safety workers can retire as early as 50. And some public employees had cashed out unused vacation and other perks to unjustly spike their retirement pay.
    "California pension funds are running dry," by Marc Lifsher, Los Angeles Times, November 13, 2014 ---
    http://www.latimes.com/business/la-fi-controller-pension-website-20141114-story.html

    A decade ago, many of California's public pension plans had plenty of money to pay for workers' retirements.

    All that has changed, according to a far-reaching package of data from the state controller. Taxpayers are now on the hook for billions of dollars more to cover the future retirements of public workers, with the bill widely varying depending on where they live.

    The City of Los Angeles Fire and Police Pension System, for instance, had more than enough funds in 2003 to cover its estimated future bill for workers' retirement checks. A decade later, it is short $3 billion.

    The state's pension goliath, the California Public Employees' Retirement System, had $281 billion to cover the benefits promised to 1.3 million workers and retirees in 2013. Yet it needed an additional $57 billion to meet future obligations.

    The bill at the state teachers' pension fund is even higher: It has an estimated shortfall of $70 billion.

    The new data from a website created by state Controller John Chiang come at a time of growing anger from taxpayers over the skyrocketing cost of public workers' retirements.

    Until now, the bill for those government pensions was buried deep in the funds' financial reports. By making this data available, Chiang is bound to stir debate about how taxpayers can afford to make retirement more comfortable for public workers when private-sector employees' own financial futures have become less secure. For most non-government workers, fixed monthly pensions are increasingly rare. lRelated Stockton bankruptcy ruling preserves city pensions

    Business Stockton bankruptcy ruling preserves city pensions

    "Somebody, who is knowledgeable and interested, is several clicks away from the ugly mess that will define California's financial future," said Dan Pellissier, president of California Pension Reform, a Sacramento-area group seeking to stem rising statewide retirement costs.

    Chiang has assembled reams of data from 130 public pension plans run by the state, cities and other government agencies. It's now accessible at his website, ByTheNumbers.sco.ca.gov.

    In nearly eight years as controller, essentially the state's paymaster, Chiang has made good on a commitment to make government financial records more transparent and accessible.

    . . .

    The pension debate in recent years has been fueled by controversy.

    Vernon's former city manager, for example, was receiving more than $500,000 in annual pension payments. Most public safety workers can retire as early as 50. And some public employees had cashed out unused vacation and other perks to unjustly spike their retirement pay.

    Meanwhile, cash-strapped cities are facing escalating bills. Rising pension costs contributed to bankruptcies in Stockton, San Bernardino and Vallejo.

    Why should private-sector taxpayers give California's public workers more money to retire than most of them will ever make? jumped2 at 11:33 AM November 14, 2014

    Critics contend that governments can no longer afford to pay generous pensions to retirees that aren't available to most private-sector workers. Unions, meanwhile, have vehemently defended the status quo, saying these benefits were promised to workers for years of serving the public.

    "In the months ahead, California and its local communities will continue to wrestle with how to responsibly manage the unfunded liabilities associated with providing retirement security to police, firefighters, teachers and other providers of public services," Chiang said.

    "Those debates and the actions that flow from them ought to be informed by reliable data that is free of political spin or ideological bias," said Chiang.

    Continued in article

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    "Measuring Pension Liabilities under GASB Statement No. 68," by John W. Mortimer and Linda R. Henderson, Accounting Horizons, September 2014, Vol. 28, No. 3, pp. 421-454 ---
    http://aaajournals.org/doi/full/10.2308/acch-50710

    While retired government employees clearly depend on public sector defined benefit pension funds, these plans also contribute significantly to U.S. state and national economies. Growing public concern about the funding adequacy of these plans, hard hit by the great recession, raises questions about their future viability. After several years of study, the Governmental Accounting Standards Board (GASB) approved two new standards, GASB 67 and 68, with the goal of substantially improving the accounting for and transparency of financial reporting of state/municipal public employee defined benefit pension plans. GASB 68, the focus of this paper, requires state/municipal governments to calculate and report a net pension liability based on a single discount rate that combines the rate of return on funded plan assets with a low-risk index rate on the unfunded portion of the liability. This paper illustrates the calculation of estimates for GASB 68 reportable net pension liabilities, funded ratios, and single discount rates for 48 fiscal year state employee defined benefit plans by using an innovative valuation model and readily available data. The results show statistically significant increases in reportable net pension liabilities and decreases in the estimated hypothetical GASB 68 funded ratios and single discount rates. Our sensitivity analyses examine the effect of changes in the low-risk rate and time period on these results. We find that reported discount rates of weaker plans approach the low-risk rate, resulting in higher pension liabilities and creating policy incentives to increase risky assets in pension portfolios.

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     

    From EY on August 15, 2014
    GASB proposes changes in accounting for other postemployment benefits
    http://www.ey.com/Publication/vwLUAssetsAL/TechnicalLine_BB2797_OPEBPlans_14August2014/$FILE/TechnicalLine_BB2797_OPEBPlans_14August2014.pdf

    What you need to know

    • The GASB has proposed chang ing how state and local governments calculate and report the costs and obligations associated with defined benefit other postemployment benefit (OPEB) plans .

    • Government employers that fund their OPEB plans through a trust that meets the specified criteria would have to record a net OPEB liability in their accrual - basis financial statements for defined benefit plans that would be based on the plan fiduciary net position rath er than plan funding.

    • The proposal would make a government’s obligations more transparent, and m any governments would likely report a much larger OPEB liability than they do today.

    • The guidance would be effective for fiscal years beginning after 15 December 2016 , and early application would be encouraged.

    • Comments are due by 29 August 2014 . Public hearings are s et for September 2014.

    Overview
    The Governmental Accounting Standards Boa rd (GASB) has proposed changing how state and local governments calculate and report the cost of other postemployment benefits , which consist of retiree health insurance and defined benefits other than pensions and termination benefits that are provided to retirees .

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Accounting Change Will Expose ...
    http://www.statedatalab.org/news/detail/accounting-change-will-expose

    JUNE 25, 2014 | FORT WAYNE NEWS-SENTINEL (INDIANA)

    By Michael Hicks, includes “This week marked the full implementation of two new Government Accounting Standards Board rules affecting the reporting of pension liabilities. These rules -- known in the bland vernacular of accountancy as Statements 67 and 68 -- require state and municipal governments to report their pensions in ways more like that of private-sector pensions. … One result of this is that governments with very high levels of unfunded liabilities will see their bond ratings drop to levels that will make borrowing impossible. In some places, like Indianapolis or Columbus, Ohio, may have to increase their pension contributions and perhaps make modest changes to retirement plans, such as adding a year or two of work for younger workers. Places like Chicago or Charleston, West Virginia, will be effectively unable to borrow in traditional bond markets.  Pension funds in Chicago alone are underfunded by almost $15 billion. Under the new GASB rules Chicago's liability could swell to almost $60 billion or roughly $21,750 per resident. Retiree health care liabilities add another $3.6 billion or $1,324 per resident, so that each Chicago household will need to cough up $61,000 to fully fund their promises to city employees. The promise will be broken. …

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Truth in Accounting awards Chicago 'F' grade ---
    https://www.statedatalab.org/news/detail/truth-in-accounting-awards-chicago-f-grade
    For details see
    https://www.truthinaccounting.org/news/detail/new-financial-state-of-chicago

    . . .

    “We found that Chicago’s leaders have failed to address the structural problems weakening its financial system, instead plugging the holes with short-term fixes,” said TIA founder and CEO Sheila Weinberg. “When the bills come due, Chicago politicians are going to face a lose-lose dilemma: reduce services and benefits, or fix the problem on the backs of future taxpayers.”

    Fiscal accountability in U.S. politics often focuses on highly visible federal budgets or the national debt. Truth in Accounting has repeatedly found that poor budgeting and accounting practices at the city and state levels of government presents equally alarming threats.

    Jensen Comment
    Seems like the GASB has a long way to go ---
    https://en.wikipedia.org/wiki/Governmental_Accounting_Standards_Board

     


    "The Imaginary Retirement-Income Crisis:  Politicians are stirring up alarm in order to raise Social Security benefits and reduce tax incentives for saving," by Andrew G. Biggs And Sylvester J. Schieber, The Wall Street Journal,  September 29, 2014 ---
    http://online.wsj.com/articles/andrew-g-biggs-and-sylvester-j-schieber-the-imaginary-retirement-income-crisis-1412033514 

    Sen. Maria Cantwell (D., Wash.) claimed at a recent congressional hearing that 92% of Americans are unprepared for retirement. Other senators noted studies claiming that 53% to 84% of Americans will have inadequate income in old age. Progressives cite these statistics as grounds for increasing Social Security benefits, and the New America Foundation wants to curtail tax incentives for private retirement plans because it says these plans have failed.

    These statistics are vast overstatements, generated by methods that range from flawed to bogus. Changing policy based on these fanciful claims would threaten government budgets, not to mention the income security of future American retirees.

    Do Americans face a retirement crisis? One way to answer is to look at other wealthy, developed countries. In a 2013 study the Organization for Economic Cooperation and Development compared the incomes of a country's retirees with the average income in that country. The results are surprising. Despite a supposedly stingy Social Security program and ineffective retirement-savings vehicles, the average U.S. retiree has an income equal to 92% of the average American income, handily outpacing the Scandinavian countries (81%), Germany (85%), Belgium (77%) and many others.

    In dollar terms, America's retirement incomes are 53% above the OECD average, second highest in the world. If there's a crisis in the U.S., the rest of the developed world must be a virtual retirement hellhole. No one truly believes that.

    The OECD's figures actually understate the adequacy of Americans' retirement incomes. The more accurate measure of a retiree's ability to maintain his standard of living is to compare retirement income to that same individual's work earnings.

    The Social Security Administration's Office of Retirement and Disability Policy has done that with a sophisticated computer model that simulates individuals' earnings, savings, pensions and Social Security benefits. The model shows that in 2012 the income of the median 67-year-old exceeded his career-average earnings, adjusted for inflation. Since the cost of living generally is lower in retirement, today's retirees typically have a real standard of living higher than during their working years.

    This helps explain why most current retirees say they are doing well. A 2004 study by two Rand Corp. economists using data from the federally sponsored Health and Retirement Study found that 87% of retirees said their retirement years were "better" or "as good as" the years before they retired. Most current retirees, they noted, "seem to be pleasantly surprised by their level of resources." Even following the Great Recession, 75% of retirees told Gallup in June 2013 that they have enough money to live comfortably.

    Will this be true in the future? SSA estimates that the typical Gen-X (born between 1966 and 1975) household will have a retirement income equal to 110% of its real average earnings during its working years. Depression-era birth cohorts, who supposedly enjoyed a golden age of traditional pensions and generous Social Security benefits, had an average income equal to 109% of their pre-retirement earnings. Yes, more retirees will depend on IRAs and 401(k) plans while fewer will have traditional pensions. But retirees care most about how much money they have; interest groups care about where that money comes from.

    OECD data also tell us higher government pension benefits don't necessarily mean greater retirement income. U.S. Social Security is less generous than the average public pension plan, though it is on par with countries such as the U.K., Canada or New Zealand that more closely follow our political and economic traditions. But the OECD data show a strong negative relationship between the generosity of public pensions and the income that retirees collect from work and private saving.

    For each additional dollar of benefits paid by a country's government pension, that country's retirees themselves generate 94 cents less income from personal savings or employment during retirement. This metric is important since work and saving contribute to a growing economy while government transfer programs almost certainly reduce economic output.

    The statistics claiming that vast majorities of Americans are unprepared for retirement suffer from myriad methodological flaws. Some errors are simple, such as assuming that every individual should follow a precise but arbitrary schedule in determining how much to save for retirement each year. Others are more technical, such as how to project future earnings for individuals working today. Together, these factors cause studies to overstate how much income Americans will need in retirement and understate how much income they will have.

    If U.S. Social Security benefits are increased, the country will very likely experience lower employment and saving. This in turn will undercut the economic strength upon which government entitlements depend. Social Security does need reform, both to ensure solvency and to better serve low-income retirees. And we should improve access to and the use of private saving plans. But the retirement crisis narrative will lead the country down the wrong policy path.

    Mr. Biggs, a former principal deputy commissioner of the Social Security Administration, is a resident scholar at the American Enterprise Institute. Mr. Schieber, a former chairman of the Social Security Advisory Board, is an independent pension consultant.

    Jensen Comment
    This article overlooks how badly underfunded state public retirement funds are underfunded. It also overlook the entitlements disasters of promises made for Social Security and Medicare payments that will one day only be paid off with highly inflated dollars ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm

    Adding additional benefits to Social Security retirements will only make the entitlements disasters worse.


    From the CFO Journal's Morning Ledger on January 9, 2013

    Companies switching to “mark-to-market” pension accounting could reap benefits this earnings season
    AT&T
    , Verizon Communications and about 30 other companies have migrated to mark-to-market,
    the WSJ’s Michael Rapoport notes. In 2011 and 2012, that change weighed on earnings, largely because interest rates were falling. But 2013 is different, thanks to surging interest rates and strong stock-market performance. “It’s going to account for a huge rise in operating earnings” at the affected companies, said Dan Mahoney, director of research at accounting-research firm CFRA.

    Some mark-to-market companies with fiscal years ended in September have already reported pension gains. Chemical maker Ashland had a $498 million pretax mark-to-market pension gain in its Q4, versus a $493 million pension loss in its fiscal 2012 fourth quarter. That made up about 40% of the company’s $1.24 billion in operating income for fiscal 2013.

    Most companies don’t use mark-to-market pension accounting. Instead, they filter pension gains and losses into earnings gradually, and compute pension performance using an estimated rate of return, not the actual return, Rapoport says. That system is still acceptable under GAAP, but it has been widely criticized as confusing, and accounting rule-makers recently indicated they may consider revisions.

    Jensen Comment

    What I don't like about mark-to-market valuation of pensions is that the deals new retirees negotiate might vary significantly (certainly not always) whether they retire in May versus June. For example, a professor might have a lower CREF savings balance in June relative to May if something very good or very bad happens in the stock market between May and June.

    I have mixed feelings about mark-to-market of unrealized value changes in market\ values subject to frequent short-term transitory impacts that are often washed out over longer periods such that the ups and downs of short term values are more fiction than fact. For example, computer generated bid and ask trading tends to over-react to media jolts like when the President proposes legislation that has not even begun to to run the gauntlet through both legislative branches where legislation proposals can and usually do become greatly modified if the President's proposals even pass at all.

    For example the Dow went down purportedly when President Obama proposed legislation in 2014 for restoring long-term unemployment benefits. The ultimate impact of such legislation on stock prices depends upon whether this proposal ultimately passes both the House and Senate and how the spending is financed. If the Democrats agree to budget cuts in other areas, the impact on stock prices will be greatly affected by what cuts are used to fund the added  unemployment compensation.

    While the President's proposal is tied up in the legislative process the short-term pension fund mark-to-market values will move up and down in values changes that are never realized until the proposed legislation either passes or is rejected.

    What is more worrisome are those events that really spike stock prices temporarily such as reports of severe droughts or floods that greatly impact crop production in one summer but have very little impact on over multiple years.

    I also hate the way unrealized value changes are mixed with recognized earned revenue in the calculation of business net earnings. Some of the changes in earnings thereby are fictional.

    Illinois auditor: 5 state pension funds owed $100.5 billion; accounting change may have backfired ---
    http://www.statedatalab.org/news/detail/illinois-auditor-5-state-pension-funds-owed-1005-billion-accounting-change-may-have-backfired

    Includes “Illinois lawmakers thought they were saving money five years ago by changing the way the cash-strapped state counts its pension debts, but a report released Wednesday suggests the effort may have landed taxpayers with billions of dollars in extra costs. Auditor General William Holland reported the system-wide pension debt hit $100.5 billion last summer. But the total would have been $3 billion less had the Legislature not required "smoothing," an actuarial process that considers gains and losses over a five-year span, not current market values. If another state law switched back to counting current market value instead of "smoothed" value, it could save taxpayers money in the amount the state must put up as its annual pension contribution in the budget year that begins in July, although the savings were not reported. Pension leaders advise against that. "Market value is a snapshot, but is it the correct snapshot, or should we be looking more over time?" asked Rep. Elaine Nekritz, a Northbrook Democrat who was instrumental in landmark legislation signed into law last month to deal with the huge pension debt. "Smoothing looks more over time." Smoothing, Holland said in an interview, gives a more realistic look at the numbers. But five years ago when the economy was in the tank, it made them rosier. Now that the market has improved, assets "smoothed" over the past five years makes the outcome gloomier than current market value of the pension systems' assets. That calculation puts the debt at $97.5 billion, according to Holland's audit. …”

    Bob Jensen's threads on fair value accounting ---
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


    Question
    Do business professors negotiate pensions better university pensions?

    "Six-figure salary and a buyout create quite a pension," by Johanna Somers, TheDay Connecticut, January 12, 2014 ---
    http://theday.com/article/20140112/NWS12/301129954

    Of all the state pension checks cashed in 2012, none was bigger than John F. Veiga's.

    The Coventry resident spent 37 years teaching business at the University of Connecticut. In 2009, he accepted an early retirement buyout offer from the state after contributing $222,128 to his pension during his UConn career.

    Now, at age 70, that pension pays him $276,364 a year, the largest amount paid to a single state retiree in 2012, nearly nine times the $31,666 average state employee pension.

    According to calculations by the data analysis firm VisiGov: Visible Government Online Inc. for The Day, Veiga could collect another $4 million in his lifetime.

    "I don't know what to tell you," Veiga said. "Is it fair? It was what was offered. It seemed fair at the time."

    Of the top 10 state pensions in 2012 - all six figures - all but two were paid to former employees of UConn or the UConn Health Center. Nine retired under the most generous retirement plan, called Tier I.

    Veiga left Kaiser Aluminum in 1968, earned his doctorate in 1971 and became a professor at UConn after a brief stint teaching at Northeastern University in Boston. He said his former boss called him "crazy" to leave Kaiser, where he was earning $50,000 to $55,000 as a senior industrial engineer, for an assistant professor position at UConn with a starting salary of $16,000.

    But over the nearly 40 years that Veiga worked for the state, that salary gap narrowed. Private companies cut back pension and retiree health benefits, according to a 2012 Employee Benefit Research Institute report. More and more, private companies came to rely on "defined contribution plans" - 401(k)-type plans that have no guaranteed annual benefit amount.

    Veiga said the early retirement incentive package offered in 2009 during Gov. M. Jodi Rell's administration was too good to pass up. More than 4,700 state employees took advantage of the offer.

    The buyout "made it very hard to say, 'Well, I am going to keep working,' when I can earn as much on a pension as I can working," Veiga said. It added three years to his to his term of service, and the state let him add three more years because he had worked as a residence hall director at Kent State University in Ohio, and another year because he had been an assistant professor of management at Northeastern University. That brought his credited years of service to 44.

    His pension also comes with annual cost-of-living adjustments, Medicare insurance and prescription drug coverage, and supplemental health insurance and prescription coverage through the state. He pays a co-payment at the doctor's office occasionally, he said, but otherwise he does not pay for his health care.

    State Comptroller Kevin Lembo said early retirement incentive programs put a lot of stress on pension systems. While they reduce payroll, they increase lifetime pensions because they add additional years of service. To Lembo, "They are short-term thinking at best."

    The tier system
    Veiga served as chairman of the management department at the School of Business for more than two decades and as the interim dean of the School of Business in 1991 to 1992. He was named the Northeast Utilities endowed chairman of business ethics in 2000, and a Board of Trustees Distinguished Professor in 2001. His final average salary for pension calculation purposes was $361,293 annually.

    State retirees are classified according to a system of "tiers." Tier I, the most generous, was closed to new employees in 1984. As a Tier I retiree, Veiga's pension is determined by several factors, including his credited years of service and the average of his three highest salary years.

    He also receives a cost-of-living adjustment ranging from 2.5 to 6 percent.

    Pension benefits have been reduced as each new retirement tier was added. Under Tier II, retirees' benefits were based on a smaller percentage of their annual salary. Tier IIA, which began in 1997, required retirees to contribute to their retirements. With Tier III, which began in 2011, the retirement age was increased.

    The Tier I average annual pension benefit in 2012 was $36,404; for Tier II, $23,106; and for Tier IIA, $11,556. Data for Tier III retirees is not yet available.

    According to The Day's analysis, Veiga was one of 492 Tier I retires who, because of their high salaries, collected six-figure pensions in 2012. That number represents just 1.6 percent of the 30,472 Tier I retirees.

    Although the Connecticut State Employees' Retirement System is funded at only 42 percent, Veiga said that will change when the economy rebounds in the next five to 10 years. People wouldn't even be discussing whether retirees' benefits were too rich if the economy hadn't gone downhill or if the state had managed its pensions better, he said.

    "Every chance they get, where it is not obvious, they use the money right now and don't fund it all," Veiga said. "Can you imagine having money in a 401(k) somewhere and them saying, 'We will, for the next five years, not give you any interest or earnings, we are not going to do our part?' That is basically what they did."

    From fiscal years 1996 through 2013, the state rarely contributed the annual amount recommended by actuaries. If it had done so, there would be $2 billion more in the State Employees' Retirement System fund, according to the State Comptroller's Office.

    Continued in article


    The Underfunded Pension Mess in the USA
    From the CFO Journal's Morning Ledger on July 25, 2013

    Companies are getting closer to bringing their pension plans back to fully funded status this quarter, says CFOJ’s Emily Chasan.  Rising interest rates and stock prices have narrowed the gap of underfunded pension liabilities by 40% this year, and some companies—including Alaska Air, Cytec Industries and VF Corp.— have announced their pensions are nearly topped up. “A reduction in our pension expense is right around the corner, which is important because most of our competitors don’t have pension plans,” said VF Chief Financial Officer Bob Shearer.

    The vast majority of pension plans are still in the red, but more than 208 S&P 500 companies with pension plans have improved their funded status by over $100 million each since the end of last year. Boeing, Ford, General Electric and IBM are all expected to improve their funding by more than $5 billion at the end of the year.

    Ford, which reported a 19% jump in quarterly profit yesterday,  is seeing a marked improvement in its pension plan this year, says CFO Bob Shanks. Ford chipped in $2 billion, but rising discount rates were the big reason the company has closed its $9.7 billion funding gap by about $4 billion this year. That would bring the funded status to about 85%, up from 82% last year. “We’re very encouraged by the progress we’re seeing,” Mr. Shanks said.

    Jensen Comment
    Government pensions, including teacher pensions, are in far worse shape. For example, the Governor of Illinois is withholding pay of state legislators until they come to agreement on how to my public pensions in Illinois sustainable. The USA Postal Service cannot figure out how to meet its pension obligations ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     

    Horrible (shell game) accounting rules for pension accounting
    Over the past three decades, we have allowed a system of pension accounting to develop that is a shell game, misleading taxpayers and investors about the true fiscal health of their cities and companies -- and allowing management to make promises to workers that saddle future generations with huge costs. The result: According to a recent estimate by Credit Suisse First Boston, unfunded pension liabilities of companies in the S&P 500 could hit $218 billion by the end of this year. Others estimate that public pensions -- the benefits promised by state and local governments -- could be in the red upwards of $700 billion.
    Arthur Levitt, Jr., "Pensions Unplugged," The Wall Street Journal, November 10, 2005; Page A16 --- http://online.wsj.com/article/SB113159015994793200.html?mod=opinion&ojcontent=otep
     


    "Retired teachers file first lawsuit against Illinois pension reform law," by Rick Pearson, Chicago Tribune, December 28, 2013 ---
    http://www.chicagotribune.com/news/politics/clout/chi-retired-teachers-file-first-lawsuit-against-illinois-pension-reform-law-20131227,0,184867.story

    The Illinois Retired Teachers Association filed suit Friday challenging the constitutionality of the state’s historic but controversial plan to deal with the nation’s most underfunded public employee pension system.

    The lawsuit is the first of what could be many filed on behalf of state workers, university employees, lawmakers and teachers outside Chicago. The legal challenge argues the law, which limits cost-of-living increases, raises retirement ages for many current workers and caps the amount of salaries eligible for retirement benefits, violates the state Constitution.

    The lawsuit, filed in Cook County Circuit Court on behalf of eight non-union retirees, teachers and superintendents who are members of the state’s Teacher Retirement System, contended the constitutional “guarantee on which so many relied has been violated.”

    “Countless careers, retirements, personal investments and medical treatments have been planned in justifiable reliance not only on the promises that were made in collective bargaining agreements and the Illinois Pension Code, but also on the guarantee of the (state constitution’s) Pension Protection Clause,” the lawsuit said.

    But a spokeswoman for Democratic Gov. Pat Quinn, who signed the pension changes into law this month after years of political stalemate, said that just as a lawsuit had been expected, the administration “(expects) this landmark reform will be upheld as constitutional.”

    At issue is a provision of the 1970 Illinois Constitution which states that public pensions represent“an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

    The new law, however, scales back what had been annual 3 percent compounded cost-of-living increases to retirees. Instead, retirees would get 3 percent, non-compounding yearly bumps based on a formula that takes into account their years of service multiplied by $1,000. The $1,000 factor would be increased by the rate of inflation each year.

    The measure also requires many current workers to skip up to five annual cost-of-living pension increases when they retire. For current workers, it also would boost the retirement age by up to five years, depending on how old they are.

    In an attempt to make the new law constitutional by offering workers and retirees some trade offs, under a legal theory known as “consideration,” current workers would pay 1 percentage point less toward their pensions. In addition, pension systems could sue to force the state to pay its required employer share toward retirement and a limited number of workers could join a 401(k)-style defined contribution plan.

    But the lawsuit contended the constitutional “guarantee, perhaps more so than anything else in the Illinois Constitution, was used by countless families across Illinois to plan careers, retirements and financial futures.”

    It argues the state Supreme Court has consistently struck down attempts to change the state’s pension laws when benefits are diminished and that justices have warned that constitutional requirements cannot be suspended for economic reasons. Illinois state government’s shaky finances were the prime reason that after years of inaction, lawmakers this month passed the law in an attempt to deal with a $100 billion unfunded public pension liability. About 20 cents of every dollar paid in state taxes goes to fund public pensions and the amount was increasingly taking money away from education and other social services. Backers have said the new law could save an estimated $160 billion over the next 30 years.

    At the same time, Illinois government’s inability to deal with the growing pension liability resulted in downgrades of the state’s credit rating, which boosted taxpayers’ borrowing costs for public works projects. Credit rating agencies heralded the new law, but also recognized that it would be challenged in court.

    “We believe the new law is as constitutionally sound as it is urgently needed to resolve the state's pension crisis,” Quinn spokeswoman Brooke Anderson said in a statement.

    “This historic law squarely addresses the most pressing fiscal crisis of our time by eliminating the state's unfunded pension debt, a standard set by the governor two years ago. It will ensure retirement security for those who have faithfully contributed to the pension systems, end the squeeze on critical education and human services and support economic growth,” she said.

    Representatives of the “We Are One” coalition of public employee unions, including the state’s two major teachers’ unions, have said they expect to file suit after the New Year. Their lawsuit is expected to be filed outside of Cook County — in part reflecting a concern that powerful Democratic House Speaker Michael Madigan plays a powerful political interest in determining judgeships in the Chicago area.

    Continued in article

    Bob Jensen's threads on pension accounting and pension reforms are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    'The Hidden Danger in Public Pension Funds:  Their investments expose government budgets and taxpayers to 10 times more risk than in 1975," Andrew G. Biggs, The Wall Street Journal, December 15, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702303789604579196100329273892?mod=djemEditorialPage_h

    The threat that public-employee pensions pose to state and local government finances is well known—witness the federal ruling earlier this month that Detroit's pension obligations are not sacrosanct in a municipal bankruptcy. Less well known is that pensions are larger and their investments riskier than at any point since public employees began unionizing in earnest nearly half a century ago.

    Public pensions have long been advertised as offering generous, guaranteed benefits for public employees while collecting low and stable contributions from taxpayers. But with Detroit's bankruptcy filing, citing $3.5 billion in unfunded pension liabilities, and with four of the five largest municipal bankruptcies in U.S. history occurring in the past two years, reality tells us otherwise.

    How much riskier are public pensions now? According to my research, public pensions pose roughly 10 times more risk to taxpayers and government budgets than in 1975. And while elected officials—a few Democratic mayors included—are now pushing for reforms, even they may not realize the danger.

    In 1975, state and local pension assets were equal to 49% of annual government expenditures, according to my analysis of Federal Reserve data. Pension assets have nearly tripled to 143% of government outlays today. That's not because plans are better funded—today's plans are no better funded than in 1980—but mostly because pension plans have grown as public workforces have aged.

    The ratio of active public employees to retirees has fallen drastically, according to the State Budget Crisis Task Force. Today it is 1.75 to 1; in 1950, it was 7 to 1. This means that a loss in pension investments has three times the impact on state and local budgets than 40 years ago. Enlarge Image

    In a photo from Monday, Dec. 2, 2013, an empty field in Brush Park, north of Detroit's downtown is shown with an abandoned home. Associated Press

    And pensions can expect to take losses more often because of increased investment risk. Public plans have historically assumed roughly an 8% rate of return. But thanks to falling yields on safe assets, pensions must invest in riskier assets to have any hope of getting 8% returns. A one-year Treasury bond in 1975 yielded a 5.9% return. In 1980, it offered 14.8%, and in 1985 an investor could expect 6.5%. Today, the Treasury yield hovers at 0.1%.

    Meager yields leave America's enterprising public-pension plan managers with a choice: Accept a lower return—forcing higher taxpayer contributions—or take on more risk to keep 8% returns flowing. My estimate, based on Treasury yields and analysis from economists at the Office of the Comptroller of the Currency, is that a pension today must build a portfolio with a standard deviation—how much returns vary from year-to-year—of 14%. Such high volatility means that a fund would suffer losses roughly one out of every four years.

    By contrast, in 1975 a plan could achieve 8% expected returns with a standard deviation of just 3.7%. Those portfolios would lose money once every 65 years. This level of risk varied little through the 1980s and 1990s: An 8% return portfolio in 1985 would require a standard deviation of 2.7%, and 4.3% in 1995. Risk began inching upward after 2000 and has increased rapidly since the recession as low-risk assets continue to fall.

    These figures aren't theoretical. They represent public pensions' decades-long shift from safe bonds to risky stocks, along with the recent growth of "alternative investments" such as hedge funds and private equity. These alternatives are, according to Wilshire Consulting, 60% riskier than U.S. stocks and more than five times riskier than bonds.

    Larger pensions and riskier investments combine to increase risk to state and local budgets. The standard deviation of public pension investments equaled 1.8% of state and local budgets in 1975. That figure crept upward to 2.2% in 1985, and reached 5.8% in 1995. Today it stands at 19.8%. Pension investment risk to budgets has risen roughly tenfold over the past four decades.

    As pension plan managers in Detroit, California and elsewhere can attest, there aren't easy solutions. Mature pensions should move their investments away from risky assets, but many plan managers are doing the opposite in a double-or-nothing attempt to dig out of multitrillion-dollar funding shortfalls. In most instances, significant benefit cuts for current retirees who made the contributions asked of them is difficult to justify and legally problematic.

    The only real option, then, is to make structural changes, including more modest benefits and increased risk-sharing between plan sponsors and public employees. But that will only happen if elected officials accept that they can't continue with business as usual without accumulating tremendous risk.


    Having paid off bond holders for one penny on the dollar, what fool would loan it another dollar to pay its bloated unfunded pensions?

    "California City’s Return to Solvency, With Pension Problem Unsolved," by Rick Lyman and Mary Williams Walsh, The New York Times, December 3, 2013 ---
    http://www.nytimes.com/2013/12/06/us/stockton-set-to-return-to-solvency-with-pension-problem-unsolved.html

    Before Detroit filed for bankruptcy, there was Stockton.

    Battered by a collapse in real estate prices, a spike in pension and retiree health care costs, and unmanageable debt, this struggling city in the Central Valley has labored for months to find a way out of Chapter 9. Now having renegotiated its debt with most creditors, cobbled together layoffs and service cuts and raised the sales tax to 9 percent from 8.25 percent, Stockton is nearly ready to leave court protection.

    But what Stockton, along with pretty much every other city in California that has gone into bankruptcy in recent years, has not done is address the skyrocketing public pensions that are at the heart of many of these cases.

    “No city wants to take on the state pension system by itself,” said Stockton’s new mayor, Anthony Silva, referring to the California Public Employees’ Retirement System, or Calpers. “Every city thinks some other city will take care of it.”

    While a federal bankruptcy judge ruled this week that Detroit could reduce public pensions to help shed its debts, Stockton has become an experiment of whether a municipality can successfully come out of bankruptcy and stabilize its finances without touching pensions. It is an effort that has come at great cost to city services and one that some critics say will simply not work once the city starts trying to restore services and hire 120 police officers it promised to get the sales-tax increase passed.

    “They wanted to get out of bankruptcy in the worst possible way, and that’s just what they did,” said Dean Andal of the San Joaquin County Taxpayers Association, which fought the sales-tax increase. “If they go ahead and hire those new police officers, the city will be back in insolvency in four years.”

    Stockton declared fiscal emergencies in 2010 and 2011, giving it the power to renege on annual pay increases for city workers. City services were slashed. Hundreds of municipal workers were laid off. And many retirees who had been promised health coverage for life learned that they would have to begin paying for it.

    “That was the hardest part,” Councilman Elbert Holman said, “looking people in the eye and telling them sorry, you are losing your health care, but it’s absolutely necessary.”

    By the time the judge found Stockton eligible for Chapter 9 bankruptcy on April 1, the city had about $147 million in unfunded pension obligations and about $250 million in debt from various bond issues.

    The years of fiscal emergency and bankruptcy have left their mark, including a skyrocketing crime rate, which city officials and many residents attribute to staffing and service cuts in the Police Department.

    “I suddenly realized a few years ago that, just in my tiny, two-block neighborhood, there had been 11 residential burglaries in the previous nine months,” said Marci Walker, an emergency room nurse.

    Cities go bankrupt for many reasons: a collapse in real estate prices, a spike in pension and retiree health care costs, a burden of debt from expensive city projects. Stockton has experienced all three.

    When real estate prices shot up in Silicon Valley in the last decade, many commuters decided that Stockton’s cheaper housing was worth the long commute to the Bay Area. That drove up local housing prices, so when the bubble burst it had a bigger impact, giving Stockton one of the nation’s highest foreclosure rates.

    City leaders had also gone on a construction spree during the flush years, building a new sports arena, a minor-league baseball stadium and a marina. Citizens still bitterly mention the 2006 concert that opened the arena, where Neil Diamond was paid $1 million to perform.

    And through it all, the pension costs for city workers — particularly for police officers and firefighters, who can retire early and draw on those pensions for decades — kept going up.

    No part of the city has been left unscathed. Ms. Walker’s comfortable neighborhood near the University of the Pacific campus was hit with rising crime almost immediately after the police layoffs. “When the economy got bad and we lost police officers, it all started,” she said.

    So she started the Regent Street Neighborhood Watch, the first of more than 100 such organizations to sprout up in the city in the last few years.

    “We don’t confront anybody, we just let them know that we know they’re there,” Ms. Walker said. She added, “Criminals do not like eyeballs on them.”

    Continued in article

    Jensen Comment
    Off the cuff Governor Brown complained that California has to deal with a trillion dollars in unfunded pensions (he may have exaggerated). The sad ttruth is that many of these were fraudulent pensions with criminal amounts (e.g., the pensions of Bell, California) and absurd early retirement provisions at age 50 or earlier.

    City of Bell Scandal --- http://en.wikipedia.org/wiki/City_of_Bell_scandal


    "California pension funds are running dry," by Marc Lifsher, Los Angeles Times, November 13, 2014 ---
    http://www.latimes.com/business/la-fi-controller-pension-website-20141114-story.html

    A decade ago, many of California's public pension plans had plenty of money to pay for workers' retirements.

    All that has changed, according to a far-reaching package of data from the state controller. Taxpayers are now on the hook for billions of dollars more to cover the future retirements of public workers, with the bill widely varying depending on where they live.

    The City of Los Angeles Fire and Police Pension System, for instance, had more than enough funds in 2003 to cover its estimated future bill for workers' retirement checks. A decade later, it is short $3 billion.

    The state's pension goliath, the California Public Employees' Retirement System, had $281 billion to cover the benefits promised to 1.3 million workers and retirees in 2013. Yet it needed an additional $57 billion to meet future obligations.

    The bill at the state teachers' pension fund is even higher: It has an estimated shortfall of $70 billion.

    The new data from a website created by state Controller John Chiang come at a time of growing anger from taxpayers over the skyrocketing cost of public workers' retirements.

    Until now, the bill for those government pensions was buried deep in the funds' financial reports. By making this data available, Chiang is bound to stir debate about how taxpayers can afford to make retirement more comfortable for public workers when private-sector employees' own financial futures have become less secure. For most non-government workers, fixed monthly pensions are increasingly rare. lRelated Stockton bankruptcy ruling preserves city pensions

    Business Stockton bankruptcy ruling preserves city pensions

    "Somebody, who is knowledgeable and interested, is several clicks away from the ugly mess that will define California's financial future," said Dan Pellissier, president of California Pension Reform, a Sacramento-area group seeking to stem rising statewide retirement costs.

    Chiang has assembled reams of data from 130 public pension plans run by the state, cities and other government agencies. It's now accessible at his website, ByTheNumbers.sco.ca.gov.

    In nearly eight years as controller, essentially the state's paymaster, Chiang has made good on a commitment to make government financial records more transparent and accessible.

    . . .

    The pension debate in recent years has been fueled by controversy.

    Vernon's former city manager, for example, was receiving more than $500,000 in annual pension payments. Most public safety workers can retire as early as 50. And some public employees had cashed out unused vacation and other perks to unjustly spike their retirement pay.

    Meanwhile, cash-strapped cities are facing escalating bills. Rising pension costs contributed to bankruptcies in Stockton, San Bernardino and Vallejo.

    Why should private-sector taxpayers give California's public workers more money to retire than most of them will ever make? jumped2 at 11:33 AM November 14, 2014 

    Critics contend that governments can no longer afford to pay generous pensions to retirees that aren't available to most private-sector workers. Unions, meanwhile, have vehemently defended the status quo, saying these benefits were promised to workers for years of serving the public.

    "In the months ahead, California and its local communities will continue to wrestle with how to responsibly manage the unfunded liabilities associated with providing retirement security to police, firefighters, teachers and other providers of public services," Chiang said.

    "Those debates and the actions that flow from them ought to be informed by reliable data that is free of political spin or ideological bias," said Chiang.

    Continued in article

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    "Undisclosed Pension Extras Cost Detroit Billions," by Mary Williams Walsch, The New York Times, September 25, 2013 ---
    http://dealbook.nytimes.com/2013/09/25/undisclosed-payments-cost-detroit-pension-plan-billions/?_r=0

    Detroit’s municipal pension fund made undisclosed payments for decades to retirees, active workers and others above and beyond normal benefits, costing the struggling city billions of dollars, according to an outside actuary hired to examine the payments.

    The payments included bonuses to retirees, supplements to workers not yet retired and cash to the families of workers who died too young to get a pension, according to a report by the outside actuary and other sources.

    How much each person received is not known because payments were not disclosed in the annual reports of the fund.

    Detroit has nearly 12,000 retired general workers, who last year received pensions of $19,213 a year on average — hardly enough to drive a great American city into bankruptcy. But the total excess payments in some years ran to more than $100 million, a crushing expense for a city in steep decline. In some years, the outside actuary found, Detroit poured more than twice the amount into the pension fund that it would have had to contribute had it only paid the specified pension benefits.

    And even then, the city’s contributions were not enough. So much money had been drained from the pension fund that by 2005, Detroit could no longer replenish it from its dwindling tax revenues. Instead, the city turned to the public bond markets, borrowed $1.44 billion and used that to fill the hole.

    Even that didn’t work. Last June, Detroit failed to make a $39.7 million interest payment on that borrowing — the first default of what was soon to become the biggest municipal bankruptcy case in American history.

    Detroit said that making the interest payment would have consumed more than 90 percent of its available cash. And besides, the hole in its pension fund was growing again, and it needed yet another $200 million for that.

    When Detroit turned to the bond market in 2005, it acknowledged that it needed cash for its pension fund but did not explain its long history of paying out more than the plan’s legitimate benefits, including the bonuses, known as “13th checks,” which were reported earlier this month by The Detroit Free Press. Nor did the city describe the pension fund’s distributions to active workers, or that a 1998 shift to a 401(k)-style plan had been blocked and turned instead into a death benefit. In its most recent annual valuation of the fund, the plan’s actuary said it was still trying to determine the “effect of future retroactive transfers to the 1998 defined contribution plan,” without mentioning that it had not been carried out.

    All of these things eroded the financial health of the pension system, but neither the magnitude of the harm, nor its effect on the city’s own finances, were disclosed to investors. German banks were big buyers of Detroit’s pension debt; now, they are complaining that they were told it was sovereign debt.

    Finally, in 2011, the city hired the outside actuary to get a handle on where all the money was going. The pension system’s regular actuaries, with the firm of Gabriel Roeder Smith, would not provide the information because they worked for the plan trustees, not the city.

    The outside actuary, Joseph Esuchanko, concluded that the various nonpension payments had cost the struggling city nearly $2 billion from 1985 to 2008 because the city had to constantly replenish the money, with interest. The trustees began making the payments even before 1985, but it appears that Mr. Esuchanko could not get data for earlier years.

    His calculations included only the extra payments by Detroit’s pension fund for general workers. Detroit has a second pension fund, for police officers and firefighters, which also made excess payments in the past. But Mr. Esuchanko could not get the data he needed to calculate those, either.

    When Mr. Esuchanko reported his findings, Detroit’s city council voted to halt all payments except legitimate pensions, as described in plan documents. The police and firefighters’ plan trustees appear to have discontinued the practice earlier.

    Detroit’s pension trustees, and their lawyers, were unavailable on Wednesday to comment on the extra payments.

    Joseph Harris, who served as Detroit’s independent auditor general from 1995 to 2005, said the payments were approved by the pension board of trustees, and it would have been useless for the city to have tried to stop them during his term.

    “It was like dandelions,” he said. “You just accept them. They were there, something you’ve seen all your life.”

    Continued in article

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    The Underfunded Pension Mess in the USA
    From the CFO Journal's Morning Ledger on July 25, 2013

    Companies are getting closer to bringing their pension plans back to fully funded status this quarter, says CFOJ’s Emily Chasan.  Rising interest rates and stock prices have narrowed the gap of underfunded pension liabilities by 40% this year, and some companies—including Alaska Air, Cytec Industries and VF Corp.— have announced their pensions are nearly topped up. “A reduction in our pension expense is right around the corner, which is important because most of our competitors don’t have pension plans,” said VF Chief Financial Officer Bob Shearer.

    The vast majority of pension plans are still in the red, but more than 208 S&P 500 companies with pension plans have improved their funded status by over $100 million each since the end of last year. Boeing, Ford, General Electric and IBM are all expected to improve their funding by more than $5 billion at the end of the year.

    Ford, which reported a 19% jump in quarterly profit yesterday,  is seeing a marked improvement in its pension plan this year, says CFO Bob Shanks. Ford chipped in $2 billion, but rising discount rates were the big reason the company has closed its $9.7 billion funding gap by about $4 billion this year. That would bring the funded status to about 85%, up from 82% last year. “We’re very encouraged by the progress we’re seeing,” Mr. Shanks said.

    Jensen Comment

    Government pensions, including teacher pensions, are in far worse shape. For example, the Governor of Illinois is withholding pay of state legislators until they come to agreement on how to my public pensions in Illinois sustainable. The USA Postal Service cannot figure out how to meet its pension obligations ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions


    Teaching Case on Perpetual Preferred Stock
    From The Wall Street Journal Accounting Weekly Review on September 13, 2013

    Perpetual Stock Piques Interest
    by: Emily Chasan
    Sep 10, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Accounting, Financial Ratios, Preferred Stock, Stockholders' Equity

    SUMMARY: Perpetual preferred shares offer high yields similar to debt but have no maturity date. The shares may fluctuate in value in opposition to changes in overall interest rates, as bonds do, making them a risky investment for loss of principal value. The author, the CFO Journal editor, emphasizes that investors should look to purchase perpetual preferred shares from companies with "high, stable cash-flow" such as banks and insurance companies, which have added security because of regulation, and real-estate investment trusts.

    CLASSROOM APPLICATION: The article may be used when discussing accounting for stock issuances, particularly preferred stock, to demonstrate to students the need to satisfy investor demand with the terms of a company's stock.

    QUESTIONS: 
    1. (Introductory) What is preferred stock? What are perpetual preferred shares of stock?

    2. (Advanced) Why does the issuance of perpetual preferred shares avoid "...altering debt-to-equity ratios and credit ratings"?

    3. (Advanced) How are perpetual preferred shares like debt in the eyes of investors?

    4. (Introductory) According to the author, what type of company is most able to issue perpetual preferred shares to provide investors with a secure investment?

    5. (Advanced) How did AT&T use its own perpetual preferred shares? Why do you think the company needs approval from the U.S. Labor Department to take this step?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Perpetual Stock Piques Interest," by Emily Chasan, The Wall Street Journal, September 10, 2013 ---
    http://online.wsj.com/article/SB20001424127887323864604579065073951390140.html?mod=djem_jiewr_AC_domainid

    Rising interest rates this summer have dried up the market for perpetual preferred shares, but some companies are finding novel ways to squeeze out deals.

    Perpetual preferred shares—a sort of hybrid between debt and equity with no maturity date—offer companies a way to raise money quickly without issuing debt or diluting the holdings of their current common shareholders. That avoids altering debt-to-equity ratios and credit ratings, but it risks saddling a company with high dividend payments.

    For investors, however, the high yields come with the risk that the shares could lose some of their principal value as rising interest rates make them harder to sell.

    "It's very long-term capital, which is a good match for financing assets with very long lives," said James Jackson, chief financial officer of BreitBurn Energy Partners LP. He has been considering perpetual preferred shares as an alternative source of financing for his company.

    The shares are a relatively new form of financing for companies structured like BreitBurn that are known as master limited partnerships. One of BreitBurn's competitors, Vanguard Natural Resources LLC, VNR +0.47% became the first such company to sell perpetual preferred shares this summer, and its shares are trading above face value in the secondary market because of strong demand.

    In addition, AT&T Inc. T +1.18% got tentative approval from the U.S. Labor Department last week to make a pension-fund contribution of 320 million perpetual preferred shares in its mobility business, at a value of up to $9.5 billion. The AT&T deal is expected to bring the pension fund close to fully funded status and lower the company's taxes.

    Final approval could open the door for other companies to use the same approach.

    "It's a novel way to address some of these pension issues, and if other companies have an asset like this they could review it," said John Culver, an AT&T analyst at Fitch Ratings in Chicago.

    Perpetual preferreds gained popularity during the financial crisis in 2008 and 2009, when banks raised more than $400 billion using them. But banks, while still the leading issuer this year, have been pulling out of the market because of cheaper financing elsewhere and concerns that some types of perpetual preferred shares can run afoul of bank-capital requirements.

    As banks have left the market, companies with strong cash flows, including real-estate investment trusts, utilities and energy firms, have filled the void.

    "Companies definitely want to issue them. There's been a bit of a hiatus due to the rate environment and the summer. Now that the summer is over, new issuance will crank up again, but probably at higher yields," said William Scapell, who oversees investments in preferred stock funds at Cohen & Steers.

    Companies have raised more than $27 billion from perpetual preferred shares so far this year, according to data provider Dealogic. Since May, however, when long-term interest rates started to increase, the pace of deals has plummeted 62% compared with the same period a year earlier.

    Real-estate investment trusts completed some 30 perpetual preferred deals this year, the most of any nonfinancial sector, but they have also pulled back since May.

    "The market is not the right market today," said Glenn Cohen, the chief financial officer of Kimco Realty Corp., KIM -1.17% which raised $800 million in three perpetual preferred deals over the past two years at yields as low as 5.5%. Today, he said, the company would be better off raising cash with traditional 10-year bonds.

    In June, Houston-based Vanguard Natural Resources VNR +0.47% offered $61 million in preferred shares at a competitive 7.88% yield. The company told investors it wouldn't seek to redeem the perpetual preferred shares for at least 10 years, as opposed to a more typical five-year wait.

    It was the first such deal from a master limited partnership. The company found a novel way to help investors simplify the tax filings related to the shares.

    "It puts another tool in our toolbox to go out there and raise more capital," said Vanguard Treasurer Ryan Midgett. The firm intends to fund acquisitions with the proceeds, he said.

    Continued in article


    Throw away pension fund cash on lavish parties and travel to raise the ROI of the pension fund
    "This Accounting Quirk Is Setting Up Public Pensions For Disaster," by Simon Lac, Business Insider, May 5, 2013 ---
    http://www.businessinsider.com/through-the-looking-glass-into-public-pension-accounting-2013-5

    The Economist has an interesting piece in Buttonwood this week about how U.S. public pensions do their accounting. Basically, they discount their liabilities using the expected return on their assets.

    It results in some curious outcomes. For example, since holding cash typically drags down return expectations, if a pension fund simply gave away its cash (or burned it as The Economist posits) by raising its expected return on assets (no longer burdened by the cash drag) they would reduce the value of their liabilities. Their funded status might appear better even with fewer assets.

    This perverse accounting treatment got me thinking about why pension funds continue to invest in hedge funds seeking 8% returns, even though it’s been many years since hedge funds made 8% and it’s not likely they will in the near future either. Certainly not with over $2 trillion competing for opportunities.

    Based on the accounting, including an asset with an 8% return target helps reduce the value of their liabilities even if the 8% return expectation is an unreasonable expectation. So the motivation for a pension fund trustee could be to include hedge funds because of their helpful impact on the discount rate on their liabilities even while their continued failure to achieve that target doesn’t cause huge immediate problems.

    Far better than lowering the discount rate to a more appropriate level and revealing the true shortfall with all its political consequences.

    This is how the $3 trillion underfunded position is growing. Sometimes accountants can cause a lot of damage.

    Read more posts on In Pursuit of Value

    Bob Jensen's threads on pension accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    The losing New York Times wants to dump the losing Boston Globe

    From the CFO Morning Ledger on February 21, 2013

    Pension liabilities loom as NYT puts Globe on the block. The New York Times is exploring a sale of the Boston Globe, its only remaining business outside the core NYT media brand, Bloomberg reports. Times Co. tried to sell the Globe as recently as 2009, but pension liabilities got in the way. At least one bid at the time reached about $33 million in cash, but fluctuating estimates on the Boston Globe’s pension liability — ranging from $110 million to $240 million — scuttled any deal. Bidders, who would assume the full pension liability, were unclear on the total value of the pension.

    Bob Jensen's threads on the sad state of pension accounting in both the public and private sectors ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    Question
    What do the following states sadly share in common"

    Hint
    You know it must be really bad if California did not make the list.

    "Nine States with Sinking Pensions," 247 Wall Street, October 18, 2012 --- Click Here
    http://247wallst.com/2012/10/18/nine-states-with-sinking-pensions/?utm_source=247WallStDailyNewsletter&utm_medium=email&utm_content=OCT182012A&utm_campaign=DailyNewsletter

    Several years after from the financial crisis of 2008, state pension funds continue to languish. According to data released this week by Milliman, Inc. and by the Pew Center on the States, there was a $859 billion gap between the obligations of the country’s 100 largest public pension plans and the funding of these pensions. Most of these are state funds, and state legislatures have attempted to respond to this growing crisis by making numerous reforms to try to combat this growing deficit.

    In 2010, only Wisconsin’s pension funds were fully funded. Nine states, meanwhile, were 60% funded or less — this would mean that at least 40% of the amount the state owes current and future retirees is not in the state’s coffers. In Illinois, just 45% of the state’s pension liabilities were funded. In some of these states, the gap between the outstanding liability and the amount funded was in the tens of billions of dollars. California alone had $113 billion in unfunded liability. Based on Pew’s report, “The Widening Gap Update,” 24/7 Wall St. identified the nine states with sinking pensions.

    Each year, actuaries determine how much a state should contribute to its pensions to keep them funded. Many states, for various reasons, did not pay the full recommended contributions for 2010, while others have been paying the recommended amount for years. In an interview with 24/7 Wall St., Milliman Inc. principal and consulting actuary Becky Sielman explained that despite states making the recommended payments, many large individual public retirement funds are still underfunded.

    Of the nine states with pensions that are underfunded by 40% or more, three paid more than 90% of the recommended contributions, and two, Rhode Island and New Hampshire, paid the full amount. Despite this, pension contributions were still generally higher in states that were better funded. Of the 16 states that were at least 80% funded — a level experts consider to be fiscally responsible — 11 contributed at least 97% of the recommended amount.

    In an interview with 24/7 Wall St., Pew Center on the States senior researcher David Draine explained why, despite paying the full amount, several states continued to be severely underfunded. He pointed out that meeting contributions was important. He added that states that made full contributions in 2010 were 84% funded on average, compared to those that did not, which were only 72% funded.

    To explain why several states that are making full contributions are still underfunded, Draine said much of it has to do with investment losses. “The 2000s have been a terrible period for pension investments that have fallen short of their expectations … that’s a big part of the growth in the funding gap.”

    Unfunded liability can also grow due to overly optimistic assumptions about investment growth, pension payments that become deferred, and an increase in benefits or an increase in the number of beneficiaries without a corresponding increase in contributions, Draine explained.

    Based on the Pew Center for the States report, “The Widening Gap Update,” 24/7 Wall St. identified the nine states with public pensions that were 60% or less funded as of 2010. From the report, we considered the total outstanding liability, the total amount funded, and the proportion of the recommended contribution each state made in 2010. We also reviewed the level of funding for the 100 largest pension funds in each state, provided by Milliman’s Public Pension Fund Study, which covered a period from June 30, 2009, to January 1, 2011.

    Continued in article

    Bob Jensen's threads on the sad state of governmental accountancy and accountability ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on March

    SEC Says Illinois Hid Pension Troubles
    by: Michael Corkery and Jeannette Neumann
    Mar 11, 2013
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com 
     

    TOPICS: Bonds, Business Ethics, GAAP, Governmental Accounting, Pension Accounting

    SUMMARY: "The Securities and Exchange Commission on Monday charged Illinois with securities fraud.... [alleging] the state failed to adequately disclose to investors the risks of its underfunded pensions systems." The SEC concurrently announced a settlement in the case and the related video clearly shows one WSJ editor thinks very little of that development. He also refers to governmental financial reports in general as "fraudulent." A related graphic shows that Illinois has some of the lowest levels of funding in the nation for its retirement plans.

    CLASSROOM APPLICATION: The article may be used in a governmental accounting course when covering pension accounting or simply to emphasize the importance of the comprehensive annual financial report and disclosures by governmental entities. It may also be used in an ethics course covering responsibility for clarity in financial reporting.

    QUESTIONS: 
    1. (Introductory) What wrongful act does the Securities and Exchange Commission (SEC) accuse the state of Illinois?

    2. (Introductory) What is the focus of the SEC's responsibilities over the problem in Illinois?

    3. (Advanced) Summarize the requirements in accounting for pension liabilities that states and other governmental entities must follow. In your answer, state the authoritative source for those requirements.

    4. (Advanced) Access the State of Illinois Comprehensive Annual Financial Report (CAFR) located on its web site at http://www.ioc.state.il.us/index.cfm/linkservid/9BE62AD6-1CC1-DE6E-2F48A7172B174FA2/showMeta/0/ Refer to the report for the fiscal year ended June 30, 2010. Scroll down to the Comptroller's transmittal letter beginning on page v, and further to her discussion of Factors Affecting Financial Condition, beginning on page vii, to Pensions discussed on page viii. How did the State of Illinois make its legally required contribution to the pension fund in 2010? Does that funding source concern you? Answer the question as if you were a citizen of the State of Illinois and if you were an employee, such as a teacher or a university professor, active in the state retirement system.

    5. (Advanced) Scroll further down to the Management Discussion and Analysis, to page 15 and the section entitled Retirement Systems. Besides bond indebtedness, what is the largest liability facing the State of Illinois? How do the amounts stated in this discussion compare to the amounts reported in the WSJ article?

    6. (Advanced) According to the WSJ article, a goal of defined benefit retirement systems such as those in the State of Illinois is to be 90% funded. When does the State of Illinois expect to reach that goal?

    7. (Advanced) According to the article, Elaine Greenberg of the SEC said that the State of Illinois did not follow required governmental accounting standards. Scroll back up to access the auditor's report for the State of Illinois, just following the transmittal letter. Who conducts the audit? Is there any indication that the state did not follow required accounting standards? Support your answer.

    8. (Introductory) Refer to the related video featuring one of the WSJ Editors and to the related Opinion page article. What do the WSJ Editors conclude about the SEC's actions in this case?

    9. (Advanced) Based on the discussion in the articles, the related video, and your knowledge of pension accounting requirements, what are the areas of judgment that might mean the problem of underfunding in Illinois, and elsewhere, could be even worse than currently estimated?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    SEC v Illinois
    by Review & Outlook Opinion Page Editors
    Mar 13, 2013
    Page: A14

     

    "SEC Says Illinois Hid Pension Troubles," by Michael Corkery and Jeannette Neumann, The Wall Street Journal, March 11, 2013 ---
    http://online.wsj.com/article/SB10001424127887323826704578354370478104256.html?mod=djem_jiewr_AC_domainid

    For years, Illinois officials misled investors and shortchanged the state pension system, leaving future generations of taxpayers to foot the bill, U.S. securities regulators allege.

    The Securities and Exchange Commission on Monday charged Illinois with securities fraud, marking only the second time the agency has filed civil-fraud charges against a state.

    But the agency and the state also announced that a settlement had already been reached in which Illinois won't pay a penalty or admit wrongdoing.

    The action was part of a broader push by the SEC to bring greater transparency and accountability to the municipal-bond market, as the agency alleged the state failed to adequately disclose to investors the risks of its underfunded pensions systems.

    The action also shows in detail how political decisions left the state with only 40 cents of assets for every dollar of pension liabilities—a financial hole Illinois officials are now scrambling to fill.

    Yet no matter how harmful the pension practices were to the state's finances, SEC officials say they could only pursue charges against Illinois for what it failed to tell bond investors, who bought bonds worth $2.2 billion.

    Most states comply with governmental accounting standards, which "Illinois did not follow," Elaine Greenberg, head of the SEC's municipal securities and public pensions unit, said in an interview. "But the SEC cannot order a state to follow any particularly methodology."

    Governor Pat Quinn's Office of Management and Budget said the state has been working to enhance its disclosure practices since 2009.

    States and cities across the U.S. face high pension costs. Rallying investment returns have helped make up the shortfalls at some plans, but others have cut benefits to workers to fill the deficit.

    Illinois has one of the most underfunded pension systems in the U.S.

    The SEC's 11-page, cease-and-desist order reveals new details about the financial and legislative practices that led to the state's current predicament.

    The state's five public-employee pension plans manage the retirement benefits for clerical workers, teachers, judges, college professors and lawmakers. Collectively, their funding level stands at 40%. Nationally, the average funding level is about 75%.

    The SEC settlement comes as Mr. Quinn, a Democrat, has pushed repeatedly to overhaul the state's pension system. Spiraling pension costs threaten to crowd out spending on other state services and are a major factor in Illinois's low credit rating. Standard & Poor's Ratings Services cut Illinois's rating one notch to A- in January, making it the lowest-rated U.S. state by S&P.

    "This is one more weight on the scale," Illinois State Senator Daniel Biss, a Democrat, said of the SEC order.

    But an overhaul, which could result in deep cuts for current workers and retirees, has remained elusive. Workers have argued that they shouldn't bear the burden for past mistakes.

    The problems date back to 1994, when Illinois lawmakers passed a funding plan that would allow the state to amortize, or spread the pension costs, over 50 years. Most pensions use a 30-year amortization period. More

    Heard: Muni Market Still in Need of a Minder

    State officials also ignored the common practice of calculating contributions to the plans based on what is known as the "Actuarially Required Contribution."

    Instead, Illinois left it to lawmakers to decide how much to contribute to the funds each year.

    In some years, the state took "pension holidays," lowering its planned pension contributions by about half.

    By 2009, actuaries and a consultant hired by the state began warning that the underfunding could lead to the system's insolvency, according to the SEC order.

    The consultant said in a document that the state's pension system was so underfunded that it would likely "never be able to afford the level of contributions" required to reach 90% funded.

    Yet, these concerns weren't disclosed to investors in bond-offering documents, the SEC said.

    As it prepared its bond documents, the state made little effort to collect "potentially pertinent" information from the pension system's actuaries, the SEC said.

    The state said it had worked to improve its practices after the SEC cited New Jersey for pension-disclosure issues in August 2010.

    The SEC accused New Jersey of allegedly misleading investors that the state was adequately funding two of its pension systems—the agency's first securities-fraud case against a state. The SEC said the state didn't disclose that it had abandoned a five-year plan to fund the pension plans. New Jersey neither admitted nor denied wrongdoing but said it would improve its disclosures.

    When New Jersey settled with the SEC, it didn't pay a fine, either. The SEC often doesn't fine governments because the costs are ultimately borne by taxpayers, according to people familiar with the agency's practices. In its Illinois order, the SEC noted that the state had taken steps to improve its disclosures, including the creation of a special "disclosure committee" that will sign off on bond-offering disclosures.

    Illinois expects to sell approximately $500 million in bonds in early April, a state official said Monday. The sale was put off in January when S&P downgraded the state's credit rating.  

    Continued in article

    The sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Teaching Case from The Wall Street Journal Accounting Weekly Review on December 13, 2012

    Hostess Maneuver Deprived Pension
    by: Julie Jargon, Rachel Feintzeig and Mike Spector
    Dec 10, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Pension Accounting

    SUMMARY: "Hostess Brands Inc. said it used wages that were supposed to help fund employee pensions for the company's operations as it sank toward bankruptcy....Hostess had 115 different collective-bargaining agreements with employees represented by the bakers union. Each contract let those workers choose an amount of wages to direct to the pension plan. For example, John Jordan, a union official and former Hostess employee, said workers at a Hostess factory in Biddeford, Maine, agreed to plow 28 cents of their 30-cents-an-hour wage increase in November 2010 into the pension plan. Hostess was supposed to take the additional 28 cents an hour and contribute it to the workers' pension plan....[However, ] in the five months before this past January's bankruptcy filing, the company missed payments to the...pension fund totaling $22.1 million...After that, forgone pension payments added up at a rate of $3 million to $4 million a month...As the company's financial condition deteriorated, 'whatever cash it had was being used to fund the business, to keep it afloat'...."

    CLASSROOM APPLICATION: The article may be used to discuss issues in payroll accounting and cash flows.

    QUESTIONS: 
    1. (Advanced) Summarize the payroll accounting process, showing a basic journal entry for a weekly payroll and describing the calculation that supports the entry.

    2. (Advanced) What is the difference between gross and net pay? What must a company do with federal income taxes and other items withheld from gross pay?

    3. (Introductory) What was Hostess supposed to do with the amounts withheld from employee wages for pension plan contributions? What did the company do instead?

    4. (Introductory) According to a letter from the former chief executive officer (CEO) of Hostess, Brian Driscoll, why did Hostess "temporarily suspend" its contributions to the employees' pension plans?

    5. (Advanced) Now that Hostess has filed for bankruptcy, what do you think is the status of the withheld wages that were not paid over to the employees' pension funds?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Hostess Maneuver Deprived Pension," by Julie Jargon, Rachel Feintzeig and Mike Spector, The Wall Street Journal, December 10, 2012 ---
    http://professional.wsj.com/article/SB10001424127887323316804578165813739413332.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Hostess Brands Inc. said it used wages that were supposed to help fund employee pensions for the company's operations as it sank toward bankruptcy.

    It isn't clear how many of the Irving, Texas, company's workers were affected by the move or how much money never wound up in their pension plans as promised.

    After the company said in August 2011 that it would stop making pension contributions, the foregone wages weren't put toward the pension. Nor were they restored.

    The maker of Twinkies, Ho-Hos and Wonder Bread filed for bankruptcy protection in January and shut down last month following a strike by one of the unions representing Hostess workers. A judge is overseeing the sale of company assets.

    Gregory Rayburn, Hostess's chief executive officer, said in an interview it is "terrible" that employee wages earmarked for the pension were steered elsewhere by the company.

    "I think it's like a lot of things in this case," he added. "It's not a good situation to have."

    Mr. Rayburn became chief executive in March and learned about the issue shortly before the company shut down, he said. "Whatever the circumstances were, whatever those decisions were, I wasn't there," he said.

    A spokeswoman for Hostess's previous top executive, Brian Driscoll, declined to comment.

    Hostess hasn't previously acknowledged that the foregone wages went toward its operations.

    The maneuver probably doesn't violate federal law because the money Hostess failed to put into the pension didn't come directly from employees, experts said.

    "It's what lawyers call betrayal without remedy," said James P. Baker, a partner at Baker & McKenzie LLP who specializes in employee benefits and isn't involved in the Hostess case. "It's sad, but that stuff does happen, unfortunately."

    The decision to cease pension contributions angered many employees. After the bankruptcy filing, Hostess tangled with the International Brotherhood of Teamsters and the Bakery, Confectionery, Tobacco and Grain Millers International Union to renegotiate labor contracts.

    While the Teamsters union agreed in September to a compromise, resistance from the bakers union was fierce.

    Halted pension contributions were a major factor in the bakers union's refusal to make a deal with the company. After a U.S. bankruptcy judge granted Hostess's request to impose a new contract, the union's employees went on strike. Hostess then moved to liquidate the company.

    The bakers union represented about 5,600 of the company's 18,500 employees.

    "The company's cessation of making pension contributions was a critical component of the bakers' decision" to walk off the job, said Jeffrey Freund, a lawyer for the union.

    "If they had continued to fund the pension, I think we'd still be working there today," said Craig Davis, a 44-year-old forklift operator who loaded trucks with Twinkies, cupcakes and sweet rolls at an Emporia, Kan., bakery, for nearly 22 years.

    Hostess's retirees receive payments mostly from so-called multiemployer pension plans. Such pensions get contributions from various companies in a particular industry. Hostess's pension plans still are making payouts to retirees.

    Most companies provide pensions through single-employer plans that they fund themselves. When companies with these plans file for bankruptcy protection, they sometimes terminate the plans, leading the Pension Benefit Guaranty Corp., the government agency that insures corporate pensions, to take over the plans and make payouts to their retirees.

    With the multiemployer plans from which most Hostess retirees receive benefits, the PBGC doesn't step in unless the plans become insolvent. If that happened, the PBGC would send roughly $12,870 for each employee with at least 30 years of service, according to an agency spokesman.

    The Bakery & Confectionary Union & Industry International Pension Fund, the largest fund covering Hostess bakers, was 72% funded when Hostess stopped making contributions, the company said.

    Teamster-represented employees at Hostess didn't contribute a portion of their wages toward pensions, a union spokesman said. But among workers in the bakers union, it was "standard practice," said Mr. Rayburn, Hostess's CEO.

    Hostess had 115 different collective-bargaining agreements with employees represented by the bakers union. Each contract let those workers choose an amount of wages to direct to the pension plan.

    For example, John Jordan, a union official and former Hostess employee, said workers at a Hostess factory in Biddeford, Maine, agreed to plow 28 cents of their 30-cents-an-hour wage increase in November 2010 into the pension plan.

    Hostess was supposed to take the additional 28 cents an hour and contribute it to the workers' pension plan.

    "This local was very aggressive about saving for the future," he said.

    Employees in Biddeford began directing wages toward pensions in 1955, and the amount grew to $4.28 an hour per employee.

    Amounts varied by location, and it isn't clear how many unionized employee groups participated in the arrangement.

    In five months before this past January's bankruptcy filing, the company missed payments to the main baker pension fund totaling $22.1 million, Mr. Freund said. After that, forgone pension payments added up at a rate of $3 million to $4 million a month until Hostess formally rejected its contracts with the union. The figures include company contributions and employee wages that were earmarked for the pension, according to Mr. Freund.

    Continued in article


    "The looming shortfall in public pension costs," by Robert Novy-Marx and Josh Rauh, The Washington Post, October 10, 2012 --- Click Here
    http://www.washingtonpost.com/opinions/the-looming-shortfall-in-public-pension-costs/2012/10/19/5b394cdc-0ced-11e2-bd1a-b868e65d57eb_story.html?utm_source=Stanford+Business+Re%3AThink&utm_campaign=1451d355ee-RTIssue2&utm_medium=email

    How much will the underfunded pension benefits of government employees cost taxpayers? The answer is usually given in trillions of dollars, and the implications of such figures are difficult for most people to comprehend. These calculations also generally reflect only legacy liabilities — what would be owed if pensions were frozen today. Yet with each passing day, the problem grows as states fail to set aside sufficient funds to cover the benefits public employees are earning.

    In a recent paper, we bring the problem closer to home. We studied how much additional money would have to be devoted annually to state and local pension systems to achieve full funding in 30 years, a standard period over which governments target fully funded pensions. Or, to put a finer point on it, we researched: How much will your taxes have to increase?

    Robert Novy-Marx is an assistant professor of finance at the University of Rochester’s Simon Graduate School of Business. Joshua Rauh is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.

    "The Revenue Demands of Public Employee Pension Promises," by Robert Novy-Marx and Joshua D. Rauh, SSRN, September 16, 2012 ---
    http://papers.ssrn.com/SOL3/PAPERS.CFM?ABSTRACT_ID=1973668

    We calculate increases in contributions required to achieve full funding of state and local pension systems in the U.S. over 30 years. Without policy changes, contributions would have to increase by 2.5 times, reaching 14.1% of the total own-revenue generated by state and local governments. This represents a tax increase of $1,385 per household per year, around half of which goes to pay down legacy liabilities while half funds the cost of new promises. We examine sensitivity to asset return assumptions, wage correlations, the treatment of workers not currently in Social Security, and endogenous geographical shifts

    Bob Jensen's threads on underfunded pensions and bad accounting rules ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    "Public Sector Pensions: 'Their Accounting Makes Enron Look Good'," Knowledge@Wharton, September 26, 2012 ---
    http://knowledge.wharton.upenn.edu/article.cfm?articleid=3080

    The growing debt crisis in public sector pensions -- governments face a $757 billion shortfall in funding their retirement promises, according to one estimate -- is coming at a time when unprecedented numbers of baby boomers are reaching retirement age. About 10,000 members of that generation are turning 65 every day, according to the Pew Research Data Center.

    In better-funded pension plans, the slew of retirements is a blip on the radar, a demographic shift that was foreseen decades earlier and properly funded. But in shakier systems, the retirements are being met with cuts to benefits across the board -- for new employees, current workers and retirees alike -- benefits that were once considered cast in stone. A generation of workers is now wondering if their pensions will still be able to pump out the funds they need to pay the bills in retirement.

    "That's a very common worry, and it's wholly justified," says Olivia Mitchell, a professor of business economics and public policy, and executive director of Wharton's Pension Research Council. "I think the whole prospect of retirement has grown much riskier than for those in previous generations. Employer-provided retiree medical plans are being cut; Medicare as we know it is facing insolvency. People hoped to retire on their little bit of savings that now is paying no interest, and Social Security is in bad shape. Homes aren't worth what people thought they would be, so nest eggs are a lot tinier.... It's not a very pretty picture for a lot of people."

    Distributing the Pain

    In defined benefit pension plans, retirees are paid a fixed monthly amount every month until they die. Often the payments are subject to cost-of-living raises, and most plans include a survivor's benefit if the employee's spouse outlives him or her.

    A defined contribution plan, like a 401(k), shifts the retirement risk to the employee. Employers allow workers to contribute a percentage of their salaries to the plan, and often match the contributions up to a certain threshold. The plans are more portable than pensions, allowing workers to move their investments as they switch jobs, but it is up to the workers to save, manage their investments and then make sure their nest eggs are sufficient for their retirement years.

    Defined benefit pensions are generally confined to the government sector now, as most private sector employers long ago abandoned them for defined contribution plans. But many state governments are currently facing pension funding obligations that are forcing lawmakers to consider making changes. The rule -- sometimes unwritten and at other times constitutionally codified -- had been that pension plan changes are limited to those who have not been hired yet, or to employees who are early in their public sector tenures.

    "You don't like to change the rules of the game for those who don't really have the ability to adjust. It's particularly painful to make changes to people who are in retirement already or approaching retirement," says Alicia Munnell, professor of management sciences at Boston College's Carroll School of Management and director of the school's Center for Retirement Research. "It is a worrisome thing to do."

    But that's exactly what happened in Rhode Island. In 2011, the state created a defined contribution system similar to a 401(k) plan and forced all its current employees to enter into a system that blended the two plans together. Cost-of-living raises for retirees were also suspended for five years.

    In other states, retiree costs are being managed by creating new, cheaper pension plans for new employees. In some cases, premiums are being driven up for retiree health care, which is generally not given the same protection as pensions.

    But the Rhode Island reforms -- which are being challenged in court -- are seen as a template for other cash-strapped states to model, giving rise to more fears that pension systems may not be as unshakable as once thought. "Any change will hurt," Munnell says. "If you were counting on your pension and the value is reduced, it can be a painful adjustment."

    Munnell also notes that the math in Rhode Island allowed for few options. By Pew Center estimates, the state had only 49 cents on hand for every dollar owed to its retirees in 2010. In some cities, the shortfall was even deeper. "The funding situation was so serious that if something wasn't done with pensions, all the money would go there," Munnell notes. "You wouldn't be able to have things like libraries or buses. When it gets that dire, you have to distribute the pain broadly. It's not fair in some sense to take away existing benefits, but when you're really suffering, you have to do things you wouldn't normally."

    Worse than Enron?

    The decisions that led to today's crossroads began decades ago.

    For most plans, a secure funding model with relatively low risk was never adopted, according to Kent Smetters, professor of business economics and public policy at Wharton. Instead, politicians allowed the funds to broaden their investment policies beyond government-backed bonds and at first dabble, then fully immerse themselves in, the stock market and progressively riskier investment vehicles.

    That allowed the plans to expand their retirement benefits while, at least on paper, requiring no more funding from the governments whose workers they served.

    Smetters argues that the most grievous pension funding error over the years has been assuming an unrealistically high discount rate, or the rate at which funds can discount their future liabilities. Also referred to as a fund's annual rate of return on its investments, most funds assume a 7.5% return on the low end and 8.5% on the high end. Many economists argue the fund liabilities should be discounted at a rate closer to 3% or 4%.

    Those assumptions open the funds up to higher levels of investment risk and dramatically understate the liabilities owed. According to the Center for Retirement Research at Boston College, public pension plans have on hand about 76 cents for every dollar they owe retirees. Under more conservative accounting standards proposed by the Government Accounting Standards Board -- an independent, seven-member nonprofit board that sets generally accepted accounting principles for the public sector -- that figure could drop to 57 cents on the dollar.

    "State and local pensions are not covered under any reasonable accounting standards," Smetters says. "Their accounting makes Enron look pretty good."

    Continued in article

    The Sad State of Government (Governmental) Accounting and Accountability ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    "A Downgrade for Illinois The worst credit rating aside from California," The Wall Street Journal, August 29, 2012 ---
    |http://professional.wsj.com/article/SB10000872396390443409904577619800234602824.html?mg=reno64-wsj#mod=djemEditorialPage_t

    "Illinois Debt Cut by S&P After No Action on Pension Funding," by Michelle Kaske, Bloomberg News, August 29, 2012 ---
    http://www.bloomberg.com/news/2012-08-29/illinois-debt-cut-by-s-p-after-lack-of-action-on-pension-funding.html

    Illinois, the U.S. state with the worst-funded pension system, had the rating on its general- obligation debt cut one level by Standard & Poor’s and may face more downgrades.

    The change to an A rating followed state lawmakers’ failure to agree to reduce retirement costs during a special session Aug. 17. The outlook for the state’s debt, which now has S&P’s sixth-highest grade, is negative. California, with an A-ranking, one level below Illinois, remains S&P’s lowest-rated state.

    Illinois has an unfunded pension liability of at least $83 billion, according to state figures. It had 45 percent of what it needed to pay future retiree obligations as of 2010, the lowest among U.S. states, data compiled by Bloomberg show.

    “The downgrade reflects the state’s weak pension funding levels and lack of action on reform measures intended to improve funding levels and diminish cost pressures associated with annual contributions,” said Robin Prunty, an S&P analyst, in a report today.

    Governor Pat Quinn said today he is inviting legislative leaders to meet in early September to work on pension changes. Lawmakers have considered boosting employee contributions, passing some costs to local school districts and forcing workers to choose between the current system and receiving free retirement health care. No Surprise

    Quinn, a Democrat, said the rating cut wasn’t a surprise.

    Erasing the fifth-most populous state’s unfunded pension liability “is vital to getting our financial house in order,” Quinn said in a statement. “Today’s action by Standard & Poor’ is more evidence that we must act.”

    Illinois had about $28 billion of general-obligation debt as of May 8, according to bond documents. The state of about 13 million people plans to sell $50 million of debt next month for technology projects, John Sinsheimer, the state’s director of capital markets, said in an interview.

    Taxpayers will pay more to issue debt because of the lower rating, state Treasurer Dan Rutherford said in a statement.

    “I urge the legislature to act decisively towards comprehensive, constitutional and fair pension reforms that will reverse this situation,” he said.

    Jensen Comment
    Unlike California, Illinois significantly increased corporate tax rates to deal with its deficit. But this turned into a sham when Gov. Quinn commenced to grant tax waivers to business firms (like Caterpillar) that threatened to relocate in other states.

    In my opinion, however, Illinois stands a much better chance than California --- which by most accounts is a basket case.

    Bob Jensen's threads on pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions


    "WHAT IS PENSION EXPENSE, REALLY? THE CASE OF WEYERHAEUSER," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants Blog, September 17, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/759

    As you may recall, we previously discussed problems in government pension accounting (see California Budget Woes and Chimerical Pension Beliefs: GASB Could Help if it Had the Will”).  In this essay we turn our attention to corporate pension accounting, pension expense specifically, using Weyerhaeuser disclosures as an example.

    Let’s begin with a brief review of the FASB’s pension rules in ASR 715.  The firm reports pension assets and liabilities in the balance sheet, netted.  The entity’s pension assets can include cash, investments, and any other assets that are in the pension plan, and these are valued at fair value.  The firm also measures its liability, the projected benefit obligation (PBO), which equals the present value of the estimated pension cash outflows to retirees, which these former employees have already earned.  The pension assets and liabilities are then netted against each other, yielding what we actually see on the balance sheet. If assets exceed liabilities, the net amount is displayed in the asset section of the balance sheet.  If the liabilities are greater, the net amount is shown in corporate liabilities.

    In the income statement, the firm reports pension expense, a complex amalgam quite different from pension contributions.  GAAP pension expense is defined as the period service cost (increase in PBO), plus the period’s interest on the PBO, minus the expected (not actual) return on the plan assets, less any amortization of prior service cost, and finally, plus or minus any amortization of pension gains and losses.  And as we would expect from our accounting standard-setters, some items bypass the income statement: prior service costs and pension gains and losses.  These two items are shown in the shareholders’ equity section of the balance sheet, in accumulated other comprehensive income (loss).  Given the complexity of the FASB’s rules, the financial statements are supplemented with an ever increasing myriad of footnote disclosures that describe various details and assumptions so the reader can “better” assess the company’s pension position.

    While one can do a lot of analysis when it comes to pension expense, our focus is on the interest cost and the expected return on pension assets components. These two items warrant particular scrutiny given management’s considerable discretion in their measurement, and because changes in their measurements can have major effects on the bottom line and on reported liabilities.

    The following analysis relies in part on a very good study written by Nick Gibbons, an analyst at Gradient AnalyticsThe study is entitled “Pension Issue Commentary #4,” and was published on June 21, 2012.  Last year’s report may be found at http://www.earningsquality.com/commentary.do?action=View.

    As stated before, the PBO is the present value of estimated future retiree cash outflows discounted at some appropriate rate, and the interest cost component of pension expense is that same assumed rate multiplied by the beginning-of-the-year value of the PBO.  Both items depend on the assumed rate that is used.  Not surprisingly, higher rates will lower the PBO liability, but increase the interest charge, and related pension expense.

    From Weyerhaeuser’s 2011 10-K footnote 8, one sees that the firm applies a discount rate of 4.5% and obtains a PBO of $5,841 (all dollar amounts in millions).  (The 4.5% rate is for U.S. plans, while the rate for Canadian plans is 4.9%).  In his study, Gibbons created a sample of 354 companies, analyzed their 2011 pension disclosures, and found a median discount rate of 4.75%. So, given the proximity of Weyerhaeuser’s discount rate to the median rate, we are somewhat comfortable with Weyerhaeuser’s choice.

    However, if one is uncomfortable with a company’s assumed rate, or if one desires to do a sensitivity analysis, there is an easy tack to employ.  Given that pension payouts already earned extend several decades into the future, one can assume the debt is a perpetuity, a stream of cash payments that continues forever.  Since the present value interest factors get pretty small 20 years out, and further, the error should be relatively small.  Then the value of an “adjusted” PBO would equal the reported PBO times the reported rate divided by the “adjusted” rate believed to be more realistic.

    For example, let’s say we question the reasonableness of Weyerhaeuser’s rate…let’s say we think it really should be 3.5%.  What happens?  Well, the PBO soars by almost 28.6% to $7,510:

     (($5,841 X 4.5%) ÷ 3.5%) = $7,510

     Conversely, if we believe that the “adjusted” rate should be 5.5%, the PBO liability drops 18.2% to $4,779.

    (($5,841 X 4.5%) ÷ 5.5%) = $4,779

     And if the “adjusted” rate is assumed to be 4.75% (to standardize everybody’s rate and increase comparability given Gibbons’ study), the PBO value is $5,533.  A change of merely one quarter of one percent decreases the liability by $308, a change of 5.3%.

    (($5,841 X 4.5%) ÷ 4.75%) = $5,533

     These examples demonstrate the impact of the discount rate on the projected benefit obligation and on the pension expense.  Given how easily managers can manipulate reported pension liabilities, such a sensitivity analysis is an important aspect of pension analysis.

    The second big assumption that managers may not be able to resist “tinkering” with is the expected rate of return on the pension assets.  Allegedly, the FASB employs the expected rate of return (rather than the actual rate of return) to try to supply a long-term perspective and smooth the pension costs.

    Continued in article


    "Pension Accounting for Dummies New government reporting rules are no better than the old ones," The Wall Street Journal, July 9, 2012 ---
    http://professional.wsj.com/article/SB10001424052702304782404577488933765069576.html?mg=reno64-wsj#mod=djemEditorialPage_t

    The Government Accounting Standards Board has issued new rules that aim to crystallize government pension liabilities. It failed on that count, but it did succeed, albeit inadvertently, in making the case for defined-contribution plans.

    GASB, as it's known in the trade, sets accounting guidelines for local governments. Since the board is run mainly by former public officials, its standards are often low. The board also usually takes several years to finalize rules, so it's often behind the times. Their new rules concerning how governments discount their pension liabilities are a case in point.

    Financial economists have recommended for decades that governments calculate pension liabilities using so-called "risk-free" rates pegged to high-grade municipal bonds or long-term Treasurys. The argument goes that since pensioners are de facto secured creditors—even bankruptcy judges have been reluctant to slash retirement benefits—pensions are riskless and therefore the liabilities should be discounted at risk-free rates.

    GASB's private cousin, the Financial Accounting Standards Board (FASB), began requiring corporations to discount their pension liabilities with high-quality fixed income assets in the 1980s. However, GASB let governments stick with their desired, er, expected rate of return, which is typically about 8%. Public pension funds have returned 5.7% on average since 2000. Achieving much higher returns over the long run would require markets to perform as well as they did in the 1980s and '90s. Would that be true.

    Governments have resisted climbing down from Fantasyland because using lower discount rates would explode their liabilities. When the Financial Accounting Standards Board introduced its risk-free rate guidelines, many companies shifted workers to 401(k)s because they didn't want to report larger liabilities. Such defined-contribution plans are by definition 100% pre-funded.

    Prodded by economists and investors, GASB began considering modifying its discount rate rules a few years ago. Public pension funds, lawmakers and unions, however, pushed back hard against suggestions that governments use risk-free rates, which could more than double their liabilities. No surprise, the government troika won.

    GASB's new rules allow governments to continue discounting their liabilities at their anticipated rate of return so long as they project enough future assets to cover their obligations. At the time they forecast they'll run out of assets, they must begin discounting their liabilities with a high-grade municipal bond rate. The idea is that governments would have to issue bonds to pay retirees when their pension funds go broke.

    But few pension funds project that they'll run dry since they're hooked up to a taxpayer IV. Those in really bad shape like Chicago's will likely rig their investment and actuarial assumptions to circumvent the new rules. FASB rejected similar guidelines in the 1980s because they were too easy to dodge. The point here is that it's impossible to get governments to come clean about their pension debt, and not just because the union allies controlling pension funds have a vested interest in obfuscating the liabilities.

    In reality, nobody knows how much taxpayers will owe because so much depends on inscrutable actuarial and economic factors like interest rates 30 years from now (not even the Federal Reserve purports to be that omniscient). Slight discrepancies in assumptions can yield huge variations in estimated liabilities. One advantage of defined-contribution plans is that they don't require governments to calculate their liabilities. There are none.

     

    GASB Statement No. 68
    Accounting and Financial Reporting for Pensions—an amendment of GASB Statement No. 27
    --- Click Here
    http://www.gasb.org/cs/ContentServer?site=GASB&c=Page&pagename=GASB%2FPage%2FGASBSectionPage&cid=1176160042391 Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    IBM Makes Significant Changes to Its Retirement Plan
    "Benefits Leader Reins In 401(k)s," by Kelly, Greene, The Wall Street Journal, December 6, 2012 --- Click Here
    http://professional.wsj.com/article/SB10001424127887323316804578163722900112526.html?mod=WSJ__LEFTTopStories&mg=reno64-wsj 

    International Business Machines Corp., IBM +0.56% a bellwether for employee benefits, is overhauling its retirement program to contribute once a year to employee 401(k) accounts in a lump-sum payment.

    Starting next year, IBM's contributions, which generally range from 6% to 10% of pay, will take place Dec. 31. Workers who leave the company before Dec. 15 won't qualify for the match, unless they retire.

    IBM's switch is the latest in a series of moves big companies have been making to rein in retirement-plan expenses in recent years—and the financial implications for employees could be significant.

    Many U.S. companies cut their 401(k) match in 2009 during the economic slowdown, and some of them have only partially restored it. In 2011, 7% of employers made no contributions at all to their plans, up from 2% in 2001, according to benefits consultant Aon AON +0.28% Hewitt.

    Benefits experts say IBM's shift could start a trend among other large employers. Earlier this year Ford Motor Co. F -0.62% said it would offer retirees a lump-sum payout to offset its pension obligations. General Motors Co. GM -1.72% and about a dozen other companies quickly followed suit, according to the Pension Rights Center, a Washington, D.C., advocacy group.

    For IBM, the latest move could help save millions of dollars a year in compensation expenses, and keep valued workers who want to ensure they receive the match more tethered to their jobs—at least until the end of a given year.

    In 2011, it paid $875 million in matching and automatic contributions.

    The change "reflects our continuing commitment to invest in our employee 401(k) plans while maintaining business competitiveness in a challenging economic environment," IBM spokesman Douglas Shelton said in a statement.

    Financial planners say the lump-sum contributions undermine one big advantage of 401(k) plans: "dollar-cost averaging," in which investors are buying stock and bonds at multiple prices over time, leveling out risk and return. It is a particular concern for older workers who are closer to retirement and have less time to make up for short-term losses, said Jason Chepenik, a certified financial planner and retirement-plan consultant in Winter Park, Fla.

    Some IBM employees are unhappy.

    "It's a huge change," said Andy Maher, a 59-year-old IBM customer engineer in Victorville, Calif. Mr. Maher, who started at the company in 1976, was an early adopter in the company's retirement offerings, eventually increasing his savings to 12% of pretax pay while raising five children.

    Now, he said, he is concerned that "you lose a whole year's worth of interest on that money. And if they lay you off Dec. 1, you don't get anything. It adds a whole other level of unnecessary uncertainty."

    All told, about 9% of employers pay out their 401(k) match once a year, according to Aon Hewitt. But most of those employers have older plans that never switched to regular matches, said Alison Borland, vice president of retirement solutions and strategies at Aon Hewitt.

    What is more, annual matches frequently are tied to a company's profits, with workers getting a larger percentage when a company does well and less when business wanes, said Brigitte Madrian, a professor of public policy and corporate management at Harvard University's Kennedy School of Government.

    Ms. Madrian added that Labor Department and U.S. Treasury officials "could be very interested in [IBM's move] and if they're concerned about it, they could say, 'You can't do that.' " She said the agencies could devise rules precluding IBM and other companies from depriving employees who leave before a set date of their matching contributions.

    For now, the risk for employees in 401(k) plans is that other companies will follow IBM's lead.

    IBM, of Armonk, N.Y., fully replaced its traditional pension with its 401(k) program in 2008, and was praised for designing a plan with low fees, access to financial planners and generous company contributions.

    When companies are looking for ways to cut the cost of their benefits, shifting to an annual match is often an idea that consultants suggest, though it is "unusual for a company to make this move," Ms. Borland said.

    "When a large organization like IBM makes the change, others are going to watch and see, and if they're struggling with the same issues from a cost-pressure perspective, and they are, it wouldn't surprise me if other companies followed suit," she added.

    In focus groups, Charles Schwab Corp. SCHW +1.01% has found that 401(k) participants view the match as the "canary in the coal mine," said Dave Gray, Schwab's vice president of 401(k) client experience.

    Continued in article

     


    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


    "CALIFORNIA BUDGET WOES AND CHIMERICAL PENSION BELIEFS: GASB COULD HELP IF IT HAD THE WILL," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 2, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/708#more-708

    Ed Ketz writes about those "idiots in California"
    "Whither Berkeley? Whither California?" by J. Edward Ketz, SmartPros, November 2009 ---
    http://accounting.smartpros.com/x68185.xml

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    Rosy Scenario:  Forecasted Returns on Pension Assets
    From The Wall Street Journal Weekly Accounting Review on June 29, 2012

    Illinois Pension Fund May Cut Return Target
    by: Michael Corkery
    Jun 28, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Pension Accounting

    SUMMARY: The article describes the Teachers' Retirement System of the State of Illinois as "bullish" given its continuing use of 8.5% for its estimated return on plan assets. The plan's Executive Director, Dick Ingram, "sent a confidential memo to the pension fund's board that later became public, warning that the state's unfunded pension liability was 'practically unmanageable'."

    CLASSROOM APPLICATION: The article brings to light the judgment involved in establishing expected rates of return; further, it emphasizes the human resource implications of those issues in pension accounting and funded status.

    QUESTIONS: 
    1. (Introductory) In the opening line of the article, how does the author describe the Teachers' Retirement System of the State of Illinois?

    2. (Introductory) Based on the description in the article, how much judgment is involved in determining the expected rate of return on pension plan assets?

    3. (Introductory) Review the graphic entitled "Off Target?" and summarize in one or two sentences what is shown.

    4. (Advanced) In general, what is the impact of the expected rate of return on pension plan calculations and accounting?

    5. (Advanced) What will be the impact on the estimated financial status of the Illinois Teachers' Retirement System from this change in expected rate of return?

    6. (Advanced) What are the human resource issues that come from the concerns expressed about the Illinois Teachers' Retirement System?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Illinois Pension Fund May Cut Return Targe," by Michael Corkery," The Wall Street Journal, June 28, 2012 ---
    http://professional.wsj.com/article/SB10001424052702303561504577492920356668852.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    One of the most bullish state pension funds is finally acknowledging that its expectations of earning consistently high returns on its investments may be unrealistic.

    In another sign of the grim realities gripping pension funds around the U.S., the Teachers' Retirement System of the State of Illinois may lower the rate of return it expects to earn every year on its $37 billion portfolio, according to its chief.

    The rate, which has been 8.5% for the past 25 years, is one of the highest among U.S. state pension funds.

    However, Dick Ingram, executive director of the fund, said in an interview that may soon change.

    "My guess is that [the rate of return] comes down," he said. "We are not immune from financial reality. We are looking at the same numbers as everyone else."

    Lowering the assumed return rate could increase liabilities at the fund serving 101,000 retired public-school employees by billions of dollars. The Illinois Teachers' Retirement System was 46% funded as of June 30, 2011.

    That means its assets as of that date covered just 46% of its long-term liabilities.

    State pension funds in Illinois are among the lowest funded in the U.S.

    Mr. Ingram said the challenging near-term outlook for returns on the pension fund's investments, which include stocks, bonds, hedge funds and private-equity funds, makes it possible that actuaries will recommend a cut in the annual-return target.

    The fund has returned on average 9.3% annually over the past 30 years.

    But over the past decade, it has failed to hit its annual return assumptions on average.

    "The question is whether that is a good number for the next 30 years," he said. "That is what we are wrestling with right now.''

    The change could come as early as August when the pension fund's board meets.

    Many large public-pension funds have bowed to the pressures of slow economic growth and volatile markets.

    Some of Illinois's other pension funds have lowered their return assumptions in recent years.

    Earlier this month, New Jersey officials approved lowering the assumed rates of return at the state's pension funds to 7.95% from 8.25%.

    Mr. Ingram, who took over the helm of the Illinois teachers fund in January 2011, has been sounding the alarm about the fund's long-term health in the past six months.

    He has been talking to teachers across Illinois about the possibility that under one scenario, the pension fund could run out of money by 2030.

    "My son is a 27-year-old teacher in New Hampshire,'' said Mr. Ingram, who used to run the Granite State's retirement system. "If he was a teacher in Illinois I couldn't tell him that he would be guaranteed to receive the pension he's been promised," he said.

    This "new reality,'' as Mr. Ingram called it, represents a change in tune for the pension director.

    During his first year on the job, Mr. Ingram and other officials at the fund blasted critics in letters to Illinois and national newspaper editors.

    One letter accused a critic of scaring teachers into thinking their pensions could be cut.

    But last fall, Mr. Ingram said he had a change of heart when he began studying the state's budget problems.

    He became persuaded that it was highly likely that the state at some point wouldn't be able to make its required payments to the pension plan.

    In February of this year, he sent a confidential memo to the pension fund's board that later became public, warning that the state's unfunded pension liability was "practically unmanageable."

    "I know teachers who think Dick Ingram should be fired,'' said Dan Montgomery, president of the Illinois Federation of Teachers, one of state's two large teacher unions.

    "There was a sense that he was singing a new tune that was leading down the path toward benefit cuts."

    Continued in article


    "New rules will decimate profits," by Steve Johnson, Financial Times, April 15, 2012 ---
    http://www.ft.com/intl/cms/s/0/b5acc0e6-84b1-11e1-b4f5-00144feab49a.html#axzz1sCTvYf00

    High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/b5acc0e6-84b1-11e1-b4f5-00144feab49a.html#ixzz1sEKqe1T3

    New accounting rules that will stop companies from padding their earnings statements with anticipated pension fund returns that may never materialise will slash hundreds of millions of euros from the profits of many European companies next year, according to Citi, the investment bank.

    A tightening of the International Accounting Standards Board’s IAS 19 directive from 2013 will bar companies from using the so-called “corridor rule”, which allows them to keep actuarial losses suffered by their final salary pension schemes off their balance sheets.

    High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/b5acc0e6-84b1-11e1-b4f5-00144feab49a.html#ixzz1sEKwjTDD

    Companies will also have to align the forecast rate of return from their pension fund assets with the discount rate used to value future liabilities in their profit and loss accounts.

    These factors will cut the annual pre-tax profits of companies such as Nestlé, Fiat, BT, Siemens, Philips, Credit Suisse, National Grid, BAE Systems, Michelin and Akzo Nobel by more than €100m, said Citi.

    The US bank foresaw a hit of €780m at Alcatel-Lucent, the French telecoms group, more than erasing consensus forecasts for a pre-tax profit of €509m in 2013/14. In the UK, transport companies exposed to the £20bn Railways Pension Scheme are among those seen as likely to be worst hit, with the rule changes seen cutting earnings by 28.8 per cent at FirstGroup, 19.3 per cent at Go-Ahead Group and 12.2 per cent at Stagecoach.

    Many of these companies set the expected rate of return on their pension fund assets 1-2 percentage points higher than their discount rate, which is the yield on high-quality corporate bonds. For Alcatel-Lucent and Fiat, which has a pension deficit larger than its market capitalisation, the gap is 2.5 points.

    “The current IAS 19 accounting requirement usually flatters the earnings of companies with large pension schemes,” said Neil Dawson, an analyst at Citi. “We do not think this accounting change has been widely factored into earnings forecasts at this stage.”

    Both KPMG and Aon Hewitt said the accounting change was likely to wipe around £10bn from the annual profits of companies in the UK, where pension funds’ equity holdings are a relatively high 40 per cent.

    “There will be a handful of companies that are heavily impacted because [their pension funds] are heavily invested in equities. There may be a few surprises, in terms of how much of the profit was coming from the pension scheme,” said Mike Smedley, partner at KPMG.

    Eric Steedman, senior international consultant at Towers Watson, added: “For the majority it will decrease earnings because they will no longer be able to allow, in the P&L, for an assumed outperformance of riskier assets,” although it will increase earnings for a minority of companies that largely hold government bonds in their schemes, he added.

    As a result the changes may accelerate the pension schemes’ ongoing switch out of equities and into lower risk assets.

    “If you can no longer have access to a higher expected return on assets because you have risk-seeking assets then you have less incentive to take risk,” said Deborah Cooper, partner at Mercer.

    However Ms Cooper believed the outlawing of the corridor approach would have more impact on the continent, where the technique is more prevalent.

    “In continental Europe they are more likely to have used a corridor approach. They will have to start to recognise immediately the entire effect on their balance sheet and that will be an ongoing volatility on their balance sheet that they did not have before.”

    Continued in article

     


    From The Wall Street Journal Accounting Weekly Review on March 9, 2012

    Next Pension Clash: Law Firms
    by: Jennifer Smith
    Mar 05, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Pension Accounting

    SUMMARY: "At some of the country's top [law] firms, younger lawyers will foot the bill for deluxe pension plans that could drag down their own earnings for years to come....Partners at some elite firms are often entitled to between 20% to 30% of their peak pay after retirement-in many cases, for life, according to partners and law firm consultants." These defined benefit pension plans are usually unfunded, "instead, most law firms with such plans pay the benefits as they go, using a portion of their current profits." Yet "...the corporate legal industry is finding it harder than ever to boost earnings....[and] firms are under mounting pressure to lower their billing rates."

    CLASSROOM APPLICATION: The article is useful to encourage students to think about pension plan obligations when those benefits are not funded, leading into a useful discussion about presentation of a plan with a funded status.

    QUESTIONS: 
    1. (Advanced) As stated in the article, the issues facing prestigious law firms "mirror the similar problems across the U.S." What has happened to pension plans at many U.S. companies?

    2. (Advanced) What does it mean to fund a pension plan and, in contrast, to "pay as you go"?

    3. (Introductory) "According to one estimate by law firm consultant Peter Giuliani, the current pension liability at a typical large New York firm with an unfunded plan could amount to $200 million, if the firm had to make the total payout today." How is such an amount calculated?

    4. (Advanced) Refer again to the estimate for law firms' obligation to pay future pension benefits. If you could view these law firms' financial statements, would this amount be included? If so, where? Explain your reasoning.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Next Pension Clash: Law Firms," by: Jennifer Smith, The Wall Street Journal, March 5, 2012 ---
    http://online.wsj.com/article/SB10001424052970204571404577258082978298056.html?mod=djem_jiewr_AC_domainid

    Retirement should be a happy time for a generation of baby boom-era lawyers near the end of their working lives. Less joy may await the partners they'll leave behind.

    At some of the country's top firms, younger lawyers will foot the bill for deluxe pension plans that could drag down their own earnings for years to come.

    These pensions are largely unfunded: there is no money saved to pay retirees. Instead, most law firms with such plans pay the benefits as they go, using a portion of their current profits.

    Partners at some elite firms are often entitled to between 20% to 30% of their peak pay after retirement—in many cases, for life, according to partners and law firm consultants. For the most profitable firms, that could mean payments of $400,000 to $600,000 a year per retired lawyer.

    Many law firms have moved to phase out unfunded pension plans. But those that haven't must pay them at a time when the corporate legal industry is finding it harder than ever to boost earnings. While law-firm profits are slowly improving after the recession, earnings have lagged behind previous years. Firms are under mounting pressure to lower their billing rates.

    Given those conditions, "it creates a significant burden on the younger partners," says Dan DiPietro, chairman of Citi Private Bank's law-firm group.

    The pension plans were devised decades earlier when life expectancy was lower and firms had fewer partners. That was before tax law changes in the 1980s made other retirement options more attractive for lawyers and law firms. But these pensions are still offered by a core slice of the most profitable law firms in the country, such as Gibson Dunn & Crutcher LLP and Davis Polk & Wardwell LLP.

    Few attorneys will complain as long as profits keep up. The trouble starts if payments to retirees grow faster than profits.

    "It's a real problem in this environment for a law firm to pay 10 or 15 cents out of every dollar of revenue to partners who have retired from the law firm," says a senior partner at one firm with a generous pension plan.

    Some managing partners at elite firms that still offer generous pensions say that such plans help build loyalty and retain top talent. "Partners take comfort in the fact that it is there. I think it's an important part of our culture," said Kenneth Doran, managing partner at Gibson Dunn & Crutcher.

    The pensions often come on top of other retirement programs, such as 401Ks, in which participants save for their retirement by putting away a portion of their earnings on a tax-deferred basis (often with a company match). Some firms also have profit-sharing plans.

    In its own way, the future liabilities for some top law firms mirror similar problems across the U.S. Benefits promised in more stable economic times seem increasingly unsustainable today. From General Motors Co. and AT&T Inc. to cash-strapped local governments employing public workers, pension liability is becoming a growing concern as the retiree pool swells.

    "It's the same thing you had with pensions in the private sector, where it was all defined benefits and companies were going bankrupt," says James Jones, a former managing partner at Arnold & Porter LLP who is now a senior fellow at Georgetown University's Center for the Study of the Legal Profession.

    Among law firms, hefty pension obligations also can jettison potential mergers or compound financial woes. For instance, some blamed the 2009 collapse of the Philadelphia firm Wolf, Block, Schorr & Solis-Cohen LLP—which followed a failed merger attempt in 2008—in part on its leadership's refusal to scale back their unfunded pension plan.

    At Gibson Dunn, partners who serve there for 20 years get a retirement benefit at age 60 that pays out 20% of their top compensation. At current profits, that could amount to $500,000 a year for eight years or life—whichever is longer. Surviving spouses would get the remaining benefit should a partner die before the eight years are up.

    Gibson Dunn reported record earnings in 2011, with gross revenue of $1.7 billion and average profit per partner at $2.47 million. Mr. Doran says his firm guards against burdening active partners with "runaway obligations" by capping pension payments at 6% of the firm's net income.

    Just how large such obligations loom is difficult to determine. U.S. law firms don't disclose financial details. Few lawyers feel comfortable discussing the subject of partner retirement benefits.

    Top firms with unfunded pensions include Cleary Gottlieb Steen & Hamilton LLP; Cravath, Swaine & Moore LLP; Debevoise & Plimpton LLP; Fried, Frank, Harris, Shriver & Jacobson LLP; and Milbank, Tweed, Hadley & McCloy LLP, according to data compiled by the American Lawyer magazine. Those firms declined to comment.

    According to one estimate by law firm consultant Peter Giuliani, the current pension liability at a typical large New York firm with an unfunded plan could amount to $200 million—if the firm had to make the total payout today.

    His calculations are based on a firm of 175 partners with an equity stake and average annual earnings of $2 million per partner, with about 20% of the partners near retirement age. The pension would pay out over two decades. That liability could be much higher at the most profitable firms, according to several people with knowledge of finances at some top law firms.

    Continued in article


    Fair Value Accounting Triples Pension Plan Deficits

    "Multiemployer Pension Plans May Be in Hot Water," by Vipal Monga, CFO Journal, March 30, 2012
    http://blogs.wsj.com/cfo/2012/03/30/multiemployer-pension-plans-may-be-in-hot-water/?mod=wsjpro_hps_cforeport

    "US union pensions hole deepens to $369bn," by Dan McCrum and Ajay Makan, Financial Times, April 8, 2012 ---
    http://www.ft.com/intl/cms/s/0/45dbbafe-7838-11e1-bffc-00144feab49a.html#axzz1rYrnhC2W

    The hole in the pension plans of US labour unions now stands at $369bn Credit Suisse has calculated with the aid of new reporting standards. This raises the prospect of higher pension contributions for employers and deteriorating industrial relations.

    Multi-employer pension schemes, managed by trade unions on behalf of members working for many different employers, are now just 52 per cent funded, the bank calculates with m ost of the burden to close this gap likely to fall on small and midsize companies.

    High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/0/45dbbafe-7838-11e1-bffc-00144feab49a.html#ixzz1rYt41s8G

    S&P 500 companies’ share of this obligation is estimated at just $43bn. However Credit Suisse identifies seven large companies in the S&P, including Safeway and UPS, where the pension liability is a significant proportion of their market capitalisation.

    There is also a “last man standing” risk for companies if other contributors to a fund fail. In 2007 it cost UPS $6.1bn to withdraw entirely from the Central States Pension Fund, capping its liability.

    More than 10m people are covered by such multi-employer schemes with contribution rates typically set by the collective bargaining agreements that cover pay, benefits and working conditions. Membership of these funds, and the businesses contributing to them, tend to be concentrated in industries with highly unionised workforces, such as construction, transport, retail and hospitality.

    The Financial Accounting Standards Board, which regulates reporting of US pensions, now requires companies to disclose more details about their involvement with such plans in their annual regulatory filings.

    Credit Suisse combined these with separate filings from over 1,350 multi-employer plans. “FASB provided the key to unlocking the door”, said David Zion, head of accounting research for the bank.

    Continued in article

    "Overpaid Public Workers: The Evidence Mounts Several new government studies make it harder for unions to deny the need for reform," By Andrew G. Biggs and Jason Richwine, The Wall Street Journal, April 10, 2012 ---
    http://online.wsj.com/article/SB10001424052702304724404577295502528869614.html#mod=djemEditorialPage_t

    . . .

    The Bureau of Economic Analysis has announced that, beginning in 2013, the National Income and Product Accounts of the United States will calculate defined-benefit pension liabilities—and the income flowing to employees in those plans—on an accrual basis that reflects the value of benefits promised, regardless of the contributions made by employers today.

    The bureau's reasoning is a 2009 research paper stating that "if the assets of a defined benefit plan are insufficient to pay promised benefits, the plan sponsor must cover the shortfall. This obligation represents an additional source of pension wealth for participants in an underfunded plan." At current interest rates, this adjustment would roughly double reported compensation paid through public pensions.

    The Congressional Budget Office endorsed a similar approach last month in a new report on federal employee compensation. The report—which congressional Democrats reportedly hoped would debunk our 2011 paper on federal pay—found that the federal retirement package of pensions plus retiree health care was 3.5 times more generous than private-sector plans, contributing to a 16% average federal compensation premium.

    Even more recently, an analysis by two Bureau of Labor Statistics economists, published in the winter 2012 Journal of Economic Perspectives, concluded that the salary and current benefits of state and local government employees nationwide are 10% and 21% higher, respectively, than private-sector employees doing similar work. This study didn't even factor in the market value of public-pension benefits, nor did it include the value of retiree health coverage.

    Basic fairness requires that public employees be paid for their skills at the same market rates as the taxpayers who fund their salaries and benefits. In some states accommodations have been struck, but in others further confrontation remains likely.

    Reformers will have more help in those battles ahead. Academic economists, the Federal Reserve, the Bureau of Economic Analysis, and the Congressional Budget Office have all thrown their weight behind proper pension valuation. It will now be that much harder for public-employee unions and their advocates to deny the obvious.


    "Companies' Pension Plea," by: Kristina Peterson, March 6, 2012 ---
    http://online.wsj.com/article/SB10001424052970204276304577261383973978306.html?mod=djem_jiewr_AC_domainid

    Business groups are urging Congress to let employers put less money into their pension funds, saying that exceptionally low interest rates are forcing them to set aside too much cash.

    A provision attached to the Senate highway bill would change the formula many large companies, including General Electric Co., Boeing Co. and Lockheed Martin Corp., must use to calculate how much to add to their pension funds, potentially shrinking their combined contributions by billions of dollars a year.

    Though its chances of becoming law aren't clear, the measure holds appeal in Congress because it would increase the government's near-term revenues, offsetting some of the costs of the highway bill. Setting aside less for pensions would leave companies with smaller tax deductions, requiring them to pay about $7.1 billion more in taxes over 10 years than under current law, according to Congress's Joint Committee on Taxation. [PENSIONS]

    The proposed change would apply to private-sector defined-benefit pension plans, which promise a specified amount of retirement pay. Though millions of Americans are covered by such plans, their prevalence has declined in past decades as companies have shifted to 401(k)s and other retirement plans that don't guarantee payouts.

    Labor unions are open to changing the contribution formula, but say that Congress shouldn't allow companies to underfund their pension plans, as has happened already in some cases.

    Companies with defined-benefit plans are required to use a "discount rate," based on a specific mix of corporate bond yields over the past two years, to help determine how much to contribute to their plans each year to meet their obligations. The rate varies by company.

    Since companies use the discount rate to calculate the present value of benefits it owes retired workers in the future, the lower the rate, the more the company must contribute to its plans. GE said in its annual report that its 2011 pension expenses rose by about $7.4 billion because its discount rate dropped to 4.2% at the end of 2011 from 5.3% at the end of 2010.

    GE didn't comment beyond the annual report.

    Business groups argue that the two-year window used in the current discount-rate formula is too narrow, leaving companies vulnerable to short-term swings in interest rates.

    The provision in the highway bill would extend the window, keeping the discount rate within 15% of an average of corporate bond rates over the preceding 10 years. A coalition including the U.S. Chamber of Commerce, National Association of Manufacturers, American Benefits Council and the ERISA Industry Committee is pushing to calculate the discount rate over a longer time period, keeping it within 10% of a 25-year average.

    Continued in article

    Question
    What do American Airlines pensions have to do with funding of the Iraq war?

    Answer
    Plenty, but who knows why?

    A pension measure tucked into last month’s Iraq war spending bill is causing some leading members of Congress to complain that American Airlines got a break worth almost $2 billion without proper scrutiny. The measure will allow American to greatly reduce its payments into its pension fund over the next 10 years. At the end of 2006, the fund had assets of $8.5 billion and needed an additional $2.5 billion to cover all its obligations. The new provision will allow American to recalculate those numbers, so that the shortfall disappears and the plan looks fully funded. Continental, along with a small number of regional airlines and a caterer, will also be able to take advantage of the provision. But American, the nation’s largest airline, is by far the biggest beneficiary, according to government calculations. Some lawmakers who would normally be involved in tax and pension measures say they were shut out of the process.
    Mary Williams Walsh, "Pension Relief for Airlines Faulted by Some Legislators," The New York Times, June 21, 2007 --- http://www.nytimes.com/2007/06/21/business/21pension.html?ref=business 

    Jensen Comment
    This was not enough to save AMR. American Airlines eventually declared bankruptcy in 2011.

    From The Wall Street Journal Accounting Weekly Review on March 9, 2012

    AMR Retreats on Terminating Pension Plans
    by: Susan Carey
    Mar 07, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Bankruptcy, Pension Accounting

    SUMMARY: This is the third in a series of articles this week on pension plans. "AMR Corp., which told employees at its American Airlines unit five weeks ago that it intended to terminate their four underfunded pension plans, reversed course Wednesday and said it has found a solution that would allow it to pursue a freeze of three of the plans." The article describes the unfunded status of the plans and the Pension Benefit Guaranty Corp. reaction to the company's plans.

    CLASSROOM APPLICATION: This article covers AMR Corp.'s unfunded pension plans and the company's planned action as it proceeds through bankruptcy court, again useful in covering pension accounting and reporting.

    QUESTIONS: 
    1. (Advanced) What is AMR Corp.? What event is this company currently going through?

    2. (Introductory) What is the funded status of AMR Corp.'s pension plans? Summarize this answer numerically, based on information in the article.

    3. (Introductory) How many pension plans does AMR Corp. have? What difference among these plans is leading the company to treat them differently?

    4. (Advanced) What is the Pension Benefit Guaranty Corp. (PBGC)?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "AMR Retreats on Terminating Pension Plans," by: Susan Carey, The Wall Street Journal, March 7, 2012 ---
    http://online.wsj.com/article/SB10001424052970204781804577267453176169244.html?mod=djem_jiewr_AC_domainid

    AMR Corp., which last month told employees at its American Airlines unit that it intended to terminate their four underfunded pension plans, reversed course Wednesday, saying it had found a solution that would let workers covered by three of the plans keep the benefits they have accrued so far.

    The company's decision to freeze, rather than terminate, the three plans could help the carrier win cost-saving concessions in negotiations with its unions, but it also will require AMR to seek an unspecified amount of new capital during its bankruptcy proceedings.

    The fourth pension plan, which covers American's pilots, is more problematic, the company said in letters to employees Wednesday. But AMR said it is committed to working with the pilots union, the Pension Benefit Guaranty Corp. and other creditors to find alternatives to terminating it.

    AMR filed for bankruptcy protection in late November and has identified $2 billion in annual cost-savings it says it must achieve as part of its reorganization. Of that sum, it is targeting $1.25 billion from employees. The new tack on pensions doesn't mean it will raise its employee cost-savings target, AMR said, but it adds to the urgency of winning those savings. without delay

    Jeff Brundage, American's senior vice president of human resources, said freezing the three plans would require AMR to seek out new capital, as part of its plan of reorganization, to cover the cost of funding the frozen plans and help reduce the pension liabilities it will continue to have on its balance sheet. Freezing the plans means management and nonunion employees, flight attendants and mechanics and ramp workers would retain the full value of the benefits they accrued before the freeze date.

    Enlarge Image AMR AMR Bloomberg News

    American's Jeff Brundage says the company's plan calls for new capital.

    Those defined-benefit plans, which promise a set level of payments, would then been succeeded by 401(k) plans, with employees managing their own investments and without guaranteed payouts.

    The pilots pension plan poses a thornier problem for the company because it allows pilots to elect a lump-sum pension payment when they retire.

    AMR is concerned that when it emerges from court restructuring, a potential mass exodus of pilots seeking to receive lump sums from a frozen plan would have "a severe, detrimental impact on our operations, and (that) is a risk the company simply cannot afford to take," Mr. Brundage said.

    More than half the carrier's 10,000 pilots are currently eligible to retire. "Unless we are able to address the lump-sum issue, a freeze scenario cannot even be considered." But the company will continue to look for options that would allow it to freeze the pilot's plan as well, he said.

    The PBGC, a government insurer of private-sector pension plans, has been urging AMR for the past three months to find a way to retain its pension plans and not dump them on the agency, leaving some workers and retirees to receive less than they would otherwise.

    On Wednesday, Josh Gotbaum, the PBGC's director, called American's new approach "great progress and good news." Bankruptcy forces tough choices, he said, "but that doesn't mean pensions must be sacrificed for companies to succeed." More

    Air France Faces Turbulent Turnaround

    The Middle Seat: The Cost of Leaving Devices on

    American's four plans cover 130,000 workers and retirees. The PBGC estimates the plans have assets of $8.3 billion to cover about $18.5 billion in benefits. If AMR terminated the plans with the assent of the bankruptcy judge, the PBGC would assume their assets and most of their liabilities and be responsible for paying benefits to American retirees. But the PBGC already has a record $26 billion deficit.

    American is hoping to get concessions in new labor contracts with its unions to achieve the targeted cost savings. Among the givebacks the company is seeking are an end to retiree medical benefits, the elimination of 13,000 jobs, closure of a maintenance base and increased productivity from its workers through more hours flown per month and other measures. The negotiations haven't gone well, leading to finger pointing on both sides.

    The Fort Worth, Texas, company has criticized its unions for dawdling, and the unions have complained that the company isn't negotiating in good faith. If they can't agree, American has said it will make a case in bankruptcy court that its current labor agreements be abrogated so the company can impose the new terms on its unionized workers.

    Mr. Brundage said Wednesday that the change in the pension strategy "would remove a major obstacle to reaching consensual agreements and help to spark needed urgency at the bargaining table." He said the company and the Transport Workers Union, which faces the potential for 9,000 job cuts, already have reached tentative agreement on a pension freeze. The executive said AMR hopes for a similar outcome with flight attendants.

    The TWU "drew a line in the sand" and said a pension termination was "totally unacceptable," said James C. Little, international president of the union. The TWU proposed a pension freeze instead, and AMR agreed to drop its demand for an additional $600 million to $800 million in concessions, he said, which the company claimed was the cost of a pension-plan freeze.

    Continued in article

    Bob Jensen's threads on pension and post-retirement accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     

     

     


    IASB introduces improvements to the accounting for post-employment benefits, June 16, 2011 ---
    http://www.ifrs.org/News/Press+Releases/IAS+19+June+2011.htm

    Jensen Comment
    Recall that it was FAS 106 that broke new ground in the booking of post-unemployment benefits other than pensions. Before FAS 106, companies that had made lifetime medical insurance coverage and other retirement promises to employees and their spouses often did not even know internally what the magnitude of the liabilities and, accordingly, did not book these liabilities on the balance sheet or even disclose them in footnotes.

    It was a real shock to management to discover the magnitude of these obligations as well as a shock to Debt/Equity ratios when these obligations were at last booked under FAS 106 mandates.


    From The Wall Street Journal Accounting Weekly Review on April 9, 2010

    AT&T Fights Pension Suit
    by: Ellen E. Schultz
    Apr 07, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Contingent Liabilities, Legal Liability, Pension Accounting

    SUMMARY: AT&T changed its defined benefit pension plan to a cash balance plan in 1998. A long-running case by 24,000 current and former employees seeks one of the largest potential claims in pension litigation based on these plaintiffs' argument that AT&T discriminated against older workers upon implementing this change. The focus of the accounting question at hand now is not pension accounting but disclosure of the contingent liability, or lack thereof, by AT&T. "Last May, the Securities and Exchange Commission asked AT&T why it hadn't disclosed its potential exposure in the pension case." Legal papers filed Monday in federal court in Newark, N.J., include the first publicly disclosed estimate for potential damages.

    CLASSROOM APPLICATION: Accounting and disclosure requirements for contingent liabilities, in this case a lawsuit related to pension plan benefits, can be covered with this article.

    QUESTIONS: 
    1. (Introductory) What is a defined benefit pension plan? What is a cash balance plan?

    2. (Introductory) According to the article, what improper action does the lawsuit claim that AT&T committed against current and former employees when it changed to a cash balance pension plan?

    3. (Advanced) Even if AT&T loses this case, the company "...would face no cash impact for the $2.3 billion pension portion of the claim" according to the article. Does this mean that there would be no financial statement impact from this lawsuit? Explain.

    4. (Introductory) How did AT&T respond when the SEC "...asked why it hadn't disclosed its potential exposure in the pension case"?

    5. (Advanced) What are the requirements in accounting for and disclosure of contingent liabilities from lawsuits? What do you think must be the basis for AT&T's response to the SEC? In your answer, comment on the fact that Monday's legal filing included "the first publicly disclosed estimate for potential damages."

    6. (Advanced) Access AT&T's annual report for 2009 filed with the SEC on 2/25/2010. The interactive form of the filing is available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=732717&accession_number=0000732717-10-000013 Alternatively, click on the live link to AT&T in the online article, click on SEC Filings on the left hand side of the page, scroll to the filing on 2/25/2010 (at least one page back) and click on the interactive data link. Review the disclosures under Note 11 and Note 15. Does your review confirm your answer to the question above? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "AT&T Fights Pension Suit," by: Ellen E. Schultz, The Wall Street Journal, April 6, 2010 ---
    http://www.wsjsmartkit.com/wsj_redirect.asp?key=AC20100408-01&mod=djem_jiewr_AC_domainid

    AT&T Inc. is seeking to dismiss a long-running pension case alleging age discrimination that seeks $2.3 billion in damages, according to documents filed this week in a federal court.

    The suit alleges a 1998 pension change effectively froze the pensions of 40,000 older management employees at AT&T, in some cases for years, but not those of younger employees. AT&T said the pension didn't discriminate against older workers.

    "We believe the conversion to our cash balance plan was appropriate and in accordance with all legal obligations," said AT&T spokesman Mark Siegel. "We believe our filing speaks for itself in explaining why we have no additional liabilities to these retirees."

    The suit, filed in 1998, has received little attention despite the number of plaintiffs—24,000 current and former employees—and the size of the potential damages, one of the largest ever in pension litigation. Legal papers filed Monday in federal court in Newark, N.J., include the first publicly disclosed estimate for potential damages.

    The $2.3 billion potential claim dwarfs the well-publicized $1 billion noncash charge the company will take to reflect the recent loss of its deductions for health-care subsidies it receives from the government.

    Last May, the Securities and Exchange Commission asked AT&T why it hadn't disclosed its potential exposure in the pension case. AT&T responded that it didn't think the case met the reporting threshold for disclosure, SEC filings show.

    Pension cases typically are decided by judges, and there are no punitive damages. But because this case includes an age-discrimination claim, under federal law the judge could send it to a jury trial. If a jury found that the company willfully discriminated against older workers, it could award punitive damages that would double the size of the claim to $4.6 billion.

    However, if the case went to trial and the company lost, it would face no cash impact for the $2.3 billion pension portion of the claim. That is because the additional benefits to current and former management employees would be paid from the pension plan, which remains well-funded. In its motion for dismissal, AT&T is asking the judge to throw out the case without a jury trial.

    AT&T was one of dozens of big companies including International Business Machines Corp. and Xerox Corp. that changed their traditional pensions to "cash-balance" plans in the 1990s. The change saved companies money because instead of calculating benefits by multiplying years of service and salary—which produces rapid pension growth in later years—the companies converted the pension to a cash-out value. This "balance" would then grow at a flat annual rate, say 4% of pay.

    Among the plaintiffs in the case is Gerald Smit. In 1997, Mr. Smit was 47 and his pension was valued at $1,985 a month when he reached age 55, according to papers filed in the case. He continued to work at AT&T for eight more years, and when he retired in 2004, his pension was still worth $1,985 a month, according to court documents.

    Minutes of a 1997 meeting of AT&T's pension consultants, included in court documents, noted that "employees in 40s could lose, [and] have to wait 10 years for benefits." Company spreadsheets, which were among the exhibits submitted by plaintiffs, found that many would wait three to eight years to begin building a benefit. By contrast, the benefit would build "immediately for younger employees," according to the meeting minutes.

    AT&T doesn't dispute there were long waiting periods for benefits to build. But it said in court filings that the older workers' pensions were affected because the former pension plan included a formula that boosted benefit growth as employees approached age 55. AT&T calls this subsidy a "disparity," according to papers filed in the case, which "benefits older workers."

    Many companies established opening "account balances" for older employees that were lower than the cash-out amounts they had earned. For example, a worker might have earned a pension that, if converted to a lump sum, would be worth $150,000. But its opening account balance would be set at $100,000. The balance would be effectively frozen until the worker received enough annual credits over the years to restore it to $150,000. Only then would the pension begin to increase again

    The 2006 Pension Protection Act banned companies from freezing the benefits of older employees when it changes the formula, a practice called "wearaway." Not all cash-balance plans have wearaway; the plan covering AT&T union workers is among those that do not.

    Documents filed by the plaintiffs' experts estimate that the average loss to people over age 45 was $65,000. SEC filings show that under the 2004 severance plan for senior officers, the officers retained the right to "participate and recover damages or other relief in the case." The company spokesman declined to comment.

    "Pension Funding Is Up, but Shortfalls Remain Companies upped their pension contributions in 2009, but many plans face trouble ahead," by Alix Stuart - CFO.com, April 8, 2010 --- http://www.cfo.com/article.cfm/14489734/c_14490044?f=home_todayinfinance

    Most of the nation's largest pension plans kept themselves out of trouble last year, according to a recent analysis of 10-K filings by Towers Watson, but many still face substantial underfunding after the 2008 market meltdown.

    According to the analysis, aggregate pension contributions for the 100 largest plans nearly doubled last year, from $15.6 billion in 2008 to $30.8 billion in 2009. Those contributions, combined with an average 18% return on plan investments, helped push those plans to an average funding ratio of 81% at the end of last year, compared with 75% at year-end 2008. Only 17% of plan sponsors had funding ratios below 70%, compared with 41% the year earlier.

    "It looks like plan sponsors put in more than the minimum contributions, probably enough to avoid the benefit restriction provisions in the Pension Protection Act of 2006," notes Mark Ruloff, director of asset allocation for Towers Watson. Under the PPA, companies start to face restrictions on their funds, such as constraints on the ability to offer retirees lump-sum payouts, if their funding level dips below 80%. If their funding level falls below 60%, companies must stop accruing new benefits for the participants until the level improves.

    Liabilities also increased in 2009, due to lower discount rates used to calculate them. (The average discount rate last year was 5.92%, compared with 6.38% in 2008.) At year-end the largest plans had an aggregate deficit of $183.5 billion, compared with a deficit of $209.6 billion in 2008.

    Companies report that they expect to reduce their pension contributions by about one-third in 2010, according to the Towers Watson research, with a projected $19.6 billion earmarked for the plans. However, PPA requirements that plans be 100% funded will likely mean much higher cash outlays in 2011 and 2012.

    "We're looking at a doubling, tripling, or even quadrupling of contributions from already-high levels going into 2011 and 2012, absent something miraculous happening in the market," says Alan Glickstein, senior consultant at Towers Watson.

    Regulatory relief in the form of an extension to the seven years that companies currently have to make up funding shortfalls would also be a potential help. The Senate passed a bill earlier this month that would allow employers two options along those lines, but the House of Representatives has yet to act on it. Extending the time frame "would probably still result in higher contributions than in the past, but they would not rise as dramatically as they would otherwise," says Glickstein.

    An analysis of the asset mix of the largest pension sponsors showed only a slight shift away from equities, with the average target equity allocation at 52.8% for 2010, down from 55.1% in 2009. That's reflective of many large sponsors having already moved to a liability-driven strategy, in which assets are more heavily focused on fixed-income vehicles.

    Ruloff says he expects the trend away from equities toward fixed income to continue, as more companies freeze or close their plans and have less of a need for "excess returns to cover growing accruals." He is also urging companies to take a proactive approach to likely changes in pension-accounting rules that would increase the level of equity-related volatility that needs to be reflected in plan valuations.

    "The pace of change may be slower than what we've seen in recent years," he says, "but the shift away from equities could move at 5% a year for many years in the future."

    Bob Jensen's threads on accounting for intangibles and contingencies ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    Question
    How are Canadian university pension funds like U.S. entitlement programs (ignoring huge differences in scale)?

    Billions and Billions of Loonies
    "Canadian Universities' Growing Pension Deficits," Inside Higher Ed, February 15, 2012 ---
    http://www.insidehighered.com/quicktakes/2012/02/15/canadian-universities-growing-pension-deficits 

    Thirteen Canadian universities have seen their pension deficits grow from $680 million to $3.2 billion in the last three years, Financial Post reported. Some universities have responded to these trends by increasing employee contributions or changing retirement eligibility dates.

    Bob Jensen's threads on entitlements ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm


    Teaching Case on Pension Accounting Trends
    From The Wall Street Journal Weekly Accounting Review on March 11, 2011

     
    Rewriting Pension History
    by: Michael Rapoport
    Mar 09, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Changes and Error Corrections, Pension Accounting, Post Retirement Benefits

    SUMMARY: AT&T Inc., Verizon Communications Inc. and Honeywell International Inc. recently changed their longstanding pension accounting in which they smooth out gains and losses on pension assets over time. These companies now include all actuarial gains and losses in income (via pension expense calculations) as they occur; the article states that they are including all gains and losses on pension assets in income as they occur. The change in accounting principle is being handled in accordance with Accounting Standards Codification 250-10-05-2 which requires retrospective application whenever practicable. Retrospective application is defined in the codification glossary as the application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years. ASC 250-10-45-2(b) requires that a change in accounting principle be adopted only if "the entity can justify the use of an allowable alternative accounting principle on the basis that it is preferable."

    CLASSROOM APPLICATION: The article is useful when covering pension accounting and when covering accounting changes, typically in advanced financial reporting or MBA classes. **Note that answers to some questions are given in the summary so that faculty using this review may want to edit before distributing to students.

    QUESTIONS: 
    1. (Advanced) What is a defined benefit pension plan?

    2. (Advanced) What are the objectives in accounting for this type of pension plan? Cite your source for this answer from the Accounting Standards Codification.

    3. (Introductory) Summarize the accounting change for pension plans described in the article. In your answer, summarize how pension accounting "smoothes" large gains and losses generated by pension assets.

    4. (Advanced) Access the AT&T Form 10-K filing for 2010 made on March 1, 2011 and available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=732717&accession_number=0000732717-11-000014&xbrl_type=v Proceed to Pension and Post Retirement Benefits (Note 11) under Notes to Financial Statements and read the third paragraph which begins "in January 2011, we announced a change in our method of recognizing actuarial gains and losses..." Are actuarial gains and losses the same as gains and losses on plan assets? Do they impact pension calculations similarly? Explain your answers.

    5. (Introductory) How is this accounting change being reflected in these companies' financial statements? Why will this accounting change impact 2008 the most?

    6. (Advanced) What accounting standard codification section promulgates the requirements for the accounting described in this article? What requirement must be met for any company to undertake any change in accounting principle, including the pension change discussed in this article?

    7. (Advanced) Compare the statements in AT&T's pension footnote to the objectives of pension accounting you identified in answer to question 2. Clearly explain what you think is the basis for justifying this change in accounting principle.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Rewriting Pension History," by Michael Rapoport, The Wall Street Journal, March 9, 2011 ---
    http://online.wsj.com/article/SB10001424052748703662804576188843415326976.html?mod=djem_jiewr_AC_domainid

    Some big companies are changing how they account for their pension plans in a way that could make their earnings look better in coming years.

    AT&T Inc., Verizon Communications Inc. and Honeywell International Inc. recently ended a longstanding practice in which they "smooth" large gains and losses generated by pension assets into their financial results over a period of years. From now on, these companies will count all such gains and losses in the same year they are incurred.

    While the moves might seem like arcane accounting steps, they have important implications for investors. The companies say the changes will make their earnings reporting more transparent, but they also sweep away tens of billions in past pension losses the companies have yet to smooth into—and hurt—their results. By charging them against their earnings from 2008, when the losses were incurred, they are taking lumps for years that many investors may no longer care about.

    "They'll put the bad news behind them" said David Zion, an accounting analyst with Credit Suisse.

    Still, the accounting change will make it clearer to investors how pension plans' performance affects the companies' income statements, where it is factored into operating earnings. And the current rock-bottom interest rates make it a good time to make such a change. Any increases in rates could improve pension-plan performance, and clearing away the old losses will heighten the impact that better performance has on the companies' earnings.

    Under current accounting rules, companies with defined-benefit pension plans, which promise to pay specified amounts to retirees, have the option to take several years to spread the cost of large pension gains and losses into earnings. That means that when a plan's investment results are much better or worse than expected—as with the 2008 market downturn—it can have a significant effect on earnings for years.

    For that and other reasons, the system of accounting for pension results in earnings long has been widely criticized. The Financial Accounting Standards Board, the U.S. accounting rule maker, has examined the issue before but hasn't made any changes, though they may revisit it soon. AT&T, Verizon and Honeywell changed their accounting methods on their own initiative. While the details differ, all three said they would start recognizing some or all of their deferred losses in the year they occur, through a "mark-to-market" adjustment to fourth-quarter earnings to reflect their pension plan's returns for the year.

    All three assessed the bulk of the change's impact against 2008 earnings, the height of the market meltdown. AT&T, for example, said its 2008 pension costs would increase by $24.9 billion because of the change, compared to a $3 billion increase for 2010. The company reduced its 2008 earnings by $15.5 billion as a result, from a profit of $12.9 billion to a loss of $2.6 billion.

    An increase in interest rates could benefit the companies' pension plans if, as expected, they move higher. That is because pension obligations that may be paid out decades into the future are discounted back to their present value. When rates are low, there's less discounting, and the obligations stay relatively high. But when rates rise, the future obligations will be discounted more aggressively, moving their present value lower.

    That means a lower base on which the company has to pay interest costs, which could translate into lower pension costs, improved pension performance and better earnings.

    "Clearly the mark-to-market approach is preferable accounting," said Kathleen Winters, Honeywell's controller. But she acknowledged that "the low interest-rate environment made this a good time to do this."

    Continued in article


    How much of the OBSF blame falls on the accounting profession?

    "Public Pension Hygiene Act:  The first reform step is exposing the true size of the funding hole," The Wall Street Journal, January 22, 2011 ---
    http://online.wsj.com/article/SB10001424052748703791904576076223177494308.html#mod=djemEditorialPage_t

    We're so accustomed to misnamed legislation like the Employee Free Choice Act (card check) that it's hard to believe that a welcome proposal called the Public Employee Pension Transparency Act describes what it actually purports to do. To wit, prohibit public pension bailouts by the federal government and expose the $3.5 trillion of unfunded public pension liabilities that local and state governments have obscured.

    Most state and local governments currently use their own estimated rate of return on their investments to discount their liabilities. By projecting unrealistically high rates of return, states minimize their unfunded liabilities, at least on paper. Lower unfunded liabilities in turn allow them to reduce how much they and public employees must contribute to their pension funds. Inflated investment assumptions are one reason that public pension funds are unfunded to the tune of $3.5 trillion.

    Public pensions typically assume an 8% annual return on average, but over the past five years state pension funds with more than $5 billion in assets have earned only 4.5%. Taxpayers must make up the difference between what the funds earn and what they need to pay retirees. For Californians that is roughly $5 billion this year.

    Local taxpayers are already seeing their services whacked and taxes raised to fill these pension holes. University of California students will have to pony up 8% more next year for tuition to offset an expected $500 million in state budget cuts. Illinois residents will soon pay 67% more in income taxes, but taxpayers won't feel the full brunt for another decade when the funds begin running out of money. When Chicago's pension fund goes dry around 2019, over half of the city's revenue will be dedicated to pensions.

    In the 1950s and 1960s, many private employers obscured their liabilities the way governments are doing today, though they didn't have a public backstop. Many funds went broke. In 1974 Congress established minimum funding requirements and penalized companies that underfunded pensions. The law also required companies to report and discount their liabilities using a more conservative rate of return.

    These changes exploded liabilities and prompted many companies to switch from defined-benefit plans to defined-contribution plans like 401(k)s. While a majority of private workers now have defined-contribution plans, defined-benefit plans remain the norm in government.

    Enter the Public Employee Pension Transparency Act, which is sponsored by House Republicans Devin Nunes and Darrell Issa of California and Wisconsin's Paul Ryan. Their bill would encourage governments to switch to defined-contribution plans by revealing the true magnitude of their unfunded liabilities. States and municipalities would have to report their liabilities to the U.S. Treasury using their own rosy investment forecasts as well as a more realistic Treasury bond rate (to be determined by a formula).

    This data would make clear how much taxpayers potentially owe and increase pressure on lawmakers to fix their plans. For instance, Illinois estimated in 2009 that it had a roughly $85 billion unfunded liability. Using a Treasury discount rate, that unfunded liability balloons to $167 billion.

    Out of respect for state sovereignty, the federal government shouldn't and can't tell local governments how to run or fund their pensions. But the bill doesn't do so and it also doesn't force states to fund their plans using a lower discount rate. States don't even have to comply with the law, though they would forego their ability to sell federally subsidized, tax-exempt bonds if they don't.

    The bill may not persuade states like Illinois and California to revamp their pensions, but it will reveal how broken they are—and that's a start.

    Bob Jensen's threads on the sad state of government accounting and accountability ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     

    From The Wall Street Journal Accounting Weekly Review on July 10, 2009

    Public Pensions Cook the Books
    by Andrew G. Biggs
    The Wall Street Journal

    Jul 06, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Advanced Financial Accounting, Financial Accounting Standards Board, Governmental Accounting, Market-Value Approach, Pension Accounting

    SUMMARY: As Mr. Biggs, a resident scholar at the American Enterprise Institute, puts it, "public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods...these plans are underfunded nationally by around $310 billion. [But] the numbers are worse using market valuation methods...which discount benefit liabilities at lower interest rates...."

    CLASSROOM APPLICATION: Introducing the importance of interest rate assumptions, and the accounting itself, for pension plans can be accomplished with this article.

    QUESTIONS: 
    1. (Introductory) Summarize the accounting for pension plans, including the process for determining pension liabilities, the funded status of a pension plan, pension expense, the use of a discount rate, the use of an expected rate of return. You may base your answer on the process used by corporations rather than governmental entities.

    2. (Advanced) Based on the discussion in the article, what is the difference between accounting for pension plans by U.S. corporations following FASB requirements and governmental entities following GASB guidance?

    3. (Introductory) What did the administrators of the Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System include in their advertisements to hire new actuaries?

    4. (Advanced) What is the concern with using the "expected return" on plan assets as the rate to discount future benefits rather than using a low, risk free rate of return for this calculation? In your answer, comment on the author's statement that "future benefits are considered to be riskless" and the impact that assessment should have on the choice of a discount rate.

    5. (Advanced) What is the response by public pension officers regarding differences between their plans and those of corporate entities? How do they argue this leads to differences in required accounting? Do you agree or disagree with this position? Support your assessment.

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "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

    Here's a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don't want to raise contributions. Cutting benefits is out of the question. To be honest, you'd really rather not even admit there's a problem, lest taxpayers get upset.

    What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that's the essence of the managers' recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn't bother applying.

    Public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

    The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized. Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That's nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it's likely these gargantuan shortfalls will have to be borne by unsuspecting taxpayers.

    Some public pension administrators have a strategy, though: Keep taxpayers unsuspecting. The Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System declare in a recent solicitation for actuarial services that "If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration."

    Scott Miller, legal counsel of the Montana Public Employees Board, was more straightforward: "The point is we aren't interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory."

    While corporate pension funds are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, public employee pensions are not. However, financial economists are united in believing that market-based techniques for valuing private sector investments should also be applied to public pensions.

    Because the power of compound interest is so strong, discounting future benefit costs using a pension plan's high expected return rather than a low riskless return can significantly reduce the plan's measured funding shortfall. But it does so only by ignoring risk. The expected return implies only the "expectation" -- meaning, at least a 50% chance, not a guarantee -- that the plan's assets will be sufficient to meet its liabilities. But when future benefits are considered to be riskless by plan participants and have been ruled to be so by state courts, a 51% chance that the returns will actually be there when they are needed hardly constitutes full funding.

    Public pension administrators argue that government plans fundamentally differ from private sector pensions, since the government cannot go out of business. Even so, the only true advantage public pensions have over private plans is the ability to raise taxes. But as the Congressional Budget Office has pointed out in 2004, "The government does not have a capacity to bear risk on its own" -- rather, government merely redistributes risk between taxpayers and beneficiaries, present and future.

    Market valuation makes the costs of these potential tax increases explicit, while the public pension administrators' approach, which obscures the possibility that the investment returns won't achieve their goals, leaves taxpayers in the dark.

    For these reasons, the Public Interest Committee of the American Academy of Actuaries recently stated, "it is in the public interest for retirement plans to disclose consistent measures of the economic value of plan assets and liabilities in order to provide the benefits promised by plan sponsors."

    Nevertheless, the National Association of State Retirement Administrators, an umbrella group representing government employee pension funds, effectively wants other public plans to take the same low road that the two Montana plans want to take. It argues against reporting the market valuation of pension shortfalls. But the association's objections seem less against market valuation itself than against the fact that higher reported underfunding "could encourage public sector plan sponsors to abandon their traditional pension plans in lieu of defined contribution plans."

    The Government Accounting Standards Board, which sets guidelines for public pension reporting, does not currently call for reporting the market value of public pension liabilities. The board announced last year a review of its position regarding market valuation but says the review may not be completed until 2013.

    This is too long for state taxpayers to wait to find out how many trillions they owe.

    Bob Jensen's threads about fraud in government are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

     


    Question
    What do American Airlines pensions have to do with funding of the Iraq war?

    Answer
    Plenty, but who knows why?

    A pension measure tucked into last month’s Iraq war spending bill is causing some leading members of Congress to complain that American Airlines got a break worth almost $2 billion without proper scrutiny. The measure will allow American to greatly reduce its payments into its pension fund over the next 10 years. At the end of 2006, the fund had assets of $8.5 billion and needed an additional $2.5 billion to cover all its obligations. The new provision will allow American to recalculate those numbers, so that the shortfall disappears and the plan looks fully funded. Continental, along with a small number of regional airlines and a caterer, will also be able to take advantage of the provision. But American, the nation’s largest airline, is by far the biggest beneficiary, according to government calculations. Some lawmakers who would normally be involved in tax and pension measures say they were shut out of the process.
    Mary Williams Walsh, "Pension Relief for Airlines Faulted by Some Legislators," The New York Times, June 21, 2007 --- http://www.nytimes.com/2007/06/21/business/21pension.html?ref=business 

    Jensen Question
    How should accountants factor in politics in disclosing and reporting pension obligations, especially for airlines that do not declare bankruptcy?


    Changed pension accounting rules are in the wind
    This week, the Financial Accounting Standards Board, which writes the accounting rules for American business, will decide whether to go ahead with plans to change the way pension accounting is done. The board's current rule is 20 years old and has drawn fire from retirees and investors for many of the same reasons that disturb Mr. Zydney, who has made his concerns about his Lucent pension into something of a crusade. "Right now, the stuff isn't transparent," Mr. Zydney said. "There's no accuracy. No consistency. And everybody's trying to play some financial game to make things look better."
    Mary Williams Walsh, "A Pension Rule, Sometimes Murky, Is Under Pressure," The New York Times, November 8, 2005 --- http://www.nytimes.com/2005/11/08/business/08pension.html?pagewanted=1

    Off the government balance sheets - out of sight and out of mind


    This may be a helpful video to use when teaching the new FAS 132(R) and the new FAS 158

    "Can You Afford to Retire?" PBS --- http://www.pbs.org/wgbh/pages/frontline/retirement/need/
    Click the Tab "Watch Online" to view the video (not free)!

    "PBS Frontline: Can You Afford to Retire," Financial Page, November 8, 2006 --- Click Here

    PBS Frontline has rebroadcast a critical examination of the nation's retirement system. You can access the interviews and written material for the program at PBS Frontline: Can You Afford to Retire. One can also view the program on-line, from the referenced link.

    The program highlights problems with both the Defined Benefit pension system (rapidly becoming obsolete) and the rising Contributory Benefit system, which brings with it a number of problems. The program considers:
    The program does not address the problem of high intermediation costs in the Contributory Pension system, or the preponderence of substandard investment vehicles (high cost annuities, load funds, and high cost active funds) in many employer provided plans.

    While the program explores the underfunding and closing of Corporate Defined Benefit plans, it does not touch on underfunding in the government pension system, nor does it address the fatal flaw of Defined Benefit plans: the total lack of portability of these plans for the employee.

    FAS 158 improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This Statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions.
    FASB --- http://www.fasb.org/st/summary/stsum158.shtml


    "FASB Proposal Puts Pension Plans on Balance Sheet," SmartPros, April 3, 2006 ---
    http://accounting.smartpros.com/x52449.xml

    The Financial Accounting Standards Board issued a proposal on Friday that would require employers to recognize the overfunded or underfunded positions of defined benefit postretirement plans, including pension plans, in their balance sheets. The proposal would also require that employers measure plan assets and obligations as of the date of their financial statements.

    According to the standards board, the proposed changes would increase the transparency and completeness of financial statements for shareholders, creditors, employees, retirees, donors, and other users.

    The exposure draft applies to plan sponsors that are public and private companies and nongovernmental not-for-profit organizations. It results from the first phase of a comprehensive project to reconsider guidance in Statement No. 87, Employers' Accounting for Pensions, and Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. A second, broader phase will address remaining issues. FASB expects to collaborate with the International Accounting Standards Board on that phase.

    In a statement released on Friday, FASB said the current accounting standards do not provide complete information about postretirement benefit obligations. For example, those standards allow an employer to recognize an asset or liability in its balance sheet that almost always differs from its overfunded or underfunded positions. Instead, they require that information about the current funded status of such plans be reported in the notes to financial statements. That incomplete reporting results because existing standards allow delayed recognition of certain changes in plan assets and obligations that affect the costs of providing such benefits.

    "Many constituents, including our advisory councils, investors, creditors, and the SEC staff believe that the current incomplete accounting makes it difficult to assess an employer's financial position and its ability to carry out the obligations of its plans," said George Batavick, FASB member. "We agree. Today's proposal, by requiring sponsoring employers to reflect the current overfunded or underfunded positions of postretirement benefit plans in the balance sheet, makes the basic financial statements more complete, useful, and transparent. "

    The proposed changes, other than the requirement to measure plan assets and obligations as of the balance sheet date, would be effective for fiscal years ending after December 15, 2006. Public companies would be required to apply the proposed changes to the measurement date for fiscal years beginning after December 15, 2006 and nonpublic entities, including not-for-profit organizations, would become subject to that requirement in fiscal years beginning after December 15, 2007.

    FASB is seeking written comments on the proposal by May 31, 2006. After the comment period, the board will hold a public roundtable meeting on the proposal on June 27, 2006, in Norwalk, Connecticut.


    So Long Footnoted Liabilities
    Pensions and other retiree benefits are graduating to the balance sheet; how far should a company go to protect its compensation information?; choosing your auditor wisely may help protect your stock price; and more.

    "So Long Footnoted Liabilities," by Rob Garver, CFO Magazine, February 2006, pp. 16-17 --- http://www.cfo.com/article.cfm/5435560/c_5461573?f=magazine_alsoinside

    Verizon, Ford, and ExxonMobil, pay attention. It looks as though pensions and other retiree benefits are about to graduate from the footnotes to the balance sheet. And companies that have previously been able to hide underfunded retirement programs may have to count them as liabilities — often multi-billion-dollar liabilities.

    In November, the Financial Accounting Standards Board voted to move toward a proposal that would require companies to report the difference between the net present value of their pension- and other retirement-benefit obligations and the amount the company has set aside to meet those obligations. And although a final decision is a year or more away, the numbers won't be pretty. (See "Will Washington Really Act?")

    Standard & Poor's, in fact, estimates a retirement-obligations shortfall of some $442 billion in the S&P 500 alone. Indeed, it is difficult to understate the potential impact of the FASB plan, which is expected to be only the first phase in a larger effort to overhaul the accounting treatment of pensions and benefits. "We believe this FASB project will have a significant impact on stock evaluations, income statements, and balance sheets, and will become the major issue in financial accounting over the next five years," S&P wrote in its December report.

    The news was welcome to many in the accounting business who have been concerned that current rules allow companies to hide retiree obligations in the footnotes. John Hepp, a senior manager with Grant Thornton LLP, praised the board's decision to move toward a "simplified approach. We think this will be a big step forward."

    But it won't be without pain for many companies faced with adding a large negative number to their balance sheets, such as telecom giant Verizon Communications Inc. Standard & Poor's reported in December that Verizon has underfunded the nonpension portion of its postretirement benefits by an estimated $22.5 billion. The company is clearly trying to get a handle on retirement benefits and health-care costs, announcing that same month that it will freeze the pension benefits of all managers who currently receive them.

    While the company refused to comment, Verizon is far from alone. Ford and General Motors have underfunded their retirement obligations by $44.7 billion and $69.0 billion, respectively, and other big names facing a shortfall include ExxonMobil ($16.4 billion) and AT&T ($14.8 billion).

    If any of these companies think the markets will treat these obligations as a one-time problem, they had better think again, says S&P equity market analyst Howard Silverblatt. "Moving this onto the balance sheet is going to wake people up," he says. "The bottom line is that shareholder equity [in the S&P 500] is going to be decreased by about 9 percent." And as companies begin to explore their legal options for limiting the financial damage — including paring back benefits even further — Silverblatt predicts that the issue will become more politicized and remain in the public eye for years to come.


    Pension Fund Accounting Fraud in San Diego

    "San Diego Charges," by Nicole Gelinas, The Wall Street Journal, November 27, 2006; Page A12 --- http://online.wsj.com/article/SB116459315111633209.html?mod=todays_us_opinion

    The SEC has announced that it has resolved its pension-fund fraud case against San Diego, with the city agreeing not to commit illegal shenanigans in the future and to hire an "independent monitor" to help it avoid doing so. Although the SEC went easy on the residents and taxpayers of San Diego in its settlement, it still has an opportunity to make an example of the former officials who the SEC determined committed the fraud. The feds should seize that chance to show they're serious about policing a sector of the investment world that remains vulnerable to similar fraud.

    San Diego ran into legal trouble with its pension fund because elected officials wanted to keep its municipal workers happy by awarding them more generous pension and health-care benefits, but also wanted to keep taxpayers happy by sticking to a lean budget. The two goals were mathematically irreconcilable. So San Diego officials, with the cooperation of the board members of the city employees' retirement system (the majority of whom were also city officials), intentionally underfunded the pension plan for years. They used the "savings" to award workers and retirees more benefits, some retroactive. Because taxpayers couldn't see how much retirement benefits for public employees eventually would cost them, they couldn't protest against those high future costs. The fund also violated sound investment principles by using "surplus" earnings in boom years to pay extra benefits to retirees, including a "13th check" in some years. Trustees should have put such "surpluses" aside for years in which the market was down.

    But the alleged escalated in 2002 and 2003, when city officials brushed aside warnings from outside groups, as well as from an analyst it had itself commissioned, about the fund's parlous financial straits. Although figures clearly showed that the pension fund would face a seven-fold increase in its deficit, to more than $2 billion, over less than a decade, San Diego didn't disclose what, according to the SEC, it "knew or was reckless in not knowing" was an inevitability, instead maintaining its charade. City officials disclosed not a word of the fund's financial troubles to potential investors or bond analysts as it raised nearly $300 million in new municipal securities during those two years.

    The SEC elected to go easy on the city. The feds won't levy a fine against it, reasoning that it would end up being the taxpayers who would pay. This argument has merit, since these taxpayers are already on the hook for the $1.5 billion deficit -- roughly equal to the city's operating budget -- the pension-fund fraud had concealed. Taxpayers could face fallout if wronged investors sue the city. But while SEC won't punish taxpayers, it can't afford to go so easy on the officials it's still investigating. (The SEC doesn't name the current and former officials under its scrutiny, but former Mayor Dick Murphy, former city manager Michael Uberuaga and former auditor Ed Ryan, as well as members of the City Council, all had degrees of responsibility for and knowledge of the pension fund's operations.) The SEC must demonstrate that it considers the fraud officials committed against the city's bondholders to be just as grave as similar frauds in the private sector.

    People who invest in municipal bonds do so because they feel that such investments are safer than investing in the common stocks of corporations. That's why cities and states enjoy access to capital at affordable interest rates. And, for tax reasons, municipal-bond investors often invest in the bonds of the city in which they reside, so they face double jeopardy. In the first place, if city officials are committing fraud, their bonds will turn out not to be as sound (and thus not as valuable) as they thought they were. The second risk is that they will have to pay higher taxes, or suffer lower government services, to cover pension-funding shortfalls in their city's budget if that is the case.

    Continued in article


    Questions
    What is the importance of the Stanford University logo on a research study that is a political bomb shell?
    What do accountancy pension experts think of this study?

    "Pension Bomb Ticks Louder:  California's public funds are assuming unlikely rates of return," The Wall Street Journal, April 27, 2010 ---
    http://online.wsj.com/article/SB10001424052702303695604575181983634524348.html?mod=djemEditorialPage_t

    The time-bomb that is public-pension obligations keeps ticking louder and louder. Eventually someone will have to notice.

    This month, Stanford's Institute for Economic Policy Research released a study suggesting a more than $500 billion unfunded liability for California's three biggest pension funds—Calpers, Calstrs and the University of California Retirement System. The shortfall is about six times the size of this year's California state budget and seven times more than the outstanding voter-approved general obligations bonds.

    The pension funds responsible for the time bombs denounced the report. Calstrs CEO Jack Ehnes declared at a board meeting that "most people would give [this study] a letter grade of 'F' for quality" but "since it bears the brand of Stanford, it clearly ripples out there quite a bit." He called its assumptions "faulty," its research "shoddy" and its conclusions "political." Calpers chief Joseph Dear wrote in the San Francisco Chronicle that the study is "fundamentally flawed" because it "uses a controversial method that is out of step with governmental accounting standards."

    Those standards bear some scrutiny.

    The Stanford study uses what's called a "risk-free" 4.14% discount rate, which is tied to 10-year Treasury bonds. The Government Accounting Standards Board requires corporate pensions to use a risk-free rate, but it allows public pension funds to discount pension liabilities at their expected rate of return, which the pension funds determine. Calstrs assumes a rate of return of 8%, Calpers 7.75% and the UC fund 7.5%. But the CEO of the global investment management firm BlackRock Inc., Laurence Fink, says Calpers would be lucky to earn 6% on its portfolio. A 5% return is more realistic.

    Last year the accounting board proposed that the public pensions play by the same rules as corporate pensions. But unions for the public employees balked because the changed standard would likely require employees and employers to contribute more to the pensions, especially in times when interest rates are low. For now, it appears the public employee unions will prevail with the status quo accounting method.

    Using these higher return rates for their pension portfolios, the pension giants calculate a much smaller, but still significant, $55 billion shortfall. Discounting liabilities at these higher rates, however, ignores the probability that actual returns will fall below expected levels and allows pension funds to paper over the magnitude of their problem.

    Instead, the Stanford researchers choose to use a risk-free rate to calculate the unfunded liability because financial economics says that the risk of the investment portfolio should match the risk of pension liabilities. But public pensions carry no liability. They're riskless. That's because public employees will receive their defined benefit pensions regardless of the market's performance or the funds' investment returns. Under California law, public pensions are a vested, contractual right. What this means is that taxpayers are on the hook if the economy falters or the pension portfolios don't perform as well as expected.

    As David Crane, California Governor Arnold Schwarzenegger's adviser notes, this year's unfunded pension liability is next year's budget cut—or tax hike. This year $5.5 billion was diverted from other programs such as higher education and parks to cover the shortfall in California's retiree pension and health-care benefits. The Governor's office projects that, absent reform, this figure will balloon to over $15 billion in the next 10 years.

    What to do? The Stanford study suggests that at the least the state needs to contribute to pensions at a steadier rate and not shortchange the funds when markets are booming. It also recommends shifting investments to more fixed-income assets to reduce risks.

    But what the public-pension giants find "political" and "controversial" is the study's recommendation to move away from a defined benefits system to a 401(k)-style system for new hires. Public employee unions oppose this because defined benefits plans are usually more lavish, and someone else is on the hook to make up shortfalls. Calpers and Calstrs are decrying the Stanford study because it has revealed exactly who is on the hook for all of this unfunded obligation—California's taxpayers.

    April 28, 2010 reply from Mark Eckman, Rockwell Collins [mseckman@ROCKWELLCOLLINS.COM]

    Every time one of these articles appears some reporter is shocked, and they focus on pointing a finger at the accounting, the actuarial science or the politics of pensions. But the story dies because the issues are too complicated to present in a newspaper or newscast. I'm not necessarily talking about corporate pensions. Yes, there have probably been more than a couple of companies that have nudged the expected rate of return to raise EPS and in turn the value of the executive stock options, but public pensions are much more direct in how they are abused.

    Consider the three groups and their goals and you begin to get the idea. The accountant wants all the number to flow together in a neat package that can be explained in terms of cash flow, assets and liabilities. The actuary wants a theoretical value based on assumptions, and current investment conditions. But the politician wants only the power all this money provides. Mention discount rates, duration of liabilities and actuarial losses to confuse the real issue and focus on what is the defined benefit from either plan and politically created public confusion takes over any desire to understand in the masses. Add to that the localized nature of the report, (Does anyone in Mississippi really care about paying for California municipal pensions?) and that lack of desire becomes apathy.

    Similar to the auto industry in the US, many public pension plans have offered and provided more than the public ever envisioned. In the public arena, pensions provide a license to steal on many levels. The examples of these articles typically tell of a one term mayor that receives a pension of 100% of salary as a pension, or the 20 year municipal employee with a pension equal to 200% of their wages when they retire at age 45. Need to settle a union dispute, bargain for more pension benefits. Got a budget crunch - defer payment to the pension system. All of the fuss about defined contributions comes from those that already have a vested stake in the defined contribution system. Those are gross abuses of the design to serve a political purpose rather than outright theft. But, theft also does occur. My personal favorite is how the State of New Jersey issued bonds to fund the pension, only to have the money stolen by the state legislature. When problems becomes visible in the public pension arena, those responsible have finished gorging at the trough, are not accountable, and look back thanking the accounting rules, the actuarial standards and the political control that made the theft legitimate.

    Gee, sounds a lot like yesterday's Goldman Sachs hearings...

    Mark S. Eckman


    "FASB Improves Employer Pension & Postretirement Plan Accounting," AccountingWeb, October 4, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102640

    The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans last week, making it easier for users of financial information to understand and assess an employer’s financial position and its ability to fulfill benefit plan obligations. The new standard requires that employers fully recognize those obligations associated with single-employer defined benefit pension, retiree healthcare and other postretirement plans in their financial statements. It amends Statements No. 87, 88, 106 and 132R.

    “Previous standards covering these benefits went a long way toward improving financial reporting. However, the Board at that time acknowledged that future changes would be needed, and now our constituents share this view,” said George Batavick, FASB member, in the statement announcing the new standard. “Accordingly, today’s standard represents a significant improvement in financial reporting as it provides employees, retirees, investors and other financial statement users with access to more complete information. This information will help users make more informed assessments about a company’s financial position and its ability to carry out the benefit promises made through these plans.”

    The new standard requires an employer to:

    Statement No. 158 applies to plan sponsors that are public and private companies and nongovernmental not-for-profit organizations. The requirements recognize the funded status of a benefit plan and disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006, for employers with publicly traded equity securities and the end of the fiscal year ending after June 15, 2007, for all other entities. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008.

    http://www.fasb.org/pdf/fas158.pdf Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans was developed in direct response to concerns expressed by many FASB constituents that past standards of accounting for postretirement benefit plans needed to be revisited to improve the transparency and usefulness of the information reported about them. Among the Board’s constituents calling for change were many members of the investment community, the Financial Accounting Standards Advisory Council, the User Advisory Council, the Securities and Exchange Commission (SEC) and others.

    The issuing of Statement No. 158 completes the first phase of the Board’s comprehensive project to improve the accounting and reporting for defined benefit pension and other postretirement plans. A second, broader phase of this project will comprehensively address remaining issues. The Board expects to collaborate with the International Accounting Standards Board on that phase.


    Like Texas (which has a bill pending to hide pension and health care liabilities for retired government workers and families)
    Connecticut has picked a fight with the independent board that tells state and local governments how to report their financial affairs.
    Mary Williams Walsh, "Connecticut Takes Up Fight Over Accounting Rules," The New York Times, June 2, 2007 ---
    Click Here
    Jensen Comment
    Funny thing is Andy Fastow said the same thing about accounting standards and auditors. If you're going to sell your bonds in the public capital markets, it seems that hiding debt from bond purchasers is not an especially good idea.

    At issue is the immense amount of such debt even when discounted back to a present value amount.
    Bob Jensen's threads on this controversial topic are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Pensions


    "Shocks Seen in New Math for Pensions," by Mary Williams Walsh, The New York Times, March 31, 2006 ---
    Click Here

    The board that writes accounting rules for American business is proposing a new method of reporting pension obligations that is likely to show that many companies have a lot more debt than was obvious before.

    In some cases, particularly at old industrial companies like automakers, the newly disclosed obligations are likely to be so large that they will wipe out the net worth of the company.

    The panel, the Financial Accounting Standards Board, said the new method, which it plans to issue today for public comment, would address a widespread complaint about the current pension accounting method: that it exposes shareholders and employees to billions of dollars in risks that they cannot easily see or evaluate. The new accounting rule would also apply to retirees' health plans and other benefits.

    A member of the accounting board, George Batavick, said, "We took on this project because the current accounting standards just don't provide complete information about these obligations."

    The board is moving ahead with the proposed pension changes even as Congress remains bogged down on much broader revisions of the law that governs company pension plans. In fact, Representative John A. Boehner, Republican of Ohio and the new House majority leader, who has been a driving force behind pension changes in Congress, said yesterday that he saw little chance of a finished bill before a deadline for corporate pension contributions in mid-April.

    Congress is trying to tighten the rules that govern how much money companies are to set aside in advance to pay for benefits. The accounting board is working with a different set of rules that govern what companies tell investors about their retirement plans.

    The new method proposed by the accounting board would require companies to take certain pension values they now report deep in the footnotes of their financial statements and move the information onto their balance sheets — where all their assets and liabilities are reflected. The pension values that now appear on corporate balance sheets are almost universally derided as of little use in understanding the status of a company's retirement plan.

    Mr. Batavick of the accounting board said the new rule would also require companies to measure their pension funds' values on the same date they measure all their other corporate obligations. Companies now have delays as long as three months between the time they calculate their pension values and when they measure everything else. That can yield misleading results as market fluctuations change the values.

    "Old industrial, old economy companies with heavily unionized work forces" would be affected most sharply by the new rule, said Janet Pegg, an accounting analyst with Bear, Stearns. A recent report by Ms. Pegg and other Bear, Stearns analysts found that the companies with the biggest balance-sheet changes were likely to include General Motors, Ford, Verizon, BellSouth and General Electric.

    Using information in the footnotes of Ford's 2005 financial statements, Ms. Pegg said that if the new rule were already in effect, Ford's balance sheet would reflect about $20 billion more in obligations than it now does. The full recognition of health care promised to Ford's retirees accounts for most of the difference. Ford now reports a net worth of $14 billion. That would be wiped out under the new rule. Ford officials said they had not evaluated the effect of the new accounting rule and therefore could not comment.

    Applying the same method to General Motors' balance sheet suggests that if the accounting rule had been in effect at the end of 2005, there would be a swing of about $37 billion. At the end of 2005, the company reported a net worth of $14.6 billion. A G.M. spokesman declined to comment, noting that the new accounting rule had not yet been issued.

    Many complaints about the way obligations are now reported revolve around the practice of spreading pension figures over many years. Calculating pensions involves making many assumptions about the future, and at the end of every year there are differences between the assumptions and what actually happened. Actuaries keep track of these differences in a running balance, and incorporate them into pension calculations slowly.

    That practice means that many companies' pension disclosures do not yet show the full impact of the bear market of 2000-3, because they are easing the losses onto their books a little at a time. The new accounting rule will force them to bring the pension values up to date immediately, and use the adjusted numbers on their balance sheets.

    Not all companies would be adversely affected by the new rule. A small number might even see improvement in their balance sheets. One appears to be Berkshire Hathaway. Even though its pension fund has a shortfall of $501 million, adjusting the numbers on its balance sheet means reducing an even larger shortfall of $528 million that the company recognized at the end of 2005.

    Berkshire Hathaway's pension plan differs from that of many other companies because it is invested in assets that tend to be less volatile. Its assumptions about investment returns are also lower, and it will not have to make a big adjustment for earlier-year losses when the accounting rule takes effect. Berkshire also looks less indebted than other companies because it does not have retiree medical plans.

    Mr. Batavick said he did not know what kind of public comments to expect, but hoped to have a final standard completed by the third quarter of the year. Companies would then be expected to use it for their 2006 annual reports. The rule will also apply to nonprofit institutions like universities and museums, as well as privately held companies.

    The rule would not have any effect on corporate profits, only on the balance sheets. The accounting board plans to make additional pension accounting changes after this one takes effect. Those are expected to affect the bottom line and could easily be more contentious.


    First They Do
    "Bill Requires Reporting Unfunded Federal Liabilities," AccountingWeb, April 12, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102016

    With state and local governments scrambling to meet the Government Accounting Standards Board’s (GASB) amended rules for reporting on postretirement benefits, and private and public companies getting ready for compliance with the Financial Accounting Standards Board’s (FASB) proposed statement on recording pension liabilities, a congressman from Indiana has introduced legislation that would require the federal government to meet a similar standard. The Truth in Accounting Act, sponsored by Rep. Chris Chocola (R-Ind) and co-sponsored by Reps. Jim Cooper (D-Tenn) and Mark Kirk (R – Ill), would require the federal government to accurately report the nation’s unfunded long-term liabilities, including Social Security and Medicare, a debt that amounts to $43 trillion dollars, during the next 75 years, Chocola says, according to wndu.com.

    The U.S. Treasury Department is not currently required to file an annual report of these debts to Congress, wndu.com says.

    “When I was in business, the federal government required our company to account for long-term liabilities using generally accepted accounting principles,” Chocola told the South Bend Tribune. “This bill would require the federal government to follow the same laws they require every public business in America to follow. If any company accounted for its business the way the government accounts, the business would be bankrupt and the executives would be thrown into jail.”

    The legislation doesn’t propose solutions for the burgeoning liabilities, but it takes a crucial first step, according to Chocola, “by requiring the Treasury Department to begin reporting and tracking those liabilities according to net present value calculations and accrual accounting principles,” the Tribune reports.

    “In order to solve our problems and prevent an impending fiscal crisis,” Chocola said, “we have to first identify where and how large the problem is.”

    Chocola clearly sees a looming fiscal crisis. “Congress is the Levee Commission and the flood is coming,” he told the Tribune. “This [bill] is intended to sound the warning bell.”

    To support his position, according to the Tribune, Chocola referred to an article written by David Walker, a Clinton appointee who serves as Comptroller General of the United States and head of the U.S. Government Accountability Office (GAO). Walker wrote that the government was on an “unsustainable path”.

    Speaking to a British audience last month, Walker said that the U.S. is headed for a financial crisis unless it changes its course of racking up huge deficits, Reuters reported. Walker said some combination of reforming Social Security and Medicare spending, discretionary spending and possibly changes in tax policy would be required to get the deficits under control.

    “I think it’s going to take 20-plus years before we are ultimately on a prudent and sustainable path,” Walker said, according to Reuters, partly because so many American consumers follow the government’s example. “Too many Americans are spending more than they take in and are running up debt at record rates.”

    Now They Don't
    "Bill Requires Reporting Unfunded Federal Liabilities," AccountingWeb, April 12, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102016

    With state and local governments scrambling to meet the Government Accounting Standards Board’s (GASB) amended rules for reporting on postretirement benefits, and private and public companies getting ready for compliance with the Financial Accounting Standards Board’s (FASB) proposed statement on recording pension liabilities, a congressman from Indiana has introduced legislation that would require the federal government to meet a similar standard. The Truth in Accounting Act, sponsored by Rep. Chris Chocola (R-Ind) and co-sponsored by Reps. Jim Cooper (D-Tenn) and Mark Kirk (R – Ill), would require the federal government to accurately report the nation’s unfunded long-term liabilities, including Social Security and Medicare, a debt that amounts to $43 trillion dollars, during the next 75 years, Chocola says, according to wndu.com.

    The U.S. Treasury Department is not currently required to file an annual report of these debts to Congress, wndu.com says.

    “When I was in business, the federal government required our company to account for long-term liabilities using generally accepted accounting principles,” Chocola told the South Bend Tribune. “This bill would require the federal government to follow the same laws they require every public business in America to follow. If any company accounted for its business the way the government accounts, the business would be bankrupt and the executives would be thrown into jail.”

    The legislation doesn’t propose solutions for the burgeoning liabilities, but it takes a crucial first step, according to Chocola, “by requiring the Treasury Department to begin reporting and tracking those liabilities according to net present value calculations and accrual accounting principles,” the Tribune reports.

    “In order to solve our problems and prevent an impending fiscal crisis,” Chocola said, “we have to first identify where and how large the problem is.”

    Chocola clearly sees a looming fiscal crisis. “Congress is the Levee Commission and the flood is coming,” he told the Tribune. “This [bill] is intended to sound the warning bell.”

    To support his position, according to the Tribune, Chocola referred to an article written by David Walker, a Clinton appointee who serves as Comptroller General of the United States and head of the U.S. Government Accountability Office (GAO). Walker wrote that the government was on an “unsustainable path”.

    Speaking to a British audience last month, Walker said that the U.S. is headed for a financial crisis unless it changes its course of racking up huge deficits, Reuters reported. Walker said some combination of reforming Social Security and Medicare spending, discretionary spending and possibly changes in tax policy would be required to get the deficits under control.

    “I think it’s going to take 20-plus years before we are ultimately on a prudent and sustainable path,” Walker said, according to Reuters, partly because so many American consumers follow the government’s example. “Too many Americans are spending more than they take in and are running up debt at record rates.”


    "The Next Retirement Time Bomb," by Milt Freudenheim and Mary Williams, The New York Times, December 11, 2005 --- http://www.nytimes.com/2005/12/11/business/yourmoney/11retire.html 

    SINCE 1983, the city of Duluth, Minn., has been promising free lifetime health care to all of its retired workers, their spouses and their children up to age 26. No one really knew how much it would cost. Three years ago, the city decided to find out.

    It took an actuary about three months to identify all the past and current city workers who qualified for the benefits. She tallied their data by age, sex, previous insurance claims and other factors. Then she estimated how much it would cost to provide free lifetime care to such a group.

    The total came to about $178 million, or more than double the city's operating budget. And the bill was growing.

    "Then we knew we were looking down the barrel of a pretty high-caliber weapon," said Gary Meier, Duluth's human resources manager, who attended the meeting where the actuary presented her findings.

    Mayor Herb Bergson was more direct. "We can't pay for it," he said in a recent interview. "The city isn't going to function because it's just going to be in the health care business."

    Duluth's doleful discovery is about to be repeated across the country. Thousands of government bodies, including states, cities, towns, school districts and water authorities, are in for the same kind of shock in the next year or so. For years, governments have been promising generous medical benefits to millions of schoolteachers, firefighters and other employees when they retire, yet experts say that virtually none of these governments have kept track of the mounting price tag. The usual practice is to budget for health care a year at a time, and to leave the rest for the future.

    Off the government balance sheets - out of sight and out of mind - those obligations have been ballooning as health care costs have spiraled and as the baby-boom generation has approached retirement. And now the accounting rulemaker for the public sector, the Governmental Accounting Standards Board, says it is time for every government to do what Duluth has done: to come to grips with the total value of its promises, and to report it to their taxpayers and bondholders.

    Continued in article


    NEWS RELEASE 11/10/05 FASB Adds Comprehensive Project to Reconsider Accounting for Pensions and Other Postretirement Benefits

    Board Seeks to Improve Transparency and Usefulness for Investors, Creditors, Employees, Retirees and Other Users of Financial Information

    Norwalk, CT, November 10, 2005—The Financial Accounting Standards Board (FASB) voted today to add a project to its agenda to reconsider guidance in Statement No. 87, Employers’ Accounting for Pensions, and Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.

    The Board’s objective in undertaking the project is to improve the reporting of pensions and other postretirement benefit plans in the financial statements by making information more useful and transparent for investors, creditors, employees, retirees, and other users. The agenda addition reflects the Board’s commitment to ensure that its standards address current accounting issues and changing business practices.

    In making its decision, the Board considered requests by various constituents, including members of the Financial Accounting Standards Advisory Council (FASAC), the FASB’s User Advisory Council (UAC), and the United States Securities and Exchange Commission (SEC).

    Complex and Comprehensive

    “We have heard many different views from our constituents about how the current accounting model should be reconsidered to improve transparency and usefulness. The breadth and complexity of the issues involved and the views on how to address them are deeply held. While the accounting and reporting issues do not appear to lend themselves to a simple fix, the Board believes that immediate improvements are necessary and will look for areas that can be improved quickly,” said Robert Herz, Chairman of the Financial Accounting Standards Board.

    The accounting and reporting issues involved touch on many fundamental areas of accounting, including measurement of assets and liabilities, consolidation, and reporting of financial performance. They are also impacted by complex funding and tax rules that, while not directly associated with accounting standards, affect the economics the accounting seeks to depict.

    Comprehensive Approach with Initial Improvements in 2006

    Given these complexities, the Board believes that a comprehensive project conducted in two phases is the most effective way to address these issues. The first phase is expected to be finalized by the end of 2006.

    The first phase seeks to address the fact that under current accounting standards, important information about the financial status of a company’s plan is reported in the footnotes, but not in the basic financial statements. Accordingly, this phase seeks to improve financial reporting by requiring that the funded or unfunded status of postretirement benefit plans, measured as the difference between the fair value of plan assets and the benefit obligation - i.e., the projected benefit obligation (PBO) for pensions and the accumulated postretirement benefit obligation (APBO) for other postretirement benefits - be recognized on the balance sheet.

    The second broader phase would comprehensively address remaining issues, including:

    How to best recognize and display in earnings and other comprehensive income the various elements that affect the cost of providing postretirement benefits

    How to best measure the obligation, in particular the obligations under plans with lump-sum settlement options

    Whether more or different guidance should be provided regarding measurement assumptions

    Whether postretirement benefit trusts should be consolidated by the plan sponsor

    In conducting the project, the FASB will seek the views of parties currently involved in other, independent reviews of the pension system including the Department of Labor and the Pension Benefit Guaranty Corporation. Furthermore, consistent with its effort toward international convergence of accounting standards, the FASB expects to work with the International Accounting Standards Board and other standards setters.

    An Ongoing Improvement Effort

    The agenda addition represents the latest step in the FASB’s effort to ensure that standards for pensions and other postretirement benefits provide credible, comparable, conceptually sound and usable information to the public.

    In 1987, the Board issued Statement 87, which made significant improvements in the way the costs of defined benefit plans were measured and disclosed. It is important to note that at that time, the Board acknowledged that pension accounting was still in a transitional stage and that future changes might be warranted.

    Accordingly, additional enhancements since that time have included:

    Statement No. 106 (1990)—which made similar significant improvements to those made in Statement No. 87 but for postretirement benefits other than pensions

    Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, (1998)—which revised employers’ disclosures about pension and other postretirement benefits to enhance the information disclosed about changes in the benefit obligation and fair value of plan assets

    Statement No. 132R, Employers’ Disclosures about Pensions and Other Postretirement Benefits (Revised 2003)—which provided expanded disclosures in several areas, including plan assets, benefit obligations, and cash flows.


    "Huge Rise Looms for Health Care in City's Budget," by Mary Williams Walsh and Milt Freudenheim, The New York
    Times,
    December 26, 2005 --- http://snipurl.com/NYT122605

    But the cost of pensions may look paltry next to that of another benefit soon to hit New York and most other states and cities: the health care promised to retired teachers, judges, firefighters, bus drivers and other former employees, which must be figured under a new accounting formula.

    The city currently provides free health insurance to its retirees, their spouses and dependent children. The state is almost as generous, promising to pay, depending on the date of hire, 90 to 100 percent of the cost for individual retirees, and 82 to 86 percent for retiree families.

    Those bills - $911 million this year for city retirees and $859 million for state retirees out of a total city and state budget of $156.6 billion - may seem affordable now. But the New York governments, like most other public agencies across the country, have been calculating the costs in a way that sharply understates their price tag over time.

    Although governments will not have to come up with the cash immediately, failure to find a way to finance the yearly total will eventually hurt their ability to borrow money affordably.

    When the numbers are added up under new accounting rules scheduled to go into effect at the end of 2006, New York City's annual expense for retiree health care is expected to at least quintuple, experts say, approaching and maybe surpassing $5 billion, for exactly the same benefits the retirees get today. The number will grow because the city must start including the value of all the benefits earned in a given year, even those that will not be paid until future years.

    Some actuaries say the new yearly amount could be as high as $10 billion. The increases for the state could be equally startling. Most other states and cities also offer health benefits to retirees, and will also be affected by the accounting change.

    Continued in article

    Jensen Comment
    FAS 106 (effective December 15, 1992) prohibits keeping post-retirement benefits such as medical benefits off private sector  balance sheets of corporations --- http://www.fasb.org/pdf/fas106.pdf .  The equivalent for the public sector is GASB 45, but the new rules do not go into effect until for cities as large as Duluth and NYC until December 15, 2006 --- http://www.gasb.org/pub/index.html

    Effective Date:

      The requirements of this Statement are effective in three phases based on a government's total annual revenues in the first fiscal year ending after June 15, 1999:

      • Governments that were phase 1 governments for the purpose of implementation of Statement 34—those with annual revenues of $100 million or more—are required to implement this Statement in financial statements for periods beginning after December 15, 2006.
      • Governments that were phase 2 governments for the purpose of implementation of Statement 34—those with total annual revenues of $10 million or more but less than $100 million—are required to implement this Statement in financial statements for periods beginning after December 15, 2007.
      • Governments that were phase 3 governments for the purpose of implementation of Statement 34—those with total annual revenues of less than $10 million—are required to implement this Statement in financial statements for periods beginning after December 15, 2008.

    The new GASB 25 implementation dates may trigger defaults and "The Next Retirement Time Bomb."

    January 2, 2006 reply from Mac Wright in Australia

    Dear Bob,

    In considering the problems faced by these bodies, one has to remember that the promise of these benefits was held out to the then potential employees as an inducement to work in the system. Thus attempts at cutbacks are a form of theft. It is no different that finding that commercial paer accepted some time back is worthless because the acceptor has disappeared with his ill gotten gains (Ponzi)!

    Perhaps the message to government workers is "demand cash up front and do not trust any promise of future benefits!"

    Kind regards,

    Mac Wright

    January 2, 2006 reply from Bob Jensen

    Hi Mac,

    I think theft is too strong a word. In a sense, all bankruptcies are a form of theft, but theft is hardly an appropriate word since the victims (e.g., creditors) often favor declaration of bankruptcy and restructuring in an attempt to salvage some of the amounts owing them. Also, employees, creditors, and investors are aware that they are taking on some risks of default.

    The United Auto Workers Union and its membership have overwhelmingly elected to reduce GM's post-retirement benefits for retirees since over $1,500 per vehicle sold today for such purposes will end GM and reduce those benefits to zero. Is this theft? No! Is this bad management? Most certainly! In my viewpoint all organizations should fully fund post-retirement benefits of employees on a pay-as-you-go basis?

    The problem is more complex for national social security and national medical plans for citizens (not just government employees). Fully funding these in advance is probably infeasible for the nation as a whole and/or will stifle economic growth needed to sustain any types of benefits.

    What will happen to Duluth and NYC if the retired employee benefits are not reduced? Due to exploding medical costs, we can easily imagine taxes becoming so oppressive that there is a mass exodus from those cities, especially among yuppies and senior citizens having greater discretion on where to live. One can easily imagine industry migrations out of high-tax cities. Texas, Delaware, Florida, and New Hampshire cities look inviting for a Wall Street move since there would no longer be oppressive NY state income taxes added to all the extra NYC taxes. It is not too far fetched to imagine that post-retirement benefits will collapse to almost zero if retirees themselves do not accept some concessions to save the post-retirement udder from going completely dry.

    What is interesting to me is how an accounting rule change suddenly awakens city managers (e.g., the Duluth managers) to the fact that they should actually try to find out how much they owe former city employees and the dependents of those employees. This is just another example of where an accounting rule change instigates better financial management. We might call city management in Duluth and other cities abnormally stupid if it were not for the history of so many companies that were oblivious to their post-retirement obligations until FAS 106 was about to be required. A whole lot of executives and directors had no idea they were in such deep trouble until being faced with FAS 106 requirements to report these huge obligations arising from past promises of bad managers (many of whom are now trying to collect on what they promised themselves and their kids in the way of medical care).

    In fact, it leads us to question conflicts of interest when managers vote themselves generous post-retirement benefits. When you use the term "theft," Mac, you might question who is stealing from whom. Perhaps some of the retirees slipped these generous benefits in because they thought they could get away with something that would not be noticed until it became too late. Dumb managers may have been "dumb like foxes."

    Bob Jensen

    January 3, 2006 reply from Bill Herrmann [billherr@ROCKETMAIL.COM]

    An alternative to this discussion is the realization is that the employee who accepts future "guarantee" of benefits is in fact loaning the value of the expected benefits to the employer so has a credit risk much the same as if they were sending in cash for bonds or stock. There is a risk of bankruptcy or insolvency with any asset held by another party. Anyone with a "guaranteed future benefit" is susceptible to this risk.

    Bill Herrmann
    Spoon River College.

     


    Leases:  A Scheme for Hiding Debt (Lease)

     

    FASB Lease accounting standard requires new auditor judgments ---
    https://www.journalofaccountancy.com/issues/2020/mar/lease-accounting-requires-new-auditor-judgments.html?utm_source=mnl:cpald&utm_medium=email&utm_campaign=02Mar2020   Tax Spotlight

    Implementing IFRS 16:  Lease Accounting is Now Very Complicated (2017)---
    http://www.ifrs.org/Current-Projects/IASB-Projects/leases-implementation/Documents/IFRS16-Leases-Article-Jan2017.pdf


    GASB issues proposed lease accounting implementation guide ---
    https://www.journalofaccountancy.com/news/2019/feb/gasb-lease-accounting-implementation-guidance-201920733.html?utm_source=mnl:cpald&utm_medium=email&utm_campaign=01Mar2019


    The two major differences in the accounting treatment of a direct-financing lease and a sales-type lease are 
    the gain or loss on the sale of the asset – there is no manufacturer’s or dealer’s gross profit or loss in a 
    direct-financing lease – and initial direct costs at lease inception.
    https://pecunica.com/knowledge-point/how-do-lessors-account-for-direct-financing-and-sales-type-leases/ 
    Also see
    https://pocketsense.com/differences-between-sales-type-leases-direct-financing-leases-journal-entries-1521.html 
    Direct Financing Lease Accounting Definition --- 
    https://www.accountingtools.com/articles/2017/5/6/direct-financing-lease 
    Examples of Accounting for a Lease With Residual Values --- 
    http://accounting-financial-tax.com/2011/09/how-residual-value-affects-accounting-for-lease/ 
    Journal Entries --- 
    https://accountinguide.com/finance-lease-journal-entry/ 
    Deferred Gross Profit Calculation --- 
    https://www.accountingtools.com/articles/deferred-gross-profit-definition-and-usage.html 

    General Summary of Lease Accounting Rules ---
    https://www.cpajournal.com/2017/08/23/accounting-leases-new-standard-part-1/

    BDO FASB TOPIC 842: PRESENTATION AND DISCLOSURE ---
    https://www.bdo.com/insights/assurance/fasb/fasb-topic-842-presentation-and-disclosure
    Note the illustration

    Lease Accounting Tools ---
    https://www.accountingtools.com/articles/lease-accounting.html

    Disclosure Illustrations ---
    https://www.bkd.com/sites/default/files/2018-07/Lease-Presentation-and-Disclosure-Requirements-Lessee.pdf

    Covid-19's Impact on Lease Accounting ---
    https://www2.deloitte.com/us/en/pages/audit/articles/a-roadmap-to-applying-the-new-leasing-standard.html

    Wikipedia Summary (note the references) ---
    https://en.wikipedia.org/wiki/Accounting_for_leases_in_the_United_States

     


    From the CFO Journal's Morning Ledger on May 2, 2019

    New international lease accounting rules are prompting some finance chiefs to overhaul how they benchmark corporate performance—a challenging move that could disenfranchise investors married to metrics once used to compare performance to past results, CFO Journal’s Nina Trentmann reports.

    New accounting, new math. The changes will cause many companies to report higher earnings before interest, taxes, depreciation and amortization, as well as higher free cash flow, a measure of cash earned from operations after capital spending. Meanwhile, some credit metrics, such as leverage ratios and earnings per share measures, will appear weaker in certain instances.

    Big risks. Changes to the inputs of familiar benchmarks also could make it harder for shareholders to compare past results to current performance or judge the success of a company’s strategy. “There are a lot of adjustments to financial metrics already,” said Mark Bentley, a director at the U.K. Individual Shareholders Society, which represents retail shareholders in Britain, “and the more we have, the more difficult it will be to assess the underlying performance of the business.”

    More money, more problems? Under the new standard, lease payments are split into two components, one of which is considered when calculating free cash flow, resulting in a higher figure. “Every company that adopts the new standard will get a boost in reported free cash flows arising from the recategorization of operating lease payments,” said Trevor Pijper, a vice president at Moody’s Investor Service Inc. “Investors could then ask, ‘What are you doing with all this free cash

     


    Accounting History Corner

    "Leases: A Review of Contemporary Academic Literature Relating to Leases," by Angela Wheeler SpencerThomas Z. Webb, Accounting Horizons, Volume 29, Issue 4
    (December 2015) ---
    http://aaajournals.org/doi/full/10.2308/acch-51239

    Accounting for corporate leasing activities has been examined and debated for more than 30 years. Currently both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are developing standards to modify financial reporting for operating leases, which are currently reported off-balance sheet. In light of these proposals, we examine existing literature to better anticipate possible effects of any changes. Namely, we review existing studies to understand why firms engage in operating leases and how information about these arrangements impacts users. First, we review studies directly examining leases. As that review reports, some studies show that companies engage in off-balance sheet leasing at least in part to manage financial statement presentation. Other studies, however, suggest that firms utilize operating leases to manage costs and preserve capital. In general, the research reports that lenders, credit rating agencies, and other capital market participants sufficiently understand off-balance sheet leases and consider them in their decision making. Second, we provide commentary on one of the current proposals' more debated areas and a current point of FASB and IASB divergence: classification of expenses associated with operating leases. While the IASB proposes disaggregating interest and amortization elements, the FASB proposes reporting a single, combined lease expense. However, very little research explicitly addresses expenses associated with operating leases. Existing studies do, however, suggest that information disaggregation, particularly with regard to operating and financing activities, is important. Our review may be useful to regulators as the reporting standards for operating leases are debated.

    In May 2013, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued a long-awaited Exposure Draft on accounting for leases. If enacted, this proposed standard will fundamentally alter accounting for operating leases, most notably, by eliminating current off-balance sheet treatment for long-term leases and by requiring lessees to recognize a right-of-use (ROU) asset and associated liability. Subsequent decisions, however, reflect divergence between the IASB and FASB regarding income statement reporting related to leases. While the IASB proposes treating all leases in a similar manner and requiring segregation of interest and amortization components, the FASB proposes to continue allowing the reporting of a single operating lease (rent) expense on the income statement.

    Proponents of the 2013 Exposure Draft maintain that these changes will increase faithful representation, aligned with Concept Statement No. 8 (FASB 2010a), thus improving the usefulness of financial reporting. Detractors charge that these changes will distort the underlying economics of some leases, obscure valuable information, and fail to increase the quality and reliability of financial statements (e.g., Rapoport 2013; Equipment Lease and Finance Association [ELFA] 2013). In light of this ongoing debate, we review evidence relevant to the issue of lease accounting, as it may prove informative in the continuing discussion and research on this issue. We focus on recent findings related to why firms lease, broadly speaking, and how information related to these structures may be applied by users of the financial statements.

    Long-standing concerns about accounting for leases focus largely on the fact that a substantial portion of these structures are kept off-balance sheet. Under U.S. GAAP, this treatment is made possible through the application of bright-line tests prescribed by Statement of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases (FASB 1976) codified as ASC Topic 840, Leases. Currently, leases are classified into two groups: (1) capital leases, which are effectively treated like purchases, with required recognition of an associated asset and liability, and (2) operating leases, for which only rent (lease) expense is recognized. Because of the bright-line tests associated with this classification, economically similar transactions sometimes receive dramatically different accounting treatment, in some cases due to deliberate structuring of the underlying arrangements (e.g., Weil 2004). Criticism of this standard began almost immediately after SFAS No. 13 was adopted. In fact, in a March 1979 meeting a majority of the FASB agreed that if SFAS No. 13 were to be reevaluated, then they would instead support “a property right approach in which all leases are included as ‘rights to use property' and as ‘lease obligations' in the lessee's balance sheet” (Dieter 1979, 19).

    Concern about proper accounting for operating leases is understandable, as their economic significance is large. For instance, the Securities and Exchange Commission (SEC) in 2005 estimated that while 22 percent of issuers report capital leases totaling approximately $45 billion (undiscounted), 63 percent of issuers report off-balance sheet operating leases totaling approximately $1.25 trillion (undiscounted) (SEC 2005, 64). Cornaggia, Franzen, and Simin (2013) further detail a dramatic 745 percent relative increase in the use of operating leases since 1980.

    Despite concerns about off-balance sheet treatment, a substantial body of evidence indicates that users generally see through the accounting associated with these structures and price the underlying economics. Given this apparent market efficiency relating to lease obligations, one might argue there is no need for regulators to act. However, as the Group of Four Plus One (G4+1)1 proposal noted in 2000, “The present accounting treatment of operating leases is not the most relevant of the choices available” (Nailor and Lennard 2000, 5) and, as Lipe (2001, 302) discusses:

    This argument ignores the costs and inaccuracies that result from numerous analysts performing their own computations. It also ignores the fact that some contracts or regulations depend solely on recognized amounts. The representational faithfulness of a coverage ratio that ignores material amounts of operating leases is questionable given the empirical results today.

    Lipe (2001) summarizes key findings of the literature related to leasing; however, the last decade has seen a number of studies, which also examine the leasing question, providing greater insight into why firms utilize leases as a financing mechanism and how users interpret the information about these structures. As the FASB and IASB revise the leasing model to a right-of-use framework, and thus require recognition of nearly all leases, and as the boards consider the possible economic consequences of this change in regulation, analysis of existing evidence is vital. Consequently, this paper extends the work of Lipe (2001) by summarizing certain studies he includes and discussing in greater detail key work completed since publication of his paper. Specifically, after summarizing the institutional background relating to leases, we synthesize existing work to address questions likely to be of concern to regulators and researchers as they anticipate the possible economic consequences associated with a change in financial reporting for these structures. Specifically, we seek to address the following two questions: (1) Why do firms engage in off-book lease arrangements? (2) How do users assess information related to these off-book structures?

    Long-standing criticisms of operating leases charge that the bright-line rules associated with these structures enable many lessees to enter into these arrangements simply to achieve off-book reporting. While some recent evidence does suggest that firms use certain types of leases opportunistically (e.g., Zechman 2010; Collins, Pasewark, and Riley 2012), other work indicates that firms use leases as a means of efficient contracting and not simply to achieve off-book treatment (e.g., Beatty, Liao, and Weber 2010).2

    Even if operating leases are entered into for the purpose of minimizing costs rather than simply to achieve financial reporting objectives, recognition of these structures may have substantial contracting implications for affected firms. For example, while evidence suggests that operating leases may be indirectly included in contract terms (e.g., through the inclusion of debt ratings), the results of Ball, Bushman, and Vasvari (2008) suggest that few debt covenant provisions appear to directly constructively capitalize operating leases, and a Deloitte (2011) survey reports that 44 percent of firms anticipate that recognition of operating leases will affect existing debt covenants.

    Further, while the bulk of the evidence supports the conclusion that off-balance sheet leases are generally well understood by users, some work suggests that less reliable and less transparent disclosures may receive different treatment (e.g., Bratten, Choudhary, and Schipper 2013). Consequently, recognition of these structures may in fact result in observable shifts in market behavior (e.g., Callahan, Smith, and Spencer 2013). Additionally, contrary to the proposed change requiring uniform capitalization of most leases, other evidence suggests that users do not necessarily consider all leases to have the same economic implications (e.g., Altamuro, Johnston, Pandit, and Zhang 2014).

    Finally, although scant work regarding the income statement reporting for operating leases exists, this is perhaps the most controversial of the proposal's unsettled issues. Users have mixed views (FASB 2013) and this issue is currently a point of divergence between the FASB and IASB.3 To better understand the potential implications of reporting the financing and operating components separately (the IASB's proposal) and of reporting lease costs as a single combined amount (the FASB's proposal), we extend our review to include literature on income statement disaggregation. While some evidence suggests limited information content associated with disaggregated earnings (e.g., Callen and Segal 2005), other work suggests information about disaggregated earnings is useful to users (e.g., Lipe 1986), particularly with regard to information concerning operating and financing activities (e.g., Lim 2014).

    From our review we conclude that while some negative contracting effects may be associated with recognition of operating leases, given what appears to be a sophisticated understanding of these structures, balance sheet recognition of these leases should have minimal implications from a user perspective. If anything, recognition would appear to aid users in understanding the value of the more opaque aspects of these arrangements. However, considering that users appear to value these arrangements differently in certain contexts, it seems imperative that complete disclosures be provided about recognized amounts. Finally, although users express different opinions on the proper income statement treatment for operating lease arrangements (e.g., Financial Accounting Standards Board [FASB] and International Financial Reporting Standards [IFRS] Foundation 2013), based on evidence to date, information on the operating and financing components of these structures appears important.

    We proceed by first examining the institutional background of leases. Second, we review literature on why firms enter into leases (broadly speaking) and operating leases (specifically). Finally, we review literature on how users apply information about operating leases, including potential use of operating and financing expense components. Table 1 summarizes a selection of the accounting studies cited.

    Continued in article


    General Electric is making an accounting change that'll make its one biggest problems look less severe (GE) ---
    https://markets.businessinsider.com/news/stocks/general-electric-stock-price-accounting-change-cash-flow-problem-less-severe-2019-2-1027924478

    General Electric's cash problem will look better in 2019 after an accounting change takes effect, an accounting professor says.

    For reporting periods beginning after December 15, 2018, all public US companies should apply a new accounting standard that requires them to recognize financing-lease assets and operating-lease assets on their balance sheets. The previous accounting term only required companies to recognized capital lease-assets. 

    With the financing-lease assets and operating-lease assets now being counted as capital expenditures (CAPEX), companies' free cash flow (operating cash flow minus capital expenditure) will look different than they used to, Charles Mulford, professor of accounting at Georgia Institute of Technology, told Markets Insider. Companies that are not growing their fixed assets quickly, or are reducing them, such as General Electric, will see a positive adjustment in their free cash flow, and vice versa, he added. 

    According to Mulford, a simple scenario for a capital lease is taking out a loan and spending that money on new equipment. Under the previous accounting standard, the equipment gained through this lease shows up as a CAPEX on the financial statement.

    In the case of using a finance lease, companies negotiate terms with a bank, which wires the money directly to the equipment lender. As companies didn't really touch the money, though still purchased the equipment, the equipment was not reported on the financial statement and only showed up in the footnote. But the new accounting standard sees it as little different than a capital lease, and thus requires it to be recognized as a CAPEX.

    Operating leases do not transfer ownership of the new equipment, and payments are made for usage of the asset.  A simple scenario is when leasing new equipment from a lender, the lessee makes payments periodically for the right to use the equipment — but does not gain equity in the equipment itself and will not own the equipment at the end of the lease. This type of asset is now required to be recognized on the balance sheet under the new accounting term.  

    Since companies' 2019 financial statements are not out yet, Mulford did the math on his own.

    Finance-lease assets, in his eyes, can be viewed as non-cash CAPEX showed in the financial statements' footnotes. Therefore, by adding the non-cash CAPEX to CAPEX, companies that disclosed non-cash CAPEX, such as Amazon, would see their free cash flow lower. General Electric didn't post any non-cash CAPEX in its footnotes — at least from 2015 to 2017 — thus it was not affected at this level of adjustment.

    Operating-lease assets should be recognized by their capitalized value, which represents what these assets would cost if they were purchased for cash, according to Mulford. He calculated the capitalized value of companies' operating-lease assets by applying a multiple to their annualized rent expense changes. He also added back the rent expense that year in the operating cash flow to avoid double accounting — since rent expense was already subtracted in the previous term. At this level, GE's free cash flow was adjusted higher because GE's rent expenditure that he added back is higher than the increase in GE's capitalized value of operating leases. 

    Companies like GE that are limiting their fixed assets will see the same phenomenon, with the adjustment being a positive one, raising adjusted free cash flow above the reported amount, said Mulford. He added that his calculation is just for reference, and when companies' 2019 financial results are reported later, they are required to recognize the two lease assets on their balance sheets. Based on GE's 2017 financial statement, its most recently disclosed annual statement, Mulford sees GE's free cash flow improving by about 2.4% under the new accounting term. 

    Recently, General Electric has sped up efforts to reduce debt and free up cash. In June, General Electric announced a massive reorganization, saying it would spin-off its healthcare business and split from the oil giant Baker Hughes. The conglomerate also said it would reduce its debt by $25 billion in an effort to shore up its balance sheet.

    Last October, GE announced it was taking a $23 billion write-down on its power business, which it was also splitting in two, and slashing the company's dividend to a penny. 

    And last Thursday, the company said GE Capital sold off $8 billion of assets in the fourth quarter and brought its debt load down by $21 billion. GE also announced that it reached an agreement in principal for a $1.5 billion settlement with the Department of Justice over WMC, its defunct subprime-mortgage business.

    GE was up 28% this year through Monday.

    Now read:

     


    From the CFO Journal's Morning Ledger on January 22, 2019

    Good day. Some companies are finding unexpected savings as they comply with new lease-accounting rules, reports CFO Journal's Nina Trentmann.

    Silver-lining: The arduous process has given finance chiefs a birds-eye view into their companies' spending on leases. Firms listed in the U.S. and Europe this year must report lease obligations on their balance sheets to comply with the new rules, which aim to increase transparency for investors and lenders. The rules are effective for 2019 financial reports.

     

    New standards: Complying with the standards requires companies to collect and disclose lease data on an unprecedented scale. It has resulted in the time-consuming process of chasing down lease agreements across offices, sometimes all over the world, and scouring contracts for variations in terms and compiling the information in one place.

    Hidden savings: Public firms have more than $3 trillion in off-balance-sheet leases, according to estimates from the International Accounting Standards Board. Some companies could cut lease expenses by 16% to 20%, said Michael Keeler, the chief executive of LeaseAccelerator Inc., which sells software to help companies comply with the new standard.


    From the CFO Journal's Morning Ledger on November 11, 2015

    Some of America’s best-known companies likely will soon have to effectively boost the debt they report on their balance sheets by tens of billions of dollars, the WSJ’s Michael Rapoport reports. The total possible impact for all companies: as much as $2 trillion. Within a few years, companies may have to add to their books the cost of many leases for real estate, aircraft and other items that aren’t already carried there.

    U.S. rule makers are set to vote Wednesday on whether to approve in principle long-awaited new rules requiring companies to make that addition, though the move wouldn’t take effect until at least 2018. Once the rules are finalized, companies are likely to get a better handle on what their balance sheets might look like going forward.

    Drugstores, large retailers, restaurants and supermarkets are likely to be most affected under the rules because of significant real-estate leases. But lease-accounting changes will also have a big impact on banks that lease space for their retail branches, airlines that lease planes and shipping and utilities companies that lease their vehicle fleets

     

    From the CPA Newsletter on March 23, 2015

    Profits may look higher under IASB's lease accounting model
    http://r.smartbrief.com/resp/gBhNBYbWhBCNxqePCidKtxCicNTVMx?format=standard
    The International Accounting Standards Board's forthcoming model for lease accounting will make companies with material off-balance sheet leases look more profitable compared with the Financial Accounting Standards Board's model, according to an IASB comparison. Companies will amortize leased assets differently under the two models. "Accordingly, the IASB expects the carrying amount of lease assets, as well as reported equity, to be higher under the FASB model than under the IASB model, although those effects are not expected to be significant for most entities," the IASB found. Compliance Week/Accounting & Auditing Update blog (3/20)


    Teaching Case on Lease Accounting
    From The Wall Street Journal Weekly Accounting Review on November 17, 2014

    A Sure-Fire Way to Harm The Economy
    by: Brad Sherman and Peter King
    Nov 10, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Lease Accounting

    SUMMARY: For hundreds of years companies have treated most lease payments as operating expenses, like rent, and not put them on their balance sheets. Under new accounting standards they would report the leases they hold on their balance sheets as liabilities-equal to the net present value of all future lease payments, which in some cases run for 20 or 30 years. That little-known and seemingly benign change in accounting rules could cost millions of jobs and billions in lost economic growth. Most business owners and their employees have no idea what may be coming. The agencies that establish accounting standards in the U.S., Europe and Asia have a proposal, now gaining momentum, to change how companies present leased property and equipment on their financial statements. If it is implemented, the effect would be dramatic.

    CLASSROOM APPLICATION: This opinion piece provides good information regarding current and proposed accounting rules for leases, as well as the problems that could result from the proposed changes.

    QUESTIONS: 
    1. (Introductory) What are the current accounting rules for leases? What are the proposed changes to those rules?

    2. (Advanced) What are the benefits of the proposed rules? What are the potential problems associated with those changes?

    3. (Advanced) Who is proposing the changes to lease accounting rules? Why does this group have authority?

    4. (Advanced) Who wrote this article? Is it a news story or an opinion piece? How do these writers have knowledge to comment on this issue? Do you respect or trust what they are saying?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "A Sure-Fire Way to Harm The Economy," by Brad Sherman and Peter King, The Wall Street Journal, November 10, 2014 ---
    http://online.wsj.com/articles/brad-sherman-and-peter-king-a-sure-fire-way-to-harm-the-economy-1415574014?mod=djem_jiewr_AC_domainid

    Just as it seems the U.S. economy might be turning a corner, a little-known and seemingly benign change in accounting rules could cost millions of jobs and billions in lost economic growth. Most business owners and their employees have no idea what may be coming.

    The agencies that establish accounting standards in the U.S., Europe and Asia have a proposal, now gaining momentum, to change how companies present leased property and equipment on their financial statements. If it is implemented, the effect would be dramatic.

    For hundreds of years companies have treated most lease payments as operating expenses, like rent, and not put them on their balance sheets. Under new accounting standards they would report the leases they hold on their balance sheets as liabilities—equal to the net present value of all future lease payments, which in some cases run for 20 or 30 years.

    IHS Global Insight has estimated that the new rule would add $2 trillion to the liabilities on companies’ balance sheets, while also adding $2 trillion in “assets” (the right to use the property or equipment). The U.S. Financial Accounting Standards Board (FASB) says this will “provide users of financial statements with a complete and understandable picture of an entity’s leasing activities.” That’s the supposed benefit. But the costs are extraordinary.

    An economic analysis by Chang and Adams Consulting for several leading nonprofit and commercial organizations found that the changes—first proposed in 2010 by the FASB and the London-based International Accounting Standards Board (IASB)—would raise the cost of capital for lessees, in the process destroying 190,000 U.S. jobs and shrinking the economy by $27.5 billion annually. And that was the best-case scenario. At worst, the cost would be 3.3 million lost jobs and an economic hit of over $400 billion a year, indefinitely.

    Businesses of all sizes have long-term loans from banks and other financial institutions. Those loans typically contain covenants allowing the bank to demand immediate repayment when liabilities grow unusually quickly, upsetting, for instance, the ratio of the company’s debt-to-equity agreed upon at the time of the loan. Because the new accounting rules would fabricate trillions in new debt, they would trigger widespread violations of these covenants. Banks could then pull the loan, demand higher interest, or require new collateral and guarantees.

    Some have proposed a five-year transition to the new rules. But this won’t solve the problem, because many business loans are for much longer terms. Pushing the effective date of the rules into the future merely delays the impact.

    The additional burdens associated with constantly tracking and remeasuring the “fair value” of leases of every kind, from a business’s office space to the photocopier down the hall, will hit businesses, and their employees and consumers, directly in the pocketbook. According to some critics, the accounting-rule change would distort the financial condition of businesses by accelerating expenses over a short timeline rather than reflect expenses over the life of a lease.

    Many private parties have sent public comment letters to the FASB urging it and the IASB to conduct field tests to see how much it would really cost lessees and tenants to do all the work the new leasing rules would require. Congress has asked the FASB for a rigorous cost-benefit analysis and field testing to objectively assess the risks of the accounting changes. Neither has been undertaken. Yet all indications are that the U.S. and international accounting-standards boards are going ahead with only minor revisions to their proposal, which may be finalized next year.

    In 1973 the Securities and Exchange Commission formally outsourced the job of writing accounting rules to the FASB. While the SEC is authorized to seek help from private standard-setting bodies on this issue, the Sarbanes-Oxley Act of 2002 explicitly reminded the SEC that these quasi-government agencies can only “assist the Commission” in fulfilling the SEC’s own responsibility to establish accounting standards for publicly held companies.

    Continued in article


    Teaching Case on Pending Lease Accounting Rule Changes
    From The Wall Street Journal Accounting Weekly Review on September 5, 2014

    The Big Number: Changes in Lease Accounting Rules Draw Closer
    by: Emily Chasan
    Sep 01, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Debt Covenants, Financial Accounting, Lease Accounting

    SUMMARY: U.S. and international accounting-rule makers are edging closer to completing a decade-long effort to overhaul lease accounting rules. The rules, which could be issued in 2015, threaten to bring roughly $2 trillion of off-balance-sheet leases onto corporate books. But adding assets and liabilities for store leases, airplanes and the like could force companies to renegotiate the terms of their loans with lenders. Banks and lenders often require companies to maintain covenants, such as a specific debt-to-equity ratio, fixed-asset ratio or earnings metric, which could all be thrown out of whack by such a significant accounting change.

    CLASSROOM APPLICATION: This is an interesting article about the changes to lease accounting because it highlights an important ripple effect: calculations for debt covenants will be affected. This is important to note for students that any change to accounting rules can change the financial statements and any corresponding financial statement analysis calculations. These ripple effects can cause problems for the firms and should be anticipated and addressed.

    QUESTIONS: 
    1. (Introductory) What changes have been proposed for accounting for leases? Why are rule-makers working on these changes?

    2. (Advanced) What are some of the ripple effects resulting from the changes to the lease rules? More specifically, what is the impact on calculations for debt covenants?

    3. (Advanced) How should lenders react? Should they adjust their calculations? How should they approach enforcing existing contract requirements?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "The Big Number: Changes in Lease Accounting Rules Draw Closer," by Emily Chasan, The Wall Street Journal, September 1, 2014 ---
    http://online.wsj.com/articles/the-big-number-changes-in-lease-accounting-rules-draw-closer-1409613447?mod=djem_jiewr_AC_domainid

    50%

    Percentage of global companies with bank-debt covenants potentially affected by lease accounting changes

    U.S. and international accounting-rule makers are edging closer to completing a decadelong effort to overhaul lease accounting rules. The rules, which could be issued next year, threaten to bring roughly $2 trillion of off-balance-sheet leases onto corporate books.

    But adding assets and liabilities for store leases, airplanes and the like could force companies to renegotiate the terms of their loans with lenders. Banks and lenders often require companies to maintain covenants, such as a specific debt-to-equity ratio, fixed-asset ratio or earnings metric, which could all be thrown out of whack by such a significant accounting change.

    Some 50% of global companies have business loans with debt covenants that could require them to repay a loan if they break any covenants, according to a survey of more than 2,000 directors and C-level executives by accounting firm Grant Thornton International Ltd. But only about 8% of those companies currently believe that putting leases on their balance sheet will affect their compliance with bank covenants.

    "Many companies are in for a big surprise when this comes out and they have to go to the bank," said Ed Nusbaum, chief executive of Grant Thornton International. "They need to start talking to their bankers."

    In North America, about 75% of the executives polled said their loans could be recalled if they break this type of covenant, but less than 5% of executives thought the lease accounting change would affect them.

    The American Bankers Association has been pushing rule makers to build a long transition period into the new rules, so that they wouldn't take effect until at least 2018.

    "There has to be a huge amount of education for loan officers, who have to start figuring out what the right ratios are and what they will have to adjust," said Michael Gullette, vice president of accounting and financial management at the ABA.

    From EY:  FASB addresses sale and leasebacks, US GAAP topics in leases project
    http://www.ey.com/Publication/vwLUAssetsAL/TothePoint_BB2822_Leases_3September2014/$FILE/TothePoint_BB2822_Leases_3September2014.pdf
    What you need to know

    • The FASB decided that repurchase options exercisable at fair value would not preclude sale accounting for sale and leaseback transaction s involving non - specialized underlying assets that are readily available in the marketplace .

    • The FASB decided that l essees that are not public business entities could make an accounting policy election to use the risk - free rate for the initial and subsequent measurement of lease liabilities. This is consistent with the Board’s 2013 proposal.

    • The Board affirmed its 2013 proposal to eliminate today’s accounting model for leveraged leases but decided that leveraged leases that exist at transition would be grandfathered.

     • The Board also affirmed its 2013 proposal for lessees and lessors to account for related party leases on the basis of the legally enforceable terms and conditions of the lease .

    Overview

    The Financial Accounting Standards Board (FASB or Board ) continued to redeliberate its 2013 joint proposal 1 t o put most leases on lessees’ balance sheets . At last week’s FASB - only meeting, the Board made more decisions to clarify the proposed guidance on the accounting for sale and leaseback transactions. The Board also affirmed its 2013 proposed decisions about the discount rate for lessee entities that are not public business entities (PBE) , the accounting for leveraged leases and the accounting for related party leasing transactions. The Board’s latest decisions, like all decisions to date, are tentative. No. 201 4 - 333 September 2014 To the Point FASB — proposed guidance

    Continued in article

    Bob Jensen's threads on lease accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases

     


    Two Teaching Cases Featuring Proposed Major Differences (FASB versus IASB) in Lease Accounting

    IASB Says the Tentative FASB Lease Accounting Model is Too Complicated

    From the CFO Journal's Morning Ledger on August 11, 2014

    About $2 trillion in off-balance sheet leases needs to be brought onto companies’ books, U.S. and international rule makers agree. But that’s about where the agreement ends. When the final version of their lease accounting overhaul arrives next year, it’s likely to involve different models for lease expensing, creating a potential headache for corporate financial staff in applying the divergent rules.

    The U.S. Financial Accounting Standards Board plans to stick with its proposed dual model for lease accounting, which treats some leases as straight-line expenses and others as financings. But the International Accounting Standards Board said last week that it has tentatively decided to go with just one model for all lease expenses, because it views the FASB’s plan as too complicated, CFOJ’s Emily Chasan reports.

    But it’s also possible that the differences won’t be too difficult to reconcile. “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Institute of Chartered Accountants of England and Wales’ financial reporting faculty.

    Teaching Case
    From The Wall Street Journal's Weekly Accounting Review on March 21, 2014

    Rule Makers Still Split on Lease Accounting
    by: Emily Chasan
    Mar 18, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Accounting Standards Board, International Accounting Standards Board, Lease Accounting

    SUMMARY: On Tuesday and Wednesday, March 18 and 19, 2014, the U.S. Financial Accounting Standards Board (FASB) and London-based International Accounting Standards Board (IASB) met to further their "aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets." According to the article, their differences have to do with the amortization of the lease cost into the income statement: straight-line presentation of the rental cost in the income statement or presentation as a long-term financing of an asset which involves depreciation expense and interest expense on the lease obligation. The former treatment is argued to be more appropriate for, say, storefront rental leases. The latter system can show higher expenses in the early years of a lease obligation.

    CLASSROOM APPLICATION: The article is an excellent one to introduce impending changes in lease accounting in financial accounting classes.

    QUESTIONS: 
    1. (Advanced) Summarize accounting by lessees under current reporting requirements.

    2. (Advanced) How do current requirements lead to lack of comparability among financial reports? How do they result in financial statements which often lack representational faithfulness? In your answer, define the qualitative characteristics of comparability and representational faithfulness.

    3. (Introductory) Summarize the two proposed methods of accounting for all leases as described in this article. Identify a timeline over which these proposals have been made.

    4. (Introductory) Summarize company reactions to these proposed accounting changes.

    5. (Advanced) Are company arguments and reactions based on accounting theory? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Rule Makers Still Split on Lease Accounting," byEmily Chasan, The Wall Street Journal, March 18, 2014 ---
    http://blogs.wsj.com/cfo/2014/03/18/rule-makers-still-split-on-lease-accounting/?mod=djem_jiewr_AC_domainid

    U.S. and international rule makers remained divided Tuesday in the first of two days of meetings aimed at resolving differences on lease accounting.

    The U.S. Financial Accounting Standards Board and London-based International Accounting Standards Board aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets. But they are still split on the fundamental model companies should use to measure those liabilities.

    “We have been struggling with this standard for many years,” Hans Hoogervorst, chairman of the IASB said at the meeting in Norwalk, Conn. “There is no simple answer.”

    The major difference is whether to restrict companies to one method to account for leases, or to let them choose between two. The debate will continue Wednesday.

    Since 2005, the Securities and Exchange Commission has recommended an overhaul of lease accounting because large off-the-books lease obligations can obscure a company’s true finances.

    Under current rules, lease accounting is based on rigid categories that let companies keep operating leases for items such as airplanes, retail stores, computers and photocopiers off the books, mentioning them only in footnotes. In other cases, where the present value of lease payments represents a very large portion of the asset’s value, they are called capital leases and treated more like debt.

    In their efforts to revamp the rules, accounting standard setters have gone back to the drawing board several times. In 2010, they proposed a method aimed at bringing leases on-the-books by categorizing them as “right of use” assets, which would treat them like financings.

    Companies pushed back, claiming it would be costly to implement and could unnecessarily front-load lease expenses.

    So the rule makers agreed to compromise in 2012 on a two-method approach: The first would let companies treat some leases like financings, such as when a company can purchase the asset at the end of a lease. The second would treat other leases as straight-line expenses, such as rental payments for retail storefronts.

    That move also drew criticism from analysts, who were concerned they wouldn’t get comparable financial information because the choice would be left up to companies.

    On Tuesday, some board members said they preferred to return to the “right of use” approach because they think the compromise is weak. Others were in favor of the two-method approach because it would be easier to implement.

    The dual method approach is the “more operational one, at least initially,” said FASB Vice Chairman Jim Kroeker.

    To speed a resolution, the boards also generally agreed to eliminate potential changes to lessor accounting from the proposal.

    The boards had received feedback from investors and analysts that the current lessor model works well and that changes could result in more work.

    Continued in article

    Teaching Case
    From The Wall Street Journal's Weekly Accounting Review on August 15, 2014

    Accounting Rule Makers Diverge on Lease Expensing
    by: Emily Chasan
    Aug 08, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: FASB, IASB, Lease Accounting

    SUMMARY: U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul, but the two boards are unlikely to use the same lease expensing model in their final rules. The London-based International Accounting Standards Board published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

    CLASSROOM APPLICATION: This article is a good update regarding accounting for leases.

    QUESTIONS: 
    1. (Introductory) What is FASB? What is IASB? What do they have in common? How do they differ?

    2. (Advanced) What are the current rules regarding accounting for leasing? Will this be changing? If so, how?

    3. (Advanced) Why do some parties take issue with the current model of accounting for leases? Do you agree that this is a problem? Why or why not?

    4. (Advanced) What is the reasoning behind the idea that there is no real difference between the FASB and IASB methods? Do you agree?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Accounting Rule Makers Diverge on Lease Expensing," by Emily Chasan, The Wall Street Journal, August 8, 2014 ---
    http://blogs.wsj.com/cfo/2014/08/08/accounting-rule-makers-diverge-on-lease-expensing/?mod=djem_jiewr_AC_domainid

    U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul by next year, but the two boards are unlikely to use the same lease expensing model in their final rules.

    The London-based International Accounting Standards Board this week published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

    FASB has tentatively decided to retain the dual model, because it believes it better reflects the economics of different types of leases, such as real estate and equipment leases. The models may not result in significant financial differences, but it could have big operational differences for corporate financial staff applying the standards, industry analysts say.

    The primary goal of the joint lease accounting overhaul has long been to push companies to bring about $2 trillion in off-balance sheet leases onto the books. Investors complain that today’s off-balance sheet leases obscure a company’s true liabilities, and that they often have to adjust calculations to include these expenses. Off-balance sheet leases may be understating the long-term liabilities of companies by 20% in Europe, by 23% in North America, and by 46% in Asia, according to IASB research.

    But the overhaul has been delayed by disagreements over how companies should measure leased assets and liabilities.

    The IASB’s single model would treat all leases like financings, requiring companies to recognize a so-called “right of use” asset and amortize it over time. FASB’s dual model would treat some leases like financings, such as when a company has the option to purchase equipment at the end of a lease term, and treat other leases, such as store rental payments, as straight-line expenses.

    “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as be dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Instituted of Chartered Accountants of England and Wales’ financial reporting faculty.

    The real estate industry has primarily been concerned that the single financing model for lease accounting would force them to front-load lease expenses. But when companies include the additional lease service components or tenant improvements into the straight-line expensing model, the final result is often similar to the financing model, according to a study of dozens of real-world leases earlier this year by leasing firm LeaseCalcs LLC.

    “In practice, the difference in the IASB and FASB positions is expected to result in little difference,” the IASB said in its update.

    Jensen Comment
    Neither the FASB nor the IASB will ever make headway with short-term lease accounting rules until they factor in probabilities of lease renewals.

    Bob Jensen's Document on How to Avoid Booking Leases Under FAS 13 and the Dual Model ---
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    Two Teaching Cases Featuring Proposed Major Differences (FASB versus IASB) in Lease Accounting

    IASB Says the Tentative FASB Lease Accounting Model is Too Complicated

    From the CFO Journal's Morning Ledger on August 11, 2014

    About $2 trillion in off-balance sheet leases needs to be brought onto companies’ books, U.S. and international rule makers agree. But that’s about where the agreement ends. When the final version of their lease accounting overhaul arrives next year, it’s likely to involve different models for lease expensing, creating a potential headache for corporate financial staff in applying the divergent rules.

    The U.S. Financial Accounting Standards Board plans to stick with its proposed dual model for lease accounting, which treats some leases as straight-line expenses and others as financings. But the International Accounting Standards Board said last week that it has tentatively decided to go with just one model for all lease expenses, because it views the FASB’s plan as too complicated, CFOJ’s Emily Chasan reports.

    But it’s also possible that the differences won’t be too difficult to reconcile. “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Institute of Chartered Accountants of England and Wales’ financial reporting faculty.

    Teaching Case
    From The Wall Street Journal's Weekly Accounting Review on March 21, 2014

    Rule Makers Still Split on Lease Accounting
    by: Emily Chasan
    Mar 18, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Accounting Standards Board, International Accounting Standards Board, Lease Accounting

    SUMMARY: On Tuesday and Wednesday, March 18 and 19, 2014, the U.S. Financial Accounting Standards Board (FASB) and London-based International Accounting Standards Board (IASB) met to further their "aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets." According to the article, their differences have to do with the amortization of the lease cost into the income statement: straight-line presentation of the rental cost in the income statement or presentation as a long-term financing of an asset which involves depreciation expense and interest expense on the lease obligation. The former treatment is argued to be more appropriate for, say, storefront rental leases. The latter system can show higher expenses in the early years of a lease obligation.

    CLASSROOM APPLICATION: The article is an excellent one to introduce impending changes in lease accounting in financial accounting classes.

    QUESTIONS: 
    1. (Advanced) Summarize accounting by lessees under current reporting requirements.

    2. (Advanced) How do current requirements lead to lack of comparability among financial reports? How do they result in financial statements which often lack representational faithfulness? In your answer, define the qualitative characteristics of comparability and representational faithfulness.

    3. (Introductory) Summarize the two proposed methods of accounting for all leases as described in this article. Identify a timeline over which these proposals have been made.

    4. (Introductory) Summarize company reactions to these proposed accounting changes.

    5. (Advanced) Are company arguments and reactions based on accounting theory? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Rule Makers Still Split on Lease Accounting," byEmily Chasan, The Wall Street Journal, March 18, 2014 ---
    http://blogs.wsj.com/cfo/2014/03/18/rule-makers-still-split-on-lease-accounting/?mod=djem_jiewr_AC_domainid

    U.S. and international rule makers remained divided Tuesday in the first of two days of meetings aimed at resolving differences on lease accounting.

    The U.S. Financial Accounting Standards Board and London-based International Accounting Standards Board aim to issue a final standard later this year that would move about $2 trillion dollars of lease obligations onto corporate balance sheets. But they are still split on the fundamental model companies should use to measure those liabilities.

    “We have been struggling with this standard for many years,” Hans Hoogervorst, chairman of the IASB said at the meeting in Norwalk, Conn. “There is no simple answer.”

    The major difference is whether to restrict companies to one method to account for leases, or to let them choose between two. The debate will continue Wednesday.

    Since 2005, the Securities and Exchange Commission has recommended an overhaul of lease accounting because large off-the-books lease obligations can obscure a company’s true finances.

    Under current rules, lease accounting is based on rigid categories that let companies keep operating leases for items such as airplanes, retail stores, computers and photocopiers off the books, mentioning them only in footnotes. In other cases, where the present value of lease payments represents a very large portion of the asset’s value, they are called capital leases and treated more like debt.

    In their efforts to revamp the rules, accounting standard setters have gone back to the drawing board several times. In 2010, they proposed a method aimed at bringing leases on-the-books by categorizing them as “right of use” assets, which would treat them like financings.

    Companies pushed back, claiming it would be costly to implement and could unnecessarily front-load lease expenses.

    So the rule makers agreed to compromise in 2012 on a two-method approach: The first would let companies treat some leases like financings, such as when a company can purchase the asset at the end of a lease. The second would treat other leases as straight-line expenses, such as rental payments for retail storefronts.

    That move also drew criticism from analysts, who were concerned they wouldn’t get comparable financial information because the choice would be left up to companies.

    On Tuesday, some board members said they preferred to return to the “right of use” approach because they think the compromise is weak. Others were in favor of the two-method approach because it would be easier to implement.

    The dual method approach is the “more operational one, at least initially,” said FASB Vice Chairman Jim Kroeker.

    To speed a resolution, the boards also generally agreed to eliminate potential changes to lessor accounting from the proposal.

    The boards had received feedback from investors and analysts that the current lessor model works well and that changes could result in more work.

    Continued in article

    Teaching Case
    From The Wall Street Journal's Weekly Accounting Review on August 15, 2014

    Accounting Rule Makers Diverge on Lease Expensing
    by: Emily Chasan
    Aug 08, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: FASB, IASB, Lease Accounting

    SUMMARY: U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul, but the two boards are unlikely to use the same lease expensing model in their final rules. The London-based International Accounting Standards Board published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

    CLASSROOM APPLICATION: This article is a good update regarding accounting for leases.

    QUESTIONS: 
    1. (Introductory) What is FASB? What is IASB? What do they have in common? How do they differ?

    2. (Advanced) What are the current rules regarding accounting for leasing? Will this be changing? If so, how?

    3. (Advanced) Why do some parties take issue with the current model of accounting for leases? Do you agree that this is a problem? Why or why not?

    4. (Advanced) What is the reasoning behind the idea that there is no real difference between the FASB and IASB methods? Do you agree?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Accounting Rule Makers Diverge on Lease Expensing," by Emily Chasan, The Wall Street Journal, August 8, 2014 ---
    http://blogs.wsj.com/cfo/2014/08/08/accounting-rule-makers-diverge-on-lease-expensing/?mod=djem_jiewr_AC_domainid

    U.S. and international accounting rule makers are getting closer to a final version of their long-awaited lease accounting overhaul by next year, but the two boards are unlikely to use the same lease expensing model in their final rules.

    The London-based International Accounting Standards Board this week published an update saying it has tentatively decided to propose a single model for lease expenses, rejecting a 2013 compromise with the U.S. Financial Accounting Standards Board for a dual model amid concerns that it is too complex.

    FASB has tentatively decided to retain the dual model, because it believes it better reflects the economics of different types of leases, such as real estate and equipment leases. The models may not result in significant financial differences, but it could have big operational differences for corporate financial staff applying the standards, industry analysts say.

    The primary goal of the joint lease accounting overhaul has long been to push companies to bring about $2 trillion in off-balance sheet leases onto the books. Investors complain that today’s off-balance sheet leases obscure a company’s true liabilities, and that they often have to adjust calculations to include these expenses. Off-balance sheet leases may be understating the long-term liabilities of companies by 20% in Europe, by 23% in North America, and by 46% in Asia, according to IASB research.

    But the overhaul has been delayed by disagreements over how companies should measure leased assets and liabilities.

    The IASB’s single model would treat all leases like financings, requiring companies to recognize a so-called “right of use” asset and amortize it over time. FASB’s dual model would treat some leases like financings, such as when a company has the option to purchase equipment at the end of a lease term, and treat other leases, such as store rental payments, as straight-line expenses.

    “While it looks like we won’t have one complete joint solution in the end, the actual impact of the differing models over time may not be as be dramatic as one might first think,” said Nigel Sleigh-Johnson, head of the Instituted of Chartered Accountants of England and Wales’ financial reporting faculty.

    The real estate industry has primarily been concerned that the single financing model for lease accounting would force them to front-load lease expenses. But when companies include the additional lease service components or tenant improvements into the straight-line expensing model, the final result is often similar to the financing model, according to a study of dozens of real-world leases earlier this year by leasing firm LeaseCalcs LLC.

    “In practice, the difference in the IASB and FASB positions is expected to result in little difference,” the IASB said in its update.

    Jensen Comment
    Neither the FASB nor the IASB will ever make headway with short-term lease accounting rules until they factor in probabilities of lease renewals.

    Bob Jensen's Document on How to Avoid Booking Leases Under FAS 13 and the Dual Model ---
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    Also see
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases

     

     

     


    "Operating Leases Are Forward Contracts, Not Debt," by Dane Mott Research, August 15, 2013 ---
    http://www.danemott.com/leasecommentletter/
    I thank Tom Selling for pointing this letter out to me.

    Jensen Comment
    This seems like a very sophisticated argument against reporting operating leases as debt. But I have some questions about the analysis.

    1. Mott makes a distinction between operating leases and capital leases without defining operating leases for this particular analysis. There's not always a clear distinction in some lease contracts, which is why FAS 13 drew four highly controversial bright lines.

    2. Mott's analysis is the same whether or not the operating lessee has a series of renewal options. For example, Consider Mott's Example 2:

    Example 1:

    Assume Coffee Shop signed an operating lease in 2010 with an initial lease term of 10 years and four 5-year renewal options.  Coffee Shop has a weighted-average cost of capital (WACC) of 10%.  The initial annual rent in 2010 is $100,000 and is scheduled to grow at 3% each year in the initial lease term and renewal option periods.  The risk-free rate yield curve and time value of money discount factors are presented in the table that follows.

    Jensen Comment
    Mott's illustration calculations make no difference between an initial lease of 30 years versus a lease of 10 years with four 5-year renewal options versus a lease on one year with 30 1-year renewal options. There are tremendous differences between these three operating lease contracts. An academic can add lease renewal probabilities into the analysis, but the lessee wants renewal options because of the difficulties of setting such probabilities, especially for probabilities of renewals 20 or more years into the unknown future.

    More importantly, Mott assumes that the bundle of forward contracts covers a fixed 30 year period. In fact, the embedded renewal options means that, possibly at no cost, the lessee can opt out of future forward contracts. What we have is a bundle of "possible forward contracts," and that's a whole lot different than having a bundle of "actual forward contracts." Mott makes no distinction between the "possible" forward contracts versus the "actual" forward contracts in a lease "bundle" of forward contracts. I would argue that this distinction is enormous.

    3. Mott makes a belabored argument that the operating lease contract is a "bundle of forward contracts" between the lessor and the lessee. Forward contracts are indeed custom contracts not traded on exchanges, but beyond that there are differences between forward contracts in the derivative financial instruments literature and lease contracts.

    Firstly, forward contracts generally assume spot prices are set by a deep market for fungible items like corn, wheat, gold, stocks, and bonds. A leased item like a coffee shop at 113 Main Street is highly unique and not a fungible item relative to any other coffee shop like the one on 346 State Street. And if Starbucks leases the both coffee shops with 1-year leases for 30 years there is no spot price set in a deep market of spot prices set by potential lessees at the end of each year because potential lessees would only bid on available leased property if Starbucks does not exercise its renewal option. With the lessee having an option to renew each year the property is not available until the current lessee declines the option. Hence the market for a non-fungible, unique leased item is at best hypothetical.

    Secondly, in forward contracts it's generally assumed that all cash flows of the forward contract flow between parties to the contract (e.g., lessors and lessees) and that the party going long on the contract (the lessee) will have a gain/loss equal to the party going short on the contract (the lessor) for each forward contract in the "bundle" of contracts. In other bundles like swap bundles of forward contracts, each contract is often net settled for cash between the parties to each forward contract.

    Suppose that at the end of 2019 in the above Example 1, the 113 Main Street location has become a complete bummer due demolition of all nearby office buildings (e.g., as in Detroit) and startup of a giant pig farm. The lessee, Starbucks, decides not to renew and simply cancels all the remaining four renewal contracts at virtually zero cost to the lessee. The lessor, however, has a huge loss if the lessee cancels the future forward contracts in the bundle, because the anticipated lease payments for the next 25 years will be much smaller and even zero if there is no longer any demand for this piece of poorly located property next to a stinking pig farm.

    The lease contract actually has two sources of cash flow for the lessee. Firstly there's the rent cash flow that's specified in the lease contract. Secondly, there's the operating cash flow such as the revenue coming in from sales of coffee and other items in a coffee shop. Unless the rents are directly tied in some way to operating profits of the lessee, there can be very low correlation between the cash flows of the lease contract and the cash flows of the business using the leased property. This can lead to great disparity between the value of the lease renewal options and the lease contract cash flows. Mott does not factor in the value of the renewal options into the bundle of lease forward contracts when in fact the lease renewal options may be far more valuable then the forward contract cash flows.

    Hence, if Mott is going to carry through the forward contract accounting, the lease renewal options should be bifurcated and valued separately. However, there is no deep market for such options and they would be very difficult to value. And they are not settled separately from the forward contracts making the valuation even more difficult.

    Jensen Conclusion
    The main problem that neither the accounting standard setting boards nor Dane Mott want to address is how to value renewal options. If lessees are hell-bent to keep operating lease debt off the balance sheet under the FASB/IASB proposed solution, lessees will simply write shorter leases with more renewal options. Mott's proposed solution is no panacea because he offers no solution to how to value renewal options since there is no forward contract cash flow tied to the renewal options --- only the operating cash flows of the business using the leased property. Valuing a renewal option 20 years out for a noin-fungible unique asset boggles the mind in the real world.

    The assumption of a known and fixed WACC across 30 years can be assumed to be to simplify the illustration. But the real world estimation  is extremely complicated and enormously uncertain.  Fortunately solutions are not so sensitive to WACC errors 20 or more years into the future.


    "Type A or Type B? Lease concerns emerge at round table," by Ken Tysiac, Journal of Accountancy, September 23, 2013 ---
    http://journalofaccountancy.com/News/20138792.htm


    "FASB’s Investor Advisory Committee opposes leases proposal," by Ken Tysiac, Journal of Accountancy, September 3, 2013 ---
    http://journalofaccountancy.com/News/20138651.htm

    The converged proposal on financial reporting for leases continues to face resistance with the deadline for comment letters little more than one week away.

    FASB’s Investor Advisory Committee (IAC) last week declined to support the proposal, stating that the proposal is not an improvement to current accounting. And the Equipment Leasing and Finance Association (ELFA), a U.S. trade group, continued its campaign against the proposal with a news release drawing attention to the advisory committee’s dissent.

    “This raises another key question,” ELFA President and CEO William Sutton said Tuesday in a news release seizing upon the IAC’s conclusion. “Is the cost-benefit analysis in the exposure draft sound if key users and other stakeholders maintain that current GAAP gives them better information than the proposed exposure draft and that the proposed rules are too complex?”

    Comments are due Sept. 13 on the proposal at the websites of FASB and the International Accounting Standards Board (IASB). The proposal calls for lessees to report a straight-line lease expense in their income statement for most real estate leases. In most equipment and vehicle leases, lessees would recognize leases as a nonfinancial asset measured at cost, less amortization. This would result in a total lease expense that generally would decrease over the lease term.

    Former FASB Chairman Leslie Seidman said when the proposal was released that it reflects investors’ views that leases are liabilities that belong on the balance sheet.

    During the IAC’s meeting with FASB on Aug. 27, IAC member David Trainer, CEO of investor research company New Constructs, said it’s helpful to get more transparency on the liabilities related to leases. But he said the complexities of leasing activity make it almost impossible to create a one-size-fits-all solution that can be put on the balance sheet.

    The IAC recommended that the boards increase disclosure requirements about leases rather than placing them on the balance sheet.

    “Having to unwind an accounting construct put on the balance sheet and then having to do my own analysis is not very desirable,” Trainer said. “I’d rather just have the data there, and let me do with it what I think I ought to do with it.”

    In the spring, Moody’s Investors Service Managing Director Mark LaMonte expressed a similar view, saying the proposal would force investors and analysts to deconstruct the information placed on the balance sheet before performing their own calculations to determine lease liabilities.

    Continued in article

    "IASB chair states case for leases on balance sheets," by Ken Tysiac, Journal of Accountancy, September 10, 2013 ---
    http://www.journalofaccountancy.com/News/20138701.htm

    Jensen Comment
    I think a case can be made for bringing leases onto balance sheets. But there's a difference between that in general and the particular proposed rules being advocated by the IASB and FASB.

    Shedding Light on the Proposed Leases Standard
    For instructors who are teaching about the proposed joint FASB/IASB revision to the lease accounting standard, a rather nice summary of the proposed revisions and the Power and Utilities industry, July 2013 ---
    http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/AERS/ASC/us_aers_pu_spotlight_0713.pdf


    FASB, IASB release 2013 converged financial-reporting standard for leases
    "IASB chair: Lease changes unpopular, but necessary," by Ken Tysiac, Journal of Accountancy, May 18, 2013 ---
    http://www.journalofaccountancy.com/News/20138001.htm

    "FASB lease proposal moves forward (4-3 vote) despite dissenting views,"  by Ken Tysiac, Journal of Accountancy, April 10, 2013 ---
    http://www.journalofaccountancy.com/News/20137752.htm

    FASB decided Wednesday to move forward with a re-proposal on financial reporting for leases that will be converged with that of the International Accounting Standards Board (IASB).

    FASB Chairman Leslie Seidman cast the deciding vote in a 4–3 decision. Board members Tom Linsmeier, Marc Siegel, and R. Harold Schroeder dissented.

    The lease proposal, which is scheduled to be released for public comment by FASB in May, would put all leases on the balance sheet. It would require a dual expense-recognition approach for lessees (excluding short-term leases), depending on whether significant consumption occurs during the lease period.

    So in general, equipment and vehicle leases that tend to depreciate significantly during the life of a lease would be accounted for differently from property leases, in which the asset usually does not depreciate and sometimes increases in value over the lease period.

    In some cases, the dividing line between the two types of leases can be murky. And the very idea of having two models for accounting for leases is troubling for some because it can create complexity for users.

    “Many people think that there should be one model here,” Seidman said. “That is not universal. But they do not agree about which model. So we’ve done our best to try and articulate a distinction that reflects what some perceive as the economics of the difference between what I’ll call ‘rentals’ and what I’ll call ‘finance-type leases.’ ”

    During Wednesday’s meeting, FASB’s staff asked board members to address the effects the proposal would have on financial reporting complexity. Linsmeier said the proposal introduces significant complexity for users because it divulges lease information in multiple places in the financial statements without bringing it all together in one footnote.

    “If [users] are trying to bring all that information that’s spread throughout the financial statements together to understand what the rights and obligations are under a lease, and what the related income statement and cash flows effects are, we did not provide them sufficient information to do so,” Linsmeier said.

    The leases project has been watched carefully by various constituents because of its breadth, as many organizations are parties to lease contracts. Because of the extent to which leases are used, arriving at a converged standard could bring significant global comparability to financial statements.

    The IASB plans to release its exposure draft by June 30.

    “We have worked tirelessly with the IASB on this proposal, and we are going out with a converged proposal, which I think is a significant accomplishment,” Seidman said. “I would like to try to end up with a converged improvement on the accounting for leases, and so on that basis, I’d like to move forward with this exposure draft.”

    From CFO.com Morning Ledger on May 3, 2013

    Lease-accounting proposal still seen costing companies
    Despite significant changes, companies and investors expect that a coming proposal aimed at overhauling lease-accounting rules will be more costly in some areas than the current standard,
    Emily Chasan writes. The FASB and IASB are preparing to shortly release a new lease-accounting proposal for public comment, FASB Chairman Leslie Seidman said at a Baruch College accounting conference in New York on Thursday. “It’s appropriate at this point to re-expose that revised set of conclusions,” Ms. Seidman said. Both versions of the proposal contemplate bringing trillions of dollars of leasing obligations onto corporate balance sheets, but the new proposal allows companies to record lease expenses in two ways, among other changes. Some investors worry that the boards have made so many compromises that the new rule won’t give them a clear picture of corporate leasing obligations. “Ultimately, what’s going to end up back on the balance sheet as a result of applying the standard really isn’t going to satisfy too many users of financial statements,” Mark LaMonte, managing director at Moody’s.

    From the CFO.com Morning Ledger on May 16, 2013

    The FASB and IASB just rolled out a revised proposal to overhaul lease-accounting rules—a move that could effectively boost U.S. companies’ reported debt by hundreds of billions of dollars, the WSJ’s Michael Rapoport reports. If adopted, the new proposal would require companies to carry all but the shortest leases on real estate, construction equipment and other items on their balance sheets as obligations akin to debt. The current rules allow companies to keep many leases off their books, drawing criticism from regulators that firms sometimes structure the terms of their leases to keep them off the balance sheet.

    The change could have a big effect on a wide range of companies, from retailers and restaurant chains, which lease real estate at hundreds or thousands of locations, to airlines and package-delivery companies, which finance aircraft through leases.

    The proposal also would change how some companies reflect the costs from leases in calculating their earnings, Rapoport notes. It would set up a two-track system in which the costs of leasing real estate would be recognized evenly over the term of the lease, while the costs of leasing other items would be more front-loaded—higher in the early years of a lease, lower in the later years. We’ll have more updates on the new proposal at CFOJ throughout the day, so stay tuned.

     

    Jensen Question
    So how do lessees minimize the balance sheet impact of booking operating leases such as a sandwich shop in a Galleria Mall?
    I would consider just shortening the operating lease period to a year or less in the case where the former operating lease had a longer term. The FASB has never really seriously taken up the issue of anticipated lease renewals of "operating leases."  Of course shortening a lease could alter the rental prices, especially if the lessor is taking on more risk of non-renewal.

    Of course the sandwich shop will now have to post the contracted liabilities for monthly rent for 12 months or less, but the shortened contract gets the shop out of having to post 60 months of future rent obligation if the 60 months lease is no longer contracted with the Mall. Both the Galleria and the sandwich shop of course expect to renew the lease annually.

    One problem with putting lease renewal debt or assets on the balance sheet is deciding when the anybody's-guess number of renewals should be terminated. For example, neither the Galleria or the sandwich shop has any idea of how many times the lease will be renewed. The number or future renewals is subject to all sorts of unknowable events of the future.

    A huge difference between renting space in a Galleria Mall versus renting a jumbo jet is that the Galleria normally does not provide options to actually own leased apace in such a mall that was not intended to be a condo mall.

    FASB, IASB release 2013 converged financial-reporting standard for leases
    "IASB chair: Lease changes unpopular, but necessary," by Ken Tysiac, Journal of Accountancy, May 18, 2013 ---
    http://www.journalofaccountancy.com/News/20138001.htm

    Bob Jensen's threads on lease accounting are at
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm 


    Lease Accounting Controversies

    August 12, 2013 message from Bill Bosco

    This email is being sent to you because you are either a client, business associate or colleague.  Feel free to pass on the info in this email and attached to the email.

    Comment letters to the Leases ED are due 9/23/2013

    so far 21 have been received with only 3 in full support of the ED, 14 are totally negative and 4 have negative comments but some positive comments

    To help with your letter I attach
        my comment letter,
        some discussion points I put together to gather thoughts for the ELFA comment letter,
        an E&Y analysis of the ED
        an announcement of a AAA study that shows that off balance sheet info on op leases is processed effectively by the capital markets and anlysts
        some quotes from the AAA study - I cannot give you the actual study as you would have to buy it
        ELFA comment letter guidance from the ELFAonline website
        an AAA commentary on the G4+1 papers that gives recommendations that are in line with my views
     

     
    Bill Bosco
    Leasing 101
    17 Lancaster Dr
    Suffern, NY 10901

    914-522-3233
    http://www.leasing-101.com/


    This message (including any attachments) contains confidential information intended for a specific individual and purpose, and is protected by law. If you are not the intended recipient, you should delete this message.
     
     
    7 attachments — Download all attachments  
    ELFA_comment_letter_discussion_points2013.doc ELFA_comment_letter_discussion_points2013.doc
    86K   View   Download  
    Bosco_comment_letter__7_23_2013.docx Bosco_comment_letter__7_23_2013.docx
    86K   View   Download  
    ey_TechnicalLine_BB2589_Leases_25July2013.pdf ey_TechnicalLine_BB2589_Leases_25July2013.pdf
    1648K   View   Download  
    disclosure_vs_on_BS.pdf disclosure_vs_on_BS.pdf
    142K   View   Download  
    on_BS_off_BS_report_excerpts_AAA.docx on_BS_off_BS_report_excerpts_AAA.docx
    33K   View   Download  
    CommentLetterGuidance2013FINAL.pdf CommentLetterGuidance2013FINAL.pdf
    39K   View   Download  
    g4+1_commentary.pdf g4+1_commentary.pdf
    64K   View   Download  

    The due date for comment letters is 9/13/2013

    Also I should have attached the AAA g4+1 analysis - see attached - it os an important document as it was advice given the FASB on the leases project - much of the advice is in line wih my thinking but the FASB chose not to take the advice


    Sadly, the FASB loves (sort of in 4-3 voting) that controversial dual-recognition model for lease accounting
    "FASB lease proposal moves forward despite dissenting views," by Ken Tysiac, Journal of Accountancy, April 10, 2013 ---
    http://journalofaccountancy.com/News/20137752.htm

    Jensen Comment
    This is disappointing since I think many, many operating lease contracts will simply be rewritten to circumvent the new standard:

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

     

    Bob Jensen's threads on lease accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases


    "How Managers Do Love the Leasing ED: Let Me Count the Ways," by Tom Selling, The Accounting Onion, June 9, 2013 ---
    http://accountingonion.com/2013/06/how-managers-do-love-the-leasing-ed-let-me-count-the-ways.html

    An excerpt from a WSJ blog:

    “Outgoing FASB Chairman Leslie Seidman has had plenty of time to tackle long-standing questions about whether accounting principles are more desirable than specific accounting rules, writes Emily Chasan. The debate over whether detailed rules and bright-line exceptions are more or less useful than broad principles that require management judgment has dominated her past 1o years on the board. “I think it’s undeniable that we Americans like our rules,” Ms. Seidman said …  in her final public speech as chairman of the U.S. accounting rule maker.” [emphasis added]

    I guess that settles it.  Now we know for certain why FASB standards have gone from bad worse.

    Even if Ms. Seidman is correct, the FASB has come up way short of the mark.  The three super major projects she leaves for others to complete when her second five-year term soon comes to an end are the most direct evidence of the dysfunction: loan impairment, revenue recognition and leases.

    Focusing on lease accounting by lessees should be enough to make the point; and I want to focus on that since I just finished preparing my presentation on the most recent ED for my upcoming update course in Chicago.  There may be some rules in that ED, but all except for the requirement to recognize some modicum of a lease liability on the balance sheet, are not near as consequential as the smorgasbord of loopholes set out for managers to manipulate their earnings without waking up their auditors or getting a call from an SEC investigator.

    Some of these are carryovers from existing U.S. GAAP, but If any of the rest were to make you think they were concocted in the IASB’s central sausage factory, I wouldn’t argue with you:

    The lease smoothie—For assets that meet the definition of “property” (a judgment call all by itself), subjective criteria will determine whether management can choose to recognize lease expense straight-line — as opposed to a pattern approximating the actual economics).  The boards are leaving it to management to determine if: the lease term is not for a “major” part of the remaining “economic life” of the asset; or whether the present value of the lease payments is not a “significant” part of the value of the asset; or whether there is a “significant economic incentive” to exercise a purchase option; or that land and/or building is the “primary asset” under contract.

    Hide-the lease-payment trick #1—The lease payments to be recognized as an asset and corresponding liability generally are limited to the payments in the contract that are fixed.  However, judgment is required to determine if payments that are contingent on a level of activity (e.g., retail sales in leased store space) are in fact “disguised” as fixed lease payments.  In other words, management is supposed to say, “HA!  I caught myself disguising fixed lease payments as variable payments.”  (Gimme a break.)

    Hide-the-lease-payment trick #2Judgment (are we getting tired of that word yet?) is required to treat “expected” (not defined—what a surprise) amounts to be paid under residual value guarantees as lease payments to be capitalized.

    Who said buy-borrow?—Options to purchase the asset if they they are in-substance lease payments. (Another “HA!  I caught myself doing a bad thing.”)

    Mix and matchJudgment is required to determine if part of the cash flows are not actually lease payments; and more judgment is required to estimate how much should be accounted for according to some other standard.  It could even get to the point that a lessee would have to estimate the fair value—i.e., a sales price—for services that it would never purchase separately and arbitrarily carve them out of the cash.

    My all-time favorite—When to take account of renewal or termination options when estimating the lease term is based on whether there is a “significant economic incentive.”  For that, we have the old IASB chestnut of “management intent” as one of the factors to consider.

    Don’t wake me from my dreamsJudgement is required to determine that the factors originally used to account for a lease have changed significantly enough to make reassessment appropriate.

    There is still more, but that should be more than enough to illustrate that the FASB’s latest gift to investors is far from a compendium of “rules.”  More than a decade ago, a much more attuned SEC issued a clarion call to accounting standards setters, to finally end operating lease treatment; for it was seen then as now as the most pernicious form of off-balance sheet accounting.  This ED is nothing more than one last-ditch effort to take what was an extremely modest proposal for lease capitalization off life support.

    Continued in article

    Jensen Comment
    I'm not sure which managers love the ED. Finance executives absolutely hate the ED.

    "When Is an Asset not an Asset?  A new lease accounting proposal by regulators is still getting pummeled by finance executives." by Kathleen Hoffelder, CFO Journal, September 14, 2012 ---
    http://www3.cfo.com/article/2012/9/gaap-ifrs_lease-accounting-fasb-iasb-convergence-equipment-lease

    Note that the above criticism was published before the latest ED from the FASB. This begs the question of whether the items that made finance executives unhappy were corrected in the 2013 ED. In my opinion the answer is generally no to anticipated financial executives satisfaction.

    A good example of this dissatisfaction is the May 31, 2013 reaction to the FASB from ELFA (Equipment Leasing and Finance Association) ---
    http://www.elfaonline.org/issues/accounting/pdfs/ELFACreditLossesCommentLtr.pdf

    The main concern seems to be the anticipated impact on earnings (especially for Type A leases subject to accelerated expense booking) --- which is something fair value accountants don't care much about since they are almost entirely focused on the balance sheet.


    June 27, 2012
    Hi again Tom,

    This exchange is interesting in that it begs the question of what is a "derivative" financial instrument.

    In the context of FAS 133, a "derivative" is mapped to a price/rate/credit index such as a standardized grade corn price, LIBOR, or credit rating of an investor's collateralized bond. FAS 133 scopes in derivative contracts in commodity prices, interest rates, and credit ratings.

    FAS 133 scopes out weather indexes such as average daily rainfall in Kossuth County during July. We can certainly have a derivative financial instrument such as a call option based upon a weather index, but these contracts are not scoped into FAS 133.

    The contracted index constitutes the "underlying" of a derivative financial instruments contract. In virtually all derivative financial instruments contracts the index measurement is verifiable and becomes the basis for ultimate contract settlement. For example, when settling a call option on corn price, the CBOE contracted strike price of corn is net settled against the CBOE ( http://www.cboe.com/default.aspx  )spot price (which is the underlying). The CBOE defines "standard" contracts for this index in terms of detailed chemical grading of corn (not any old puny corn qualifies for the CBOE grading standard). Interestingly, the hedged item might be puny corn but the farmer may net settle hedging CBOE corn derivative financial instruments contracts on CBOE-quality corn he's unable to grow. From a FAS 133 standpoint, this can lead to ineffectiveness of a hedge contract that is actually hedging the farm yield of puny corn.

    I think the definitional implication is that contracting parties are "takers" and not "makers" as far as the underlying is concerned. Derivative financial instruments are then "derived" from fluctuations in that underlying index outside the control of the contracting parties in a derivative financial instrument.

    My main point is that a given farmer cannot control the CBOE spot price of corn or the rainfall in Kossuth County in July that are used as an underlying in a derivative financial instrument. He can control to some extent the price of the corn he actually grows or what he's willing to pay to lease his crop land.

    In my opinion, the contract is no longer a derivative financial instrument if both the party and the counterparty totally or partially "make" the index. Hence I assume that an option contract renew a lease is not a derivative financial instrument contract if the contracting parties negotiate the rent rather than use some rent index outside their control. I don't think a rent index exists for most operating leases in the same sense that commodity price and interest rate indexes exist in such places as the CBOE, CBOT, and CME markets.

    The bottom line is that what we call lease renewal options and some other types of options are not derivative financial instruments contracts that are defined in FAS 133 or IAS 39 (soon to be IFRS 9). Hence, when we write that a business firm has an "option" contract that contract is not necessarily a derivative financial instrument. To be a derivative financial instrument it must have an underlying that contracting parties take rather than make in the market. Additionally, FAS 133 requires that to be eligible for hedge accounting there must also be a net (cash) settlement provision based upon that index rather than a requirement for physical delivery of the commodity in question.

    Lease renewal contracts are more apt to be financial instruments rather than derivative financial instruments.
    As such, they are accounted for as other financial instruments. However, there can be huge complications when attempting to carry lease renewal contracts at fair value. The leased property is almost always highly unique and not a fungible item.. The leased Gate 12 at the Manchester, NH airport is very different from the leased Gate 57 in Baltimore. The CBOE has no standardized contracts for airport gate rentals, building rentals, and equipment rentals like it has for a chemical grade of corn in CBOE options contracts.

    The main problem with lease renewals is that for operating leases these are typically forecasted transactions that are not contracts. This is outside the paradigm of an accounting Conceptual Framework built upon the paradigm of contracts. I discuss this in greater detail at
     

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

    Respectfully,
    Bob Jensen


    "When Is an Asset not an Asset? A new lease accounting proposal by regulators is still getting pummeled by finance executives," by Kathleen Hoffelder, CFO.com, September  14, 2012 ---
    http://www3.cfo.com/article/2012/9/gaap-ifrs_lease-accounting-fasb-iasb-convergence-equipment-lease

    When a corporation leases a building, is the adjoining parking lot automatically included? Or should the lot be accounted for separately? Does it make economic sense to count the lot as a separate asset from the building, since in a typical suburban office complex one generally doesn’t exist without the other?

    Such questions are getting tougher and tougher to answer for CFOs and other executives who account for lease expenses that their companies incur – especially when you consider that the parties in the debate can’t even agree on such a basic element as the definition of an “asset.” In the example above, for instance, is the parking lot an asset owned by the lessee, or is it simply a piece of rented property?

    The confusion stems from a lease accounting proposal jointly agreed upon by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in June that requires lease expenses to be recorded on corporate balance sheets. The boards decided that lessees should distinguish between equipment and property leases, and that the distinction should be based on whether the lessee acquires and/or uses up more than an “insignificant” portion of the underlying asset. Along with other criteria, if a lessee buys or consumes more than that amount, it would have to account for its cost on a property-lease basis; if less, than the arrangement would be deemed an equipment lease.

    FASB and IASB further came to an agreement on having property leases accounted for using a straight-line approach (in which a single lease expense is recognized over the life of a lease) and equipment leases accounted for in a front-loaded manner (in which larger interest charges occur at the beginning of a lease than at the end).

    Ralph Petta, chief operating officer at the Equipment Leasing and Finance Association (ELFA), notes that the boards’ decision to make the equipment lease expense recognition front-loaded creates a lot of problems. “It makes the accounting more complex than it needs to be,” he says. Since equipment leases have not previously been front-loaded, lessees would have to do a whole lot more calculating of asset values if the plan goes through.

    While ELFA supports having leases recorded on lessees’ balance sheets and incorporating two types of leases for property and equipment, the association’s leaders find fault with the way the boards are addressing those issues now.

    Critics of the proposal like Rod Hurd, CFO of Bridgeway Capital Advisors and chair of ELFA’s financial committee, don’t think the standard setters’ plan correctly addresses most lessees’ accounting needs.

    For one thing, he notes the “economics” of the FASB/IASB proposal don’t jibe with general accounting principles. In a front-loaded lease on a balance sheet, as in the case of an equipment lease, the asset appears to be worth less than its present economic value, notes Hurd.

    FASB and IASB’s front-loaded approach for equipment leases considers all equipment leases as purchases, perhaps reasoning that, in many cases, short-term lessees resemble owners more than renters. ELFA and others, however, say that the concept doesn’t match reality.

    Continued in article

    "Diversity among Analysts Makes Objective of FASB-IASB Lease Accounting Difficult to Achieve," BNA, July 31, 2012 ---
    http://www.bna.com/diversity-among-analysts-b12884910914/

    Jensen Comment
    In my opinion, standard setters, corporations, and financial analysts are avoiding the most important and the most troublesome aspect of lease accounting --- how to account for lease renewals. As long as lessees and can simply look at one lease term for accounting purposes, the leases will be written for shorter terms and thereby defeat the purpose of getting OBSF debt on the balance sheet.

    A Dual Model for Lease Accounting: 
    Redrawing the Lines Into a Brick Wall of Forecasted Lease Renewal Controversy
    http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm


    Security Analysts and Investors Versus the IASB and FASB on Lease Accounting:  Dual Model Unanimously opposed

    "Diversity among Analysts Makes Objective of FASB-IASB Lease Accounting Difficult to Achieved," Bloomberg BNA Accounting Blog, July 31, 2012 ---
    http://www.bna.com/diversity-among-analysts-b12884910914/

    The diversity in how analysts and investors look at leases in practice appears to be making it much harder for the Financial Accounting Standards Board and the International Accounting Standards Board to achieve their objectives for the joint lease accounting project.

    The boards have said that one of the key reasons for addressing lease accounting was that current lease accounting standards under both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRSs) have been criticized as failing to meet the needs of financial statement users and presents structuring opportunities. The standards-setters have been redeliberating towards issuing an exposure draft in the fourth quarter this year-their second proposal.

    In June the FASB and IASB decided upon an approach in which some lease contracts would be accounted for using an approach similar to that proposed in the 2010 leases Exposure Draft and some leases would be accounted for using an approach that results in a straight-line lease expense.

    If financial statement users were unified in the manner in which they looked at leases it would be much easier for the boards to tailor the outcome to meet investors' needs. However, during a July 24 discussion with the FASB, members of its Investors Technical Advisory Committee made it clear that given the divergent views among analysts, the boards' solution is a compromise that misses the mark.

    ITAC members held diverse views on how--in their analysis--it is most useful to present leases, said Gary Buesser, Director of Lazard Asset Management, LLC.  ITAC's views fell among three categories:

    Form of Financing.

    The crux of the whole issue may be stemming from the broad based belief among investors, financial statement users and analysts that leases are a form of financing. A significant number of analysts and investors who are using financial statements will make adjustments to put an item back on the balance sheet for leases, according to the ITAC discussion.

    Some ITAC members said the boards may be in better position if they left the accounting guidance as it is currently with some minor improvements, including enhancements to disclosures that will further improve the ability of analysts and financial statement users and investors to make the adjustments they want to make to get to the numbers that they want to look at.

    "Though current lease accounting rules are not ideal, the accounting today allows analysts to adjust in the way they want to adjust," said Mark LaMonte, Managing Director, Chief Credit Officer of Moody's Investors Service Financial Institutions Group.

    "I think it's easier for me to adjust and get the lease number I want on the balance sheet from the current accounting, than it is to unwind a kind of half way there number and then have to adjust," said LaMonte.

    "In our shop we believe leases belong on the balance sheet, so if they're already on as capital leases we accept it, if they're off balance sheet as operating leases, we're going to put them on," he said.

    The Project.

    Leasing is an important source of finance for many companies who lease assets. A FASB summary states that it is therefore important "that lease accounting provides users of financial statements with a complete and understandable picture of an entity's leasing activities."

    FASB member Lawrence Smith told the ITAC that current GAAP has two different types of leases, but it is based upon the approach that an entity would follow a whole asset approach, that is, that it is either leasing an asset or effectively it is like it is buying the asset.

    "[This is] why we get the difference between operating leases and capital leases," he explained.  "In general does ITAC have a view that perhaps the way we're accounting for it now, following the whole asset is the appropriate way of doing it?" asked Smith.

    With the level of diversity among analysts, even among ITAC, it would be difficult to come up with a one sized fixed all solution, the analysts said. "Maybe the best thing to do is to make sure that the information is there so that people can adjust to what they want," LaMonte said. "Keep it as simple as possible and give information so that people can make the adjustments they want to make," he said.

    Dual Model Unanimously opposed.

    One of the reasons the board decided to go down the route of having a dual model is because the board became convinced during outreach with constituents that there is more than one kind of lease economically, and to properly reflect that a dual model was needed.

    But ITAC members, who unanimously opposed the duel model income statement approach, said they found it complex and confusing. "We thought that if I leave real estate, I continue with today's current accounting, if I moved toward leasing equipments, I go to a financing arrangement and I have amortization plus interest expense, this could require many adjustments in particular for companies that have both real estate leases and equipment leases," said Buesser. "So we felt that there was something about that--that supply," he said.

    Continued in article

    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

     


    "Can we talk about lessee accounting...again?" by PwC, March 2, 2012 --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=KOCL-8RZTS7&SecNavCode=MSRA-84YH44&ContentType=Content

    Summary:
    The February 28-29 joint FASB/IASB board meetings on leases focused on the continued objections from constituents to the 2010 exposure draft's proposed "front-loaded" lessee expense recognition pattern. The boards discussed two possible paths forward, but were unable to reach any tentative decisions and requested that the staff perform further outreach. Read our In brief article for an overview of the two approaches discussed at the meeting.


    The Grumps Think Rite Aid Should Get a Going Concern Report from Deloitte

    "STILL SEARCHING FOR 'THE ‘RITE’ STUFF'," by Anthony H. Catanach Jr. and J. Edward, Ketz, Grumpy Old Accountants Blog, April 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/643

    There are no academy awards in the offing for Rite Aid’s version of the 1983 test pilot film classic.  Recently, the Company released its 10-K, and things are still a mess.  No rocket science here.  Rite Aid cannot earn a profit and cash flows are dwindling even with an extra week of operations included (2011 was a 53 week fiscal year).  And the balance sheet is disgraceful. The Company just cannot seem to do anything “rite!”  Maybe management would have done better with a comedy like “Failure to Launch.”

    Things have only worsened since we initially visited the Company in Rite Aid: Is Management Selling Drugs or Using Them?  It has not posted a positive earnings number since 2007.  Sure, the net loss is less than it was for the past few years, but a loss is still a loss, and remember, it had an extra week for this year’s performance reports.  It continues to bleed lease termination and impairment charges, as well as losses on debt modifications and retirements.  Yet, managers continue to perpetuate a turnaround façade via “improving” adjusted EBITDA numbers which suggest almost a $1 billion in “real” earnings.  Instead, the Company needs a dramatically new business model that emphasizes operating effectiveness and efficiency.  Only then will revenues rise, and cost of sales and other operating costs decline, both requirements for the Company’s delivering a profit.  We understand that the Company has implemented cost cutting initiatives, but when will see some believable and meaningful results?

    The balance sheet remains in shambles.  Okay, there are enough current assets to cover current liabilities, but that’s the end of any good news in the balance sheet.  Total assets are $7,364 (all accounts are in millions of dollars), while total liabilities are $9,951, thereby yielding a shareholders’ deficit of $(2,587).  How this firm avoids corporate bankruptcy we just don’t know!

    Actually, the balance sheet condition is much worse because the Company has humongous lease obligations that are carried “off-balance sheet.”  Using the data in financial statement note 10, we estimate the present value of the Company’s lease liabilities to be $5,939.  This adjustment increases total liabilities to $15,890, causing the stockholders’ deficit to worsen to $(8,526).

    At least Rite Aid does not carry goodwill on its books any more, having written off the last vestiges of this intangible “asset” in 2009.  The only remaining reported intangibles are for favorable leases and for prescription files.  Oh please…favorable leases for a Company in this financial condition…we would be inclined to reduce the favorable lease asset, but the amounts are just not big enough to fret over given the “death watch” status of the Company.

    However, to its credit, Rite Aid has not followed the example of Citicorp and some other banks that pumped earnings up by recognizing gains due to market value declines of debt due to problems in its own creditworthiness.  This practice is a sham even if condorsed (condoned and endorsed) by the FASB.

    Even though the cash flow statement does provide some positive news, reported cash flows are a bit down (and again there was that extra week in the fiscal period).  Cash flows from operating activities were $(325), $395, and $266 for 2009-2011, while free cash flows were $(519), $209, and $16, respectively.  So, Rite Aid is reporting a positive free cash flow, albeit smaller than last year’s.

    Ironically, if the Company would capitalize all of its operating leases, the cash flow picture improves considerably!  That’s because rental expenditures under operating lease accounting are displayed as operating activities; however, when leases are capitalized, the cash flows are divided between interest payments and payments against the lease obligation, the latter payments being properly categorized as financing cash flows.  Interest payments are still considered part of operating activities.  Thus, adjusted free cash flows paint a rosier picture for Rite Aid:  they are $(45), $691, and $545 for 2009-2011.

    Given the Company’s precarious state, why doesn’t the auditor, Deloitte & Touche, issue a going concern report?  After all, Rite Aid’s troubles make it a bankruptcy candidateClearly, profits are negative for five years, and there are significantly more liabilities than assets.  Perhaps the auditor also adjusts operating leases to obtain the healthier free cash flow numbers that we have estimated, and deduces that the firm can survive.  If so, then the auditor should persuade, if not require, Rite Aid to capitalize all of its leases.

    Taking a long term perspective, most of the troubles endured by Rite Aid over the last several years seem a result of the failed Eckerd and Brooks business combination, which it bought from the Jean Coutu Group.  In short, Rite Aid paid too much for the business.  When the subsidiary did not generate enough cash flows, Rite Aid borrowed to the hilt, and has been operating under a heavy debt burden ever since.  (As a side note the Jean Coutu Group recently sold a substantial number of its Rite Aid shares, reducing its ownership to about 20 percent.)

    Continued in article

    The Grumps respond to their AECM critics on accounting for leasing at Rite Aid. I forwarded the AECM messaging concerning whether the Grumps made a mistake on their Rite Aid posting.

    "A NOTE ON THE RITE AID ANALYSIS; AND A POX ON THE FASB," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants Blog, May ,, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/652

    Last time we discussed Rite Aid and claimed the balance sheet was in shamblesSome fellow accounting professors objected to the analysis, so we need to respond to them.  We’ll answer the criticism and point out the big point that they all missed.

    You will recall that Rite Aid’s most recent balance sheets has total assets of $7,364, total liabilities of $9,951, and shareholders’ equity of $(2,587).  As before, all amounts are in millions of U.S. dollars.  We then said our estimate of the present value of the operating leases was $5,939, thereby increasing total debts to $15,890 and causing shareholders’ equity to dip to $(8,526).

    The criticism we received concerns the hit to equity.  They state that the entire amount should not go against equity but that a sizable amount should be in assets.

    The criticism is well taken—up to a point.  Our analysis indicated that the assets were over half depreciated, so only a relatively small portion would be added to the left-hand side of the balance sheet.  Besides, as Rite Aid is a Pennsylvania corporation, we have been in several of the stores, and we think that the fair value of the leases needs to be written down.  At that point we took a short cut and assumed none of it would be there.  It made the work a lot shorter and helped us to make our point succinctly.

    But, since our friends and associates want a full-blown adjustment instead of this raw short cut, here goes.  We adjust the income statement by taking out rental expense and by adding in depreciation, interest, and the differential income tax.  We adjust the assets in the balance sheet for the leased resources minus their accumulated depreciation.  We adjust the current debts for the present value of next year’s lease payment.  We adjust noncurrent debts for the present value of the remaining lease payments and for deferred income taxes.  Finally, we adjust the stockholders’ equity for the cumulative effect of past year differences in the firm’s net income.

    What we find is the following:

       

    Reported

    Adjusted

    Revenues

    26,121

    26,121

    Expense

    26,490

    26,472

    Net income

    (368)

    (351)

           
           
           
    Current assets

    4,504

    4,504

    Plant  

    2,860

    5,177

    Total assets

    7,364

    9,681

           
    Current debts

    2,570

    3,547

    Long-term debts  

    7,381

    12,438

    Total debts  

    9,951

    15,985

    Equity  

    (2,586)

    (6,304)

    Total  

    7,364

    9,681

     

    Yes, the total assets are larger by $2.3 billion, but notice that the total debts are larger by $6 billion and the shareholders’ equity is lower by $3.7 billion.  (The liabilities are higher than the $5.9 we previously mentioned because now we are including the deferred income tax effect.)

    So the criticism is correct inasmuch as the full $5.9 billion does not decrease equity, only $3.7 billion.  But given that we originally just wanted a rough approximation, we still don’t think it was off as badly as our colleagues thought.  As they obviously are watching carefully, we promise not to take this short cut again.

    Having said that mea culpa, let’s observe that the thrust of our previous work is correct.  The balance sheet of Rite Aid is in shambles and the losses are habitual.  Operating cash flows are higher than reported, as we explained in the previous column, but that implies that financing cash outflows are correspondingly worse.  Rite Aid is in trouble.

    Jensen Comment
    I might note that to date the IASB and the FASB cannot agree on a new joint standard on leasing. The joint project is now entering a new Plan D under consideration. Until then, Rite Aid is subject to existing FASB rules on lease capitalization and expensing.

    Whole contract, or Approach D, is a fourth possible approach for lease accounting that could be included in the second exposure draft for the lease accounting convergence project. It was added to the list of approaches after the International Accounting Standards Board and the Financial Accounting Standards Board could not agree on the other approaches. Whole contract "accrues the average rent as the reported lease cost ... and adjusts the lease liability on each balance sheet date to be the present value of the remaining lease payments," Erika Morphy writes in this article.
    AICPA Newsletter


    "IS A LEASE ACCOUNTING BREAKTHROUGH IN THE OFFING? WE ARE HOLDING OUR BREATH," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, June 4, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/

    Bob Jensen's threads on lease accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases

     


    When the IASB and the FASB Cannot Agree Try Plan D

    Whole contract, or Approach D, is a fourth possible approach for lease accounting that could be included in the second exposure draft for the lease accounting convergence project. It was added to the list of approaches after the International Accounting Standards Board and the Financial Accounting Standards Board could not agree on the other approaches. Whole contract "accrues the average rent as the reported lease cost ... and adjusts the lease liability on each balance sheet date to be the present value of the remaining lease payments," Erika Morphy writes in this article.
    AICPA Newsletter When Introducing the Link Below

    "What’s Approach D? Maybe the Answer to CRE’s Lease Accounting Concerns," by Erika Morphey, Globe Street, May 2012 ---
    http://www.globest.com/news/12_342/washington/accounting/Whats-Approach-D-Maybe-the-Answer-to-CREs-Lease-Accounting-Concerns-321140.html

    WASHINGTON, DC-A key concern of commercial real estate companies is looming changes to how they account for leases. The International Accounting Standards Board and the US Financial Standards Board have worked—or rather, struggled—to converge their two respective lease accounting standards, and so far the proposals have been less than pleasing to the CRE industry.

    Now, a new proposal has emerged that could be satisfactory to real estate and other business users, Bill Bosco, a consultant for the Washington, DC-based Equipment Leasing and Finance Association and principal of Leasing 101, tells GlobeSt.com.

    There are still some hurdles, namely IASB is reportedly not yet on board, he says. “But this is the proposal we think most of the stakeholders would agree is an acceptable method,” he states. “Certainly real estate owners, concerned about what their lease costs will look like, will accept this one as the best of all proposed methods.” He estimates that 75 to 80% of the dollar volume of operating leases are real estate leases.

    This new proposal is called whole contract. It accrues the average rent as the reported lease cost--much the same as current GAAP--and adjusts the lease liability on each balance sheet date to be the present value of the remaining lease payments. “It does not change the P&L or the cash flow presentation for what used to be the operating lease,” Bosco says.

    Whole contract, or Approach D as it is also called, was added as a fourth possibility after FASB and IASB could not come to an agreement this February on the lessee cost pattern issue. This is deemed to be the most significant unresolved issue that is holding up the issuance of a new exposure draft for converged lease accounting project.

    When the boards were unable to agree on any of the three lessee accounting approaches presented at their meetings, their staff was directed to conduct industry outreach to get preparer and user feedback. Approach D is up for consideration to be included in the second exposure draft.

    Continued in article


    "The Tax Import of the FASB/IASB Proposal on Lease Accounting," by George Mundstock, SSRN, September 11, 2012 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2144935 

    In August of 2010, FASB and the IASB jointly proposed completely new financial accounting rules for simple leases. Basically, the proposal would treat all leases as involving both the use of the leased property and a financing of that use. One consequence of this treatment is more accelerated recognition of rent revenue and expense than currently. This article reviews the proposal, considers how, as financial accounting, the proposal would impact U.S. Federal, state, and local tax-related matters, and then explores whether the proposal should be adopted as U.S. income tax law. The proposal would improve U.S. tax law, including providing the foundation for better rules for sourcing the income of multinational businesses. Even if FASB and IASB do not implement their proposal, its approach would provide the basis for valuable tax reform.

    Jensen Comment
    Reactions to the Dual Model Lease Proposal have been so overwhelmingly negative, it's not yet what will new lease accounting rules will emerge. Personally, I don't think anything will be resolved until standard setters invent a better way for dealing with short-term lease renewal/cancellation options.


    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:

    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


    Jagdish wrote:
     
    "It is not a paradigm shift, for there is no
    paradigm at all. All accounting concepts
    are socially constructed and are subject to
    social reality (and social acceptability)
    checks."


    I totally disagree.
    There have been certain foundational paradigms of accounting standard setting for centuries. The most permanent of these, until now, is that accounting assets and liabilities are built upon contractual obligations, most of which carry some penalties or benefits if they are broken --- this is the basis of bankruptcies and most civil lawsuits.


    The booking of forecasted transactions is what I view as a paradigm shift. Until now I've mostly thought about this in terms of the booking of airline gate lease renewals on the lessee's balance sheet or the booking of a forecasted transaction of a lessee to buy jet fuel a year from now.


    Suppose the Southwest Airlines books the estimated discounted cash flow lease renewals for an airline gate --- this is a booked  liability. What happens on the books of the lessor? Presumably this becomes a booked asset. What happens to the asset (to the lessor) and the liability (to the lessee) if the lessee simply elects not to renew the lease?


    In double entry accounting what are the entries for not renewing booked lease renewals?
    Please answer in terms of the books of both the lessee and the lessor.




    For convenience I repeat part of an earlier message:


     
    Suppose we define the event as the signing of a 18-month lease of Gate 12 at the Manchester, New Hampshire airport. The lease contract calls for 12 monthly payments of $10,000 each. In addition, the lease has a forecasted transaction of renewal on each year thereafter at the discretion of Southwest Airlines for ten years at a monthly rate of $10,000 per month plus or minus a rental premium or discount pegged to the change in U.S Treasury Rates. For simplicity ignore cancellation fees, leasehold improvement costs, and rental rate inflation adjustments. The treasury rate adjustment is probably unrealistic, but for educational purposes this does add a hedgeable component to the forecasted transaction prices. I think it is common in lease renewals to have hedgeable components.
     
     
    The future annual renewals are forecasted transactions in the same sense as forecasted transactions of jet annual jet fuel purchases of an airliner. The forecasted transactions of fuel expenses cannot be booked under GAAP even if they are hedged items. I assume that the forecasted transactions of gate lease renewals will be booked under the new joinrt lease capitalization standard. Thus there's a question about consistency in terms of the Conceptual Framework.
     
     
    My question is whether capitalizing some forecasted transactions (e.g., lease renewals) while not capitalizing most other forecasted transactions (e.g., forecasted jet fuel purchases) are both in formal logic conformance with the FASB's Conceptual Framework.
     
     
    Another way of putting this question is whether cherry picking what forecasted transactions are required to be booked under new or revised standards is consistent with the Conceptual Framework. And are there any Conceptual Framework guidelines for deciding whether a forecasted transaction must be booked?


    In double entry accounting what are the entries for not renewing booked lease renewals?
    Please answer in terms of the books of both the lessee and the lessor.

    A dual model for lease accounting: redrawing the lines --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8VAMTX&SecNavCode=MSRA-84YH44&ContentType=Content


     

     
     
    Note that no contracts are signed for forecasted transactions. These are defined in FAS 133, and you can read about them by scrolling down at
    http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms
    Page references are to Version 1 of FAS 133.
     
     


    Forecasted Transaction =
     
    a transaction that is expected, with high probability, to occur but as to which there has been no firm commitment. Particularly important is the absence penalties for breach of contract.  Paragraph 540 on Page 245 of FAS 133 defines it as follows:
     
    A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.
     
    To my students I like to relate firm commitments and forecasted transactions to purchase commitments or sales contracts that call for future delivery.  If the contract specifies an exact quantity at a fixed (firm) price, the commitment is deemed a "firm commitment."   Cash flow is never in doubt with a firm (fixed-price) commitments and, therefore, a firm commitment cannot be hedged by a cash flow hedge.  For example, suppose Company A enters into a purchase contract to purchase 10,000 tons of a commodity for $600 per ton in three months time.  This a firm commitment without any doubt about the cash flows.  However, if the price is contracted at "spot price" in three months, the commitment is no longer a "firm" commitment.  The clause "spot price" makes this a forecasted transaction for 10,000 at a future price that can can move up or down from its current level.  It is possible to enter into a cash flow hedge with a derivative instrument that will lock in price of a forecasted transaction.  In the case of a firm commitment there is no need for a cash flow hedge.
     
    In the case of a firm commitment the cash flow is fixed but the value can vary with spot prices.  For example, in three months time the firm commitment cash flow may be ($600)($10,000) = $6,000,000.  If the spot price moves to $500, the cash flow is more than the value of the commodity at the time of purchase.  It is possible, however, to use a derivative financial instrument to hedge the value at a given level (called a fair value hedge) such that if the spot rate falls to $500, the hedge will pay ($600-$500)(10,000 tons) =  $1,000,000.
     
    In the case of a forecasted transaction at spot rates, the value stays fixed at ($ spot rate)(10,000 tons).  However, the cash flow accordingly varies.  It is possible to enter into a cash flow hedge using a derivative financial instrument, however, such that the cash flow is fixed a desired level.  In summary either cash flows are fixed and values vary (i.e., a fixed commitment) or cash flows vary and values are fixed (forecasted transaction).  If hedging takes place, firm commitments are only hedged with respect to value, whereas forecasted transactions are only hedged as to cash flow.
     
    Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or obligations for future sacrifices.  Firm commitments differ from forecasted transactions in terms of legal rights and obligations.  A forecasted transaction has no contractual rights and obligations. Forecasted transactions are referred to at various points in FAS 133. For example, see FAS 133 Paragraphs 29-35, 93, 358, 463-465, 472-473, and 482-487. A forecasted transaction, unlike a firm commitment, may need a cash flow hedge.  
    Paragraph 29b on Page 20 of FAS 133 requires that the forecasted transaction be probable.  Important in this criterion would be past sales and purchases transactions.  An on-going baking company, for example, must purchase flour.  It does not have to purchase materials for a plant renovation, however, until management decisions to renovate are firmed up.
    Paragraph 325 on Page 157 of FAS 133 states that even though forecasted transactions may be highly probable, they lack the rights and obligations of a firm commitment, including unrecognized firm commitments that are not booked as assets and liabilities. 
    Forecasted transactions differ from firm commitments in terms of enforcement rights and obligations. They do not differ in terms of the need for a specific notional and a specific underlying under Paragraph 440a on Page 195 of FAS 133.  Section a of that paragraph reads as follows:
     
    a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign
    currency. It also may be expressed as a specified interest rate or specified effective yield.
    In Paragraph 29c on Page 20 of FAS 133, the forecasted transaction cannot be with a related party such as a subsidiary or parent company if it is to qualify as the hedged transaction of a cash flow hedging derivative.  An exception is made in Paragraph 40 on Page 25 for forecasted intercompany foreign currency-denominated transactions if the conditions on Page 26 are satisfied. Also see Paragraphs 471 and 487.  Paragraph 40 beginning on Page 25 allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  However, a consolidated group may not apply cash flow hedge accounting as stated in Paragraph 40d on Page 26. 
    Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For reasons and references, see equity method.
    Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.
     
    One question that arises is whether a hedged item and its hedge may have different maturity dates.  Paragraph 18 beginning on Page 9 of FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than the hedged item such as a variable rate loan or receivable.  On the other hand, having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998) states the following.  A portion of that example reads as follows:
     
    Although the criteria specified in paragraph 28(a) of the Standard do not address whether a portion of a single transaction may be identified as a hedged item, we believer that the proportion principles discussed in fair value hedging model also apply to forecasted transactions.
     
    Paragraph 29d precludes forecasted transactions from being the hedged items in cash flow hedges if those items, when the transaction is completed, will be remeasured on each reporting date at fair value with holding gains and losses taken directly into current earnings (as opposed to comprehensive income).  Also see Paragraph 36 on Page 23 of FAS 133.  Thus, a forecasted purchase of raw material inventory maintained at cost can be a hedged item, but the forecasted purchase of a trading security not subject to APB 15 equity method accounting and as defined in SFAS 115, cannot be a hedged item. That is because SFAS 115 requires that trading securities be revalued with unrealized holding gains and losses being booked to current earnings.  Conversely, the forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.
    Even more confusing is Paragraph 29e that requires the cash flow hedge to be on prices rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.


     
    A forecasted transaction must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.    Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:
    Paragraph 21 on Page 13,
    Paragraph 29 beginning on Page 20,
    Paragraph 241 on Page 130,
    Paragraph317 on Page 155,
    Paragraphs 333-334 beginning on Page 159,
    Paragraph 432 on Page 192,
    Paragraph 435 on Page 193,
    Paragraph 443-450 beginning on Page 196
    Paragraph 462 on Page 202,
    Paragraph 477 on Page 208.
     
     
    For example, a group of variable rate notes indexed in the same way upon LIBOR might qualify, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.    Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.  It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  For more detail see foreign currency hedge.
    Merely meeting the tests of being a forecasted transaction or a firm commitment does not automatically qualify the item to be designated a hedge item in a hedging transaction.  For example, it cannot be a forecasted transaction cannot be hedged for cash flows if it is remeasured at fair value on reporting dates.  For example, trading securities under SFAS 115 are remeasured at fair value with unrealized gains and losses going directly into earnings. 
    Paragraph 40 beginning on Page 25 bans a forecasted transaction of a subsidiary company from being a hedged item if the parent company wants to hedge the cash flow on the subsidiary's behalf.  However Paragraph 40a allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  Also see Paragraphs 471 and 487.
    Paragraph 21c on Page 14 and Paragraph 29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge.   Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133.
     
    Respectfully,
    Bob Jensen

     

    A dual model for lease accounting: redrawing the lines --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8VAMTX&SecNavCode=MSRA-84YH44&ContentType=Content
     

    Bob Jensen's threads on lease accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases

     


    Lease Accounting

    The August 2010 Exposure Draft and Comment Letters are at
    http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/ed10/Ed.htm

    It seems to me that the ED does not properly account for the key advantage of what was formerly an operating lease --- the “right” to get out of the lease in a short period of time such as a year or less. This is a legal “right” that is not properly addressed in the ED based upon my very hurried reading of the ED. Sure a capital lease can be broken, but the penalties for doing so are usually much more onerous.

    The term “rights” is a very squishy term, much like the very squishy term “control” that is now a popular basis for proposed asset and revenue recognition accounting. The FASB and IASB need to present us with more precise definitions of what is a “right” and what is “control.” I’m not impressed with a standard that simply ignores the difference between a “right” to easily end an operating lease versus the not-so-hot right to terminate a capital lease with an onerous penalty payment.

    There is also moral hazard here. A lessor or lessee might tip his/her hand by disclosing in the April 2011 release of the 2010 financial statements an increased probability of terminating operating leases in less than 12 months. Therefore, in an effort to not tip the hand, the lessor or lessee is highly tempted to lie by stating that  “optional renewal periods that are ‘more likely than not’ to be exercised’ when in fact it may almost be certain that the operating lease will be terminated.

    For example, the lessor may not want to tip his or her hand that secret negotiations are underway to sell the 40-story building containing all those operating leases. The buyer may intend to implode the building and erect an 80-story skyscraper. Up to now, it was taken for granted that operating leases that were disclosed but not capitalized were subject to termination. Now the IASB and FASB are telling us to capitalize future lease payments based upon implied renewals when, in secret, such renewals are in jeopardy and the lessor/lessee really does not want to tip his or her hand in advance of completed negotiations.

    For what we formerly called operating leases the ED is not properly accounting for the value of the “right to terminate” an operating lease at zero penalty cost. That right also has value, but it is a value that’s difficult to book in the general ledger.

    PwC has an “In Brief” take on this ED --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=THUG-88EU62&SecNavCode=MSRA-84YH44&ContentType=Content

    The Key Provisions

    Lessee Accounting

    The proposal effectively eliminates off-balance sheet accounting for most leases. All assets currently leased under operating leases would be brought onto the balance sheet, removing the distinction between capital and operating leases. Other significant impacts include:

    The new asset — representing the right to use the leased item for the lease term — and liability — representing the obligation to pay rentals — would be recognized and carried at amortized cost, based on the present value of payments over the term of the lease.

    The lease term would include optional renewal periods that are “more likely than not” to be exercised – a significant departure from current accounting which (absent a penalty) generally only included non-cancellable periods in the lease term.

    Lease payments used to measure the initial value of the asset and liability would include ―contingen amounts, such as rents based on a percentage of sales or rent increases linked to variables such as the Consumer Price Index (CPI). Today, contingent rents are generally excluded from minimum lease payments and reflected in the period they arise.

    Lease renewal and contingent rents would need to be continually reassessed, and the related estimates adjusted as facts and circumstances change. Under current accounting, absent a modification or binding exercise of an extension option, there is no reassessment of lease term and contingent rentals.

    Income statement ―geograph and the recognition pattern for lease expenses would change. Straight-line rent expense would be replaced by amortization and interest expense. This would result in an acceleration of expense recognition, as interest on the obligation would be greater in the earlier years, similar to a mortgage.

    Lessor Accounting

    After much debate, the boards are proposing a dual model for lessor accounting. Depending on the economic characteristics of the lease, a lessor would apply either a performance obligation approach or a derecognition approach.

    The performance obligation approach would be used for leases where the lessor retains exposure to significant risks or benefits associated with the leased asset either during the term of the contract or subsequent to the term of the contract.

    Under this approach, the lessor would recognize a lease receivable, representing the right to receive rental payments from the lessee, with a corresponding performance obligation, representing the obligation to permit the lessee to use the leased asset.


    Continued in article

     


    "Can we talk about lessee accounting...again?" by PwC, March 2, 2012 --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=KOCL-8RZTS7&SecNavCode=MSRA-84YH44&ContentType=Content

    Summary:
    The February 28-29 joint FASB/IASB board meetings on leases focused on the continued objections from constituents to the 2010 exposure draft's proposed "front-loaded" lessee expense recognition pattern. The boards discussed two possible paths forward, but were unable to reach any tentative decisions and requested that the staff perform further outreach. Read our In brief article for an overview of the two approaches discussed at the meeting.

    Bob Jensen's threads on lease accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases


    "THE ECONOMIC IMPACT OF CAPITALIZING LEASES: THE CHAMBER OF COMMERCE STUDY," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, February 27, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/538 

    On February 16, 2012, the U.S. Chamber of Commerce (COC) issued a report that purportedly examined the economic impact of capitalizing leases as outlined in a recent FASB exposure draft. The actual research was conducted and published by Chang & Adams Consulting, but presumably was funded by the COC and various affiliates. The study claims dire consequences for the U.S. if the FASB continues on its course, including the loss of millions of jobs and the destruction of between $27.5 and $478.6 billion in U.S. Gross Domestic Product (GDP). If this were true, the Congress and the White House should declare the FASB a national villain, strip it of its funding, dissolve its charter, and tar-and-feather the board members and their advisers. Shame on the FASB!

    These doomsday predictions border not only on the ridiculous, but also the whimsical.  The study is flawed and would be easily rejected by all mainstream accounting and finance journals.  Research rigor is absent.  The real shame rests with the economists who carried out this awful “research.”

    As an aside, we recently reviewed a similar study conducted by the Equipment Leasing & Financing (ELF) Foundation (“Economic Impacts of Capitalizing Leases: The ELF Study”).  This research about the impact of lease capitalization on financial statements seemed reasonably good and consistent, as it replicated the results of similar academic studies carried out over the past 30 years.  But, when ELF attempted to measure the induced economic impacts, the research became flawed.  What we find amazing is the timing and the similarity of these studies.  Did ELF coordinate its tactics with the COC?  Are these independent studies?

    Be that as it may, let us focus on the recent COC study,The Economic Impact of the Current IASB and FASB Exposure Draft on Leases.”  This report:

    “… specifically looks at how the proposed standard would negatively impact job creation, the health of the U.S. real estate sector, and liabilities of U.S. publicly traded companies.  The report analyzes the current proposal and under a best case scenario estimated its economic impacts as:

    Continued in article


    "A Perspective on the Joint IASB/FASB Exposure Draft on Accounting for Leases," by the  American Accounting Association's Financial Accounting Standards Committee (AAA FASC):  Yuri Biondi et al., Accounting Horizons, December 2011, pp. 861-877

    . . .

    CONCLUSION

    The committee members are in agreement about the importance of lease accounting for users of financial statements. Overall, we are pleased to see that this exposure draft introduces the “right-of-use” model, rather than the ownership model, which has worked so poorly in practice. Unfortunately, current lease accounting is plagued by loopholes, transaction structuring, and other actions by management to circumvent the intent of the standard. Preventing all transaction structuring is of course a difficult endeavor. The ED makes a good effort at dealing with the current problems of lease accounting, but some big loopholes (concerning especially scope, SPE and intragroup operations, definition of lease term, discounting, and executory contracts for services) remain that need to be closed off. With regard to revaluation, we prefer the current FASB approach (impairment testing), but are opposed to fair value assessments and reassessments that create structuring opportunities.

    The ED as currently specified is not ready for use and needs significant modification. In response to comments from this committee and others, the FASB/IASB have held a number of re-deliberation meetings in 2011 and directed staff to re-examine several issues. Key focus has been on the scope and definition of a lease, measurement of contingent rentals, renewal options, revaluations, the discount rate to be used, lack of consistency between the lessor and lessee accounting, and consistency with current revenue recognition and financial statement presentation projects.

    As of March 27, 2011 (see IASB 2011), the FASB/IASB have affirmed the scope and definitions used in the lease ED, the need to distinguish a lease from a service contract, the need to separate lease and non-lease components of a contract, and to have two types of leases called finance leases (current IASB terminology) and other than finance leases (like current operating leases in U.S. GAAP). Additional clarification has been issued about the discount rate to be used by the lessor and lessee (the rate charged by the lessor to the lessee) though this is complicated because the lessor's rate may not be known by the lessee. Additional guidance has also been issued to count a renewal option in the lease term “when there is a significant economic incentive for an entity to exercise an option to extend the lease.” The need to align this standard with the revenue recognition, consolidation, and financial statement presentation projects indicate that the board has continued need for re-deliberation, and is struggling to construct a lease standard that will achieve consistent and comparable financial reporting.

    Yuri Biondi (principle author), Robert J. Bloomfield, Jonathan C. Glover, Karim Jamal, James A. Ohlson, Stephen H. Penman, Eiko Tsujiyama, and T. Jeffrey Wilks


    "ECONOMIC IMPACTS OF CAPITALIZING LEASES: THE ELF STUDY," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, January 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/arch
    ives/491#more-491

    The Equipment Leasing & Financing (ELF) Foundation issued a study on leases in December.  We assume these elves were hoping Santa would present them a gift of no amendments to lessee accounting.  After all, why report economic reality if you don’t have to?

    Specifically, ELF issuedEconomic Impacts of the Proposed Changes to Lease Accounting Standardin an attempt to display the dysfunctional consequences of the FASB’s exposure draft on the topic.  The foundation empirically studied the impact of this proposal on more than 1,800 publicly traded companies.  The results show deteriorations in corporate balance sheets and income statements, so ELF concluded the new lease accounting will be disastrous for the U.S. economy.

    Before we lob grenades at the FASB for its lack of support for capitalism, let’s take a closer look at the study and its conclusions.  When we do, we find biases and myths that render the report’s conclusions worthless.

    Let’s begin with the comment letters.  The FASB received about 800 letters on this leasing project; upon reading them, one finds a number of concerns from the letter writers, including ambiguities in the exposure draft, the need for more explanation, the magnitude of implementation costs, and the problem of debt covenants.  We dismiss these concerns and the letters in general because corporate managers acting in their self-interest have long orchestrated major campaigns to smear the FASB whenever it attempted to improve financial reporting.  The number of letters doesn’t mean a thing; the source says it all.

    While there are indeed some items that need conceptual editing, and perhaps even some parts that could use more explanations, these features too often are a smokescreen to force the FASB to compromise its principles to better align with managerial objectives.  As to implementation costs, we think the argument silly for the necessary data should already be collected if these firms have good internal control systems, particularly in light of developing fair value disclosure requirements.  Any firm that does not currently assimilate these data is admitting poor stewardship.

    With respect to debt covenants, we thought that corporate managers and general counsel would have figured out that one should always include in these contracts a provision to hold accounting methods constant.  And surely, these highly compensated legal minds are familiar with waivers and modifications of debt covenants, aren’t they? Any firm foolish enough not to immunize itself contractually from accounting changes deserves whatever consequences it faces.

    With respect to the empirical analysis by ELF, for the most part, it is well done and corresponds closely with academic research over the last 30 years.  In particular, ELF estimates the direct and indirect impacts from the capitalization of leases.  As other studies have found, this research reports large increases to reported debt and some decreases to net income because of the front-loading effect in capitalized leases.  Analysts (and our accounting students) have known this for decades…there is no news here.

    The report also points out that these effects vary by industry and by firm.  For example, the impacts are greatest for firms such as CVS and Walgreen and for industries such as banking and airline.  The impact is smallest, of course, for those who do not employ leases.

    For the U.S. economy, the study estimates the addition of $2 trillion of reported debt, an 11 percent increase, and a decrease in pre-tax income of 2.4 percent.  ELF concludes that these effects will have deleterious effects on the economy and thus recommends opposing the FASB’s exposure draft.  At this point, however, it confuses reported items on the financial statements with real and fictional constructs.  The question the authors should be asking is whether the stuff currently omitted from financial reports is real.

    In particular, is the lease obligation that arises in capital leases real?  Of course.  Does the non-capitalization of leases change this?  Of course not!  Because the lessee has signed a contract with a lessor that requires it to make certain future payments, the liability is real whether or not the firm records it.  That’s why sophisticated financial analysts have been estimating lease obligations for at least two decades.  That’s why rating agencies have been estimating lease obligations for several years.  If you want to know the truth and the corporation does not disclose the truth, sophisticated investors and their analysts will make their own assessments and include them in their analyses.

    Because of these changes in the reported numbers, the ELF study group posits “induced impacts” and claims a variety of dysfunctional consequences such as job losses and increased interest rates.  Unfortunately, because the researchers ignored the fact that many financial analysts and investors already estimate the effects of leases and recast the financial statements accordingly, these induced impacts are exaggerated and thus misleading.  Stock and debt markets already incorporate such information into their models; therefore, the aggregate effects of capitalizing leases are likely nil.

    The authors mention the fact that capitalization will make cash flow from operating activities higher, but they do not emphasize it.  We wonder whether this de-emphasis is because they don’t want to report any positive effects from adopting this accounting proposal.  Further, if they continue to believe that markets are naïve in their assimilation of financial information, they would have to conclude that higher free cash flows imply higher stock prices.

    Continued in article

     


    Ernst & Young


    To the Point: A U-turn on straight-line lease expense

    Today (May 19, 2011) , the FASB and the IASB reversed course on their tentative decision to introduce lease classification and straight-line rent expense into their new accounting model for lessees. The Boards have decided to go back to their exposure draft approach of requiring lessees to recognize interest expense using the interest method and separately amortize the right-of-use asset (generally on a straight-line basis). This approach accelerates lease expense for today's operating leases.
    Our To the Point publication summarizes what you need to know about these developments.
     
    To the Point: Key differences between IASB's new consolidation guidance and US GAAP

    Click Here
    http://www.ey.com/global/assets.nsf/United%20Accounting/TothePoint_BB2134_Leases_19May2011/%24file/TothePoint_BB2134_Leases_19May2011.pdf

    The IASB has issued new consolidation accounting guidance that establishes a single consolidation model for all entities. The new guidance is more similar to the guidance for the consolidation of variable interest entities (VIEs) in US GAAP than the current IASB guidance, but it creates new differences between US GAAP and IFRS in some areas. Some longstanding differences also remain. Our To the Point publication highlights some of the significant differences that exist between current US GAAP and the IASB's new guidance.

    Bob Jensen's threads on leasing are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Leases


    In the future operating leases will be capitalized more and more under newer accounting standards. Here's an investigation on what to expect in terms of impact on cost of capital, although the study suggests that the impact will not be as abrupt as some might expect given the increased attention on operating leases in capital markets.

    "The Impact of Operating Leases on Firm Financial and Operating Risk," by Dan Dhaliwal, Hye Seung (Grace) Lee, and Monica Neamtiu, Journal of Accounting Auditing and Finance, 2011 --- http://jaf.sagepub.com/content/26/2/151

    Abstract
    This study uses ex ante cost-of-equity capital measures based on accounting valuation models to assess the risk relevance of off-balance sheet operating leases. We investigate whether off-balance sheet operating leases have the same risk-relevance for explaining ex ante measures of risk as a firm’s on-balance sheet capital leases. We also investigate how investors’ risk perception of operating leases has changed in recent years when off-balance sheet transactions in general and operating leases in particular have been facing increased regulatory and investor scrutiny. This study finds that a firm’s ex ante cost-of-equity capital is positively associated with adjustments in its financial leverage (financial risk) and operating leverage (operating risk) resulting from capitalized off-balance sheet operating leases and that the positive association between the ex ante cost of capital and the impact of operating leases on a firm’s financial leverage is weaker for the operating leases compared with the capital leases. This study also finds that the positive association between the ex ante cost of capital and the impact of operating leases on a firm’s financial leverage has decreased considerably in recent years, since regulators issued interpretation letters clarifying controversial lease accounting issues
    .

    October 21, 2011 reply from Beryl Simonson

    For your lease discussion
    Beryl D. Simonson CPA
    Partner, Assurance Services
    McGladrey & Pullen, LLP
    (267) 515-5144

     
     
    From: NAREIT FirstBrief [mailto:FirstBrief@nareit.com]
    Sent: Thursday, October 20, 2011 03:54 PM
    To: Simonson, Beryl
    Subject: FASB and IASB Tentatively Expand Scope Exception for Proposed Leases Standard to All Investment Property
     
     
    View this email as a web page
    October 20, 2011

    FASB and IASB Tentatively Expand Scope Exception for Proposed Leases Standard to All Investment Property

    On Oct. 19 - 20, NAREIT attended the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) (collectively, the Boards) joint meetings on the proposed Leases standard in Norwalk, CT. The Boards tentatively decided to expand the scope exception from the proposed Leases standard to all investment property, whether measured at fair value or cost. In order to be eligible for the scope exception, investment property would need to be consistent with the definition of investment property as defined in the proposed FASB Investment Properties standard for U.S. companies and International Accounting Standards No. 40 Investment Property for companies reporting under IFRS. Based on this tentative decision, all lessors would avoid reporting under the previously proposed receivable and residual lessor accounting model. Those lessors that qualify as an investment property entity under the FASB's Investment Properties standard would be required to report their investment properties at fair value and recognize rental revenue on a contractual basis. All other investment property lessors would report rental income as currently required on a straight-line basis. Based on discussions with the FASB staff, NAREIT expects the FASB to issue the Investment Properties exposure draft in the next few days.

    On Sept. 20, NAREIT met with the FASB and IASB staff to discuss potential issues with applying the proposed receivable and residual lessor accounting model to investment properties reported at cost. NAREIT developed an illustration that served as the basis for the meeting. The illustration indicated that the proposed receivable and residual lessor accounting model was not operational and yielded irrelevant financial reporting. The FASB and IASB staff discussed NAREIT's concerns with the Boards and recommended that all investment property be exempted from the proposed receivable and residual lessor accounting model in conjunction with the staff paper on Lessor Accounting that was presented on Oct. 19. To read the staff paper on Lessor Accounting, refer to IASB Agenda Reference 2F/FASB Agenda Reference 210. Previously, the Boards tentatively decided to include a scope exception in the proposed leases standard for investment property only if measured at fair value.

    Contact

    If you have any comments or questions, please contact Christopher Drula, NAREIT's Senior Director, Financial Standards, at cdrula@nareit.com.

     

     


    Ketz Me If You Can
    "Operating Lease Obligations to be Capitalized." by J. Edward Ketz, SmartPros, August 2010 ---
    http://accounting.smartpros.com/x70304.xml

    Wow! I have wondered for a few decades whether the accounting profession ever would account for operating leases correctly. Long-term operating leases, as opposed to rentals no longer than one year, clearly convey property rights and encumber the business entity with debt obligations. Not to require this accounting has served as a badge of hypocrisy long enough.

    The FASB and the IASB issued exposure drafts August 17, which propose to make this change in the treatment of operating leases.  They also discuss some changes in the accounting for purchase options, conditionals, leases with service contracts, and the accounting for lessors, including the elimination of leveraged leases.  I shall address these topics at a later time; in this essay I wish to concentrate on the more fundamental issue of lessee accounting.

    Let’s review the history of accounting for operating leases briefly.  The board issued Statement No. 13 on lease accounting in November 1976.  (The Accounting Principles Board also had pronouncements on lease accounting, but they were simply dreadful.)  For lessees, the statement created two categories, capital leases and operating leases.  The FASB concocted four criteria for the recognition of a lease as a capital lease.  If any one of the following criteria is met, then the business enterprise must account for the lease as a capital lease.  They are: (a) if legal title passes to the lessee; (b) if the lease contains a bargain purchase option; (c) if the lease term (the length of the lease) equals or exceeds 75 percent of the asset’s life; and (d) if the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.  If none of the four criteria is met, then the business enterprise treats the lease as an operating lease.

    Accounting for these leases differs greatly.  In a capital lease, the firm capitalizes the asset at its present value (not to exceed its fair value), and it capitalizes the lease obligation at the present value of future cash flows.  On the income statement, the business enterprise shows the depreciation of the capitalized asset and displays the interest expense on the lease obligation.  In an operating lease, the entity ignores its property rights and it pretends that it has no debts, and on the income statement, the organization acknowledges a rent expense.  There is, however, no economic justification for this differential treatment.

    I think it amazing—maybe even revolutionary—for the board finally to follow its own conceptual framework in the development of lessee accounting standards.  The FASB’s conceptual framework defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”  Further, it defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” 

    It doesn’t take an accounting professor, much less Donald Trump, to figure out that leases confer to lessees probable future economic benefits and probable future sacrifices.  Present-day accounting for operating leases contradicts this rational approach of reporting the economics of these business transactions.  If the board only applies its own conceptual framework, as it appears ready to do, then it will achieve a much better accounting.

    Let’s also remind ourselves of the significant consequences of these actions.  Billions, maybe trillions, of dollars of lease obligations have been off-balance sheet since time began.  Here is a small sample of firms, with my estimates (details on my estimation scheme inHidden Financial Risk”) of the present value of the cash flows of the operating leases (numbers are millions of dollars except for percentages).

     

    Reported Debt

    PV of Operating Lease Cash Flows

    Percent Debt is Under-reported

    CVS

    25,873

    26,913

    104.02%

    Walgreens

    10,766

    23,212

    215.60%

    McDonalds

    16,191

    7,996

    49.39%

    Target

    29,186

    2,155

    7.38%

    Home Depot

    21,484

    5,846

    27.21%

    Starbucks

    2,532

    3,685

    145.54%

    Clearly, the capitalization of essentially all leases is an important step to knowing realistically what corporations owe.  Notice that this sample of only six firms has off-balance sheet lease debts of almost $70 billion.  As this amount is material to everybody (except for members of Congress and the White House), business enterprises should supply this information to investors and creditors so they can better understand the firm’s financial leverage.

    While this chapter of financial reporting is coming to a close, the most remarkable event in the history of lease accounting occurred in 1960.  That year Arthur Andersen published the booklet “The Postulate of Accounting” and averred that the only postulate of accounting is fairness.  “Financial statements cannot be so prepared as to favor the interests of any one segment without doing injustice to others.”  To add flesh to this argument, Arthur Andersen then gave the example of leases, contending that all leases should be capitalized.  Unfortunately, the AICPA’s Committee on Accounting Procedure and its Accounting Principles Board ignored these comments.

    Fifty years ago this once great firm, under the leadership of Leonard Spacek, showed how a principled and courageous analysis of the facts could lead one to the proper accounting.  It shows that principles-based accounting can work—as long as we have principled leaders in the profession.  But it also shows the dangers of principles-based accounting when others are not blessed with logical thinking or courage—when they are not principled.

    P.S.  The FASB really doesn’t have to apply an exception to short-term leases, those under twelve months in duration.  Every FASB statement is stamped with the caveat, “The provisions of this Statement need not be applied to immaterial items.”  As I expect most short-term rentals to provide income statement and balance sheet effects that are immaterially different from their capitalization, there is already a basis for firms not to worry about the accounting for such leases.

    Jensen Comment
    Something keeps nagging me that the "right to terminate" a lease in a year or less has economic value to be factored into the concocted scheme to forecast operating lease rentals ad infinitum. Until the IASB and FASB give us implementation guidelines on how to value the right to terminate, I'm not as solidly behind this revision to the standard as Professor Ketz.

    Those professionals that are the most mobile and expectant of promotions and relocations, like gifted accounting staff, are recognizing the "right to terminate" values vis-a-vis having former houses in Phoenix and Las Vegas that they just cannot unload for as much as their equity in those houses. If they knew what they know now they would've rented throughout much of their careers --- at least until they've finally settled in.. The same can be businesses growing wildly or shrinking wildly that find facilities they own very hard to unload.

    The lease versus buy cases that we've taught for years were probably incomplete --- I've never seen a case that values the "right to terminate" such that instead of capital lease versus buy we probably should've include a third alternative --- operating lease with an inherent right to terminate without penalty.

    August 23, 2010 message from Tom Selling

    If you are looking for a principles-based approach to lease accounting, you may be interested in reading these blog posts (especially the first one listed)

    Lease Accounting: Replacement Cost is the Only Hope for a Principles-Based Solution

    Reason #2 to Dump on the IASB/FASB Leasing Proposal

    The Lease Accounting Proposal: What Investors Say

    Lease Accounting: Replacement Cost is the Only Hope for a Principles-Based Solution

    Reason #2 to Dump on the IASB/FASB Leasing Proposal

    The Lease Accounting Proposal: What Investors Say

    Bob, if you are looking for information on cancellation options, I’ll bet you can find it in:

    Copeland and Antikarov, Real Options, Revised Edition: A Practitioner’s Guide. There is a chapter on how Airbus used option valuation techniques for pricing and negotiating leases of airplanes.

    I should also say that I don’t see how the presence of an option to cancel without penalty calls capital lease accounting into question. Isn’t it the mirror image of a renewal option? The only additional twist is that the option is “American style”, i.e., it may be exercised at any time, as opposed to only the expiration date (“European style”).

    Finally, I plan on writing another leasing post – probably building on Ed’s (whom I had the pleasure of meeting for the first time at the AAA). I expect the message in my post will be that lease capitalization is fine as far as it goes, but the ED blithely continues the tradition of plugging in made up numbers since nobody can bring themselves to commit to some version of current value – and historic cost principles are to leasing as a pea shooter is to an elephant.

    Best, Tom

     

    August 24, 2010 reply from Bob Jensen

    Bob Jensen's sadly neglected threads on real options and references to early applications are at
    http://faculty.trinity.edu/rjensen/Realopt.htm

    I like to think of actual examples. There was a big east-side mall in San Antonio that was a great mall suffering from a rapid decline in the surrounding neighborhood. It became a beautiful indoor congregating point for dope dealers and gangs and prostitutes. After a couple of murders in the mall, customer traffic declined dramatically and within a few years this great mall had to close. The three big department stores attached to the mall probably had long-term leases such that they were forced to try to operate on their own for a while even though the interior two-story mall with nearly 50 stores and theatres was blocked off and empty. I suspect the big department stores wanted out of their leases, but they could not do so nearly as easy as the stores inside the mall that only had operating leases with the right of termination in less than 12 months. 

    Also consider the surrounding stores and restaurants that built up around the mall and depended upon the thousands of customers drawn weekly to the mall when it was thriving. For example right next to the mall parking Toys”R”Us built its own store financed with ownership or a capital lease.

    Think of how much more valuable, in hindsight, it would have been for Toy”R”Us to have an operating lease inside the mall where the “right to terminate” became extremely valuable as the customers abandoned the mall in droves. In retrospect Toys”R”Us was stuck with long-term financing obligations that extended well beyond the profitability of the location. In short, the building quickly became a liability rather than an asset.

    An operating lease is extremely valuable in situations where future needs for buildings and/or the equipment are extremely volatile and virtually unpredictable due to nonstationarities that make mathematical forecasting models virtually worthless. Mathematical valuation models like real options models require greater statationarities.

    Real options analysis was invented by one of my fellow students, Stu Meyers (finance), in the doctoral program at Stanford. It's a brilliant financial model, but like so many finance models, it does not deal well in nonstatationarity environments. Stu did not invent the model until years later when he was a professor at MIT. I think it would be a great danger to an entrepreneur when assumed parameters are extremely tenuous.

    Other more traditional capital budgeting models also fail in in nonstationarity situations. But the problem is greatly reduced when there is less fixed cost such as when an entrepreneur commits only to an operating lease rather than a long-term mortgage or capital lease.

    Real Options Analysis --- http://en.wikipedia.org/wiki/Real_Options#Comparison_with_standard_techniques

     ROA is often contrasted with more standard techniques of capital budgeting, such as net present value (NPV), where only the most likely or representative outcomes are modelled, and the "flexibility" available to management is thus "ignored"; see Valuing flexibility under Corporate finance. The NPV framework therefore (implicitly) assumes that management will be "passive" as regards their Capital Investment once committed, whereas ROA assumes that they will be "active" and may / can modify the project as necessary. The real options value of a project is thus always higher than the NPV - the difference is most marked in projects with major uncertainty (as for financial options higher volatility of the underlying leads to higher value).

    More formally, the treatment of uncertainty inherent in investment projects differs as follows. Under ROA, uncertainty inherent is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach). Cash flows can then be discounted at the risk-free rate. Under DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate, (using e.g. the cost of capital) or the cash flows (using certainty equivalents, or applying "haircuts" to the forecast numbers). These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment.

    In general, since ROA attempts to predict the future, the quality of the output will only ever be as good as the quality of the inputs, which by their nature are sketchy. This comment also applies to net present value analysis, although NPV does not require volatility information (see below). Opinion is thus divided as to whether Real Options Analysis provides genuinely useful information to real-world practitioners. ROA is therefore increasingly used as a discussion framework, as opposed to as a valuation or modelling technique.

     

    Bob Jensen's sadly neglected threads on real options and references to early applications are at
    http://faculty.trinity.edu/rjensen/Realopt.htm

    The above document quotes a great article by Wayne Upton when he was still at the FASB.
    "Special Report: Business and Financial Reporting, Challenges from the New Economy," by Wayne Upton, Financial Accounting Standards Board, Document 219-A, April 2000 --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 
    Incidentally Wayne was the FASB's technical guru on FAS 133 and its very technical revisions like FAS 138. Last I heard, Wayne changed to the IASB.

    PS
    I’ve not lived in San Antonio for nearly five years, but I think the failed mall was eventually purchased by the School District for offices and maybe some classrooms. I could be wrong about whether that proposal for the mall's use came into being.. In any case, businesses lost a lot of money when the mall failed, but those businesses with operating leases had an easier time due to the value of the “Right to Terminate.”

    Bob Jensen

    Inconsistencies in Two Proposed IFRS Changes: The Ups and Downs of International Accounting Standard "trigger events"

    In the context of FAS 39, a "trigger event" is an event that changes the likelihood of fully collecting or paying out a forecasted stream of future cash flows. The forecasted cash flows could be contractual such as the contracted stream of cash flows from a forward contract used as a speculation or a hedge. The fair value of the future stream is said to have become "impaired" by the "trigger event" that is material in nature. Auditors are required to test for impairments in cash flow streams. The net impact on the balance sheet may vary greatly when the contract is a speculation versus when the contract is a hedge and the amount of impairment loss/gain is offset by the amount of impairment gain/loss on a hedged item and vice versa.

    For items carried at fair value, trigger events should be automatically recognized in changes in fair value unless the trigger event itself makes it impractical to measure fair value (such as a freezing or collapse in the market used to measure fair value). If a receivable is carried at amortized cost, trigger events are especially important and may signal the need to anticipate a loss such as an estimated bad debt loss.

    An example of a common trigger event is a hugely lowered credit score/rating of a debtor.

    For later reference, I might define a "wipeout trigger event" as one that reduces the NPV of a future cash flow stream to zero or virtually zero. Although such a trigger event might be analogous to when Madoff's arrest was announced, a wipeout trigger event may also be perfectly legal such as when a lessee announces in advance that a short-term lease will not be renewed.

    It seems to me that in two current proposed changes to IFRS standards, one proposal is reducing the role of explicitly defined trigger events whereas the other is increasing the role of implicitly defined wipeout trigger events. The two IASB proposed change documents are as follows:

    Financial Instruments
    IAS 39 to IFRS 9:  "IFRS 9: Financial Instruments (replacement of IAS 39)
    --- Click Here

    The objective of this project is to improve the decision usefulness for users of financial statements by simplifying the classification and measurement requirements for financial instruments. In November 2008 the IASB added this project to their active agenda. The FASB also added this project to their agenda in December 2008.

    Leases
    FASB-IASB Joint Proposal on Lease Accounting
    --- Click Here
    http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/ed10/Ed.htm

    ... the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) published for public comment joint proposals to improve the reporting of lease contracts. The proposals are one of the main projects included in the boards’ Memorandum of Understanding. The proposals, if adopted, will greatly improve the financial reporting information available to investors about the financial effects of lease contracts.

    The accounting under existing requirements depends on the classification of a lease. Classification as an operating lease results in the lessee not recording any assets or liabilities in the statement of financial position under either International Financial Reporting Standards or US standards (generally accepted accounting principles). This results in many investors having to adjust the financial statements (using disclosures and other available information) to estimate the effects of lessees’ operating leases for the purpose of investment analysis. The proposals would result in a consistent approach to lease accounting for both lessees and lessors—a ‘right-of-use’ approach. This approach would result in all leases being included in the statement of financial position, thus providing more complete and useful information to investors and other users of financial statements.

    Financial Instruments ED That Plays Down Trigger Events
    IAS 39 to IFRS 9:  "IFRS 9: Financial Instruments (replacement of IAS 39)
    --- Click Here

    This Financial Instruments Exposure Draft (ED), among other things downplays, the role of trigger events in impairment tests. In IAS 39 an anticipated loss may be delayed until a trigger event transpires to require immediate write down of an asset such as a receivable. Presumably this will not be the case in the new IFRS 9.

    When IAS 39 is replaced by IAS 9, the ED proposes to recognize losses (prior to trigger events) by earlier use of probability-weighted estimates of the amounts to be collected in a future cash flow stream. Presumably these probabilities must be subjective (Bayesian) since it is difficult to imagine circumstances where the probability distribution can be objectively estimated. Implicit in the ED is the estimation of probabilities of future states of the domestic and/or world economy.

    Auditors are no objecting to the replacement of trigger events with probability-weighted estimates on the grounds that attesting to such probability-weighted estimates before trigger events will not operational in auditing.

    "Deloitte comment letter on financial instruments," July 6, 2010 ---
    http://www.iasplus.com/dttletr/1007amortcost.pdf

    Excerpt
    We agree with the Board’s objective in this phase of the IASB project to replace IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) to address weaknesses of the incurred loss model in IAS 39 that were highlighted during the global financial crisis. An impairment loss model that focuses on an assessment of recoverable cash flows reflecting all current information about the borrower’s ability to repay would be an improvement on the current approach in IAS 39 which relies on identification of trigger events and often leads to a delay in loss recognition. However, we have concerns about the specific requirements proposed by the IASB, in particular those to determine, and allocate, the initial estimate of expected credit losses on a financial asset and to use a probability-weighted outcome approach. We believe that this approach will in many cases be unnecessarily complex. Further, the incorporation of potential future economic environments in estimating recoverable cash flows would be extremely complex, costly and burdensome to apply by preparers.
    The requirement in the ED to forecast future economic environments and events without providing sufficient guidance with respect to the level of objectivity, verifiability, or support for the underpinnings of these inputs presents significant challenges to internal auditors, external auditors, and regulators. Overall, we believe that the measurement principle would not be operational if the Board were to adopt the ED in its current form.

    Leases ED That Plays Up Wipeout Trigger Events
    FASB-IASB Joint Proposal on Lease Accounting
    --- Click Here
    http://www.ifrs.org/Current+Projects/IASB+Projects/Leases/ed10/Ed.htm

    The most controversial and in most instances welcome proposed change is the required capitalization of operating leases that were previously and commonly used to hide debt in what was tantamount to off-balance sheet financing.

    And the most controversial of the controversial proposed changes is that short term operating leases having renewal options are to assume (for accounting purposes) renewals will take place even though they are not contractually required. For example, a store in a mall may have a year-to-year lease that was not booked on the lessee or lessor balance sheets until the monthly rent is due. The ED requires assumption of renewals that are not contractually required. Hence, the NPV of a year-to-year store lease must be booked as an asset on the lessor's books and a liability on the lessee's balance sheet for a rent cash flow stream across many years in which it is estimated that the lease will be renewed.

    However, the ED does allow for what are tantamount to wipeout trigger events (not called as such in the ED). If it becomes known that the lessee or lessor will not renew the year-to-year lease, then the lessor may no longer record the NPV of future rentals that will not be received and the lessee need not book the NPV of future rentals that will not be paid.

    Jensen Comment

    For these two exposure drafts to be consistent, it would seem that either the probability-weighted requirement in the new IFRS 9 should be deleted or that a probability-weighted requirement should be imposed on short-term lease accounting. In the case of leases, probability weights would be assigned to assumed lease renewals.

    The probability-weighted short-term lease requirement would most likely be objected to by auditors for the same reasons that auditors object to the probability-weighted requirement proposed for the IFRS 9.

    I can anticipate the Deloitte objection letter to be as follows if auditing of lease renewal probability weightings were to (hypothetically) be required::

    Excerpt
    We agree with the Board’s objective to book operating leases in a manner consistent with how capital leases are booked. An impairment loss model that focuses on an assessment of renewable lease cash flows reflecting all current information about the lessee's intent to exercise a renewal option  would be an improvement on the current approach of keeping operating leases entirely off the balance sheet. However, we have concerns about the specific requirements proposed by the IASB, in particular those to determine probability weightings of lease renewals. We believe that this approach will in many cases be unnecessarily complex. Further, the incorporation of potential future economic environments in estimating lease renewal cash flows would be extremely complex, costly and burdensome to apply by preparers.
    The requirement in the ED to forecast future economic environments and events without providing sufficient guidance with respect to the level of objectivity, verifiability, or support for the underpinnings of these inputs presents significant challenges to internal auditors, external auditors, and regulators. Overall, we believe that the measurement principle would not be operational if the Board were to adopt the ED in its current form.

    In general, use of probability-weighted impairment accounting before trigger events transpire is probably an auditing nightmare in general. Trigger event impairment tests are much more realistic for auditors. However, at present the lease accounting ED does not take up the issue of how to deal with trigger events that are not wipeout trigger events.

    Increasingly we are adding subjectivity and hypothetical transactions to financial statements. The biggest example is the transitioning to fair value accounting where assets and liabilities are adjusted for transactions that did not and might not ever transpire such as the interim changing of the value of a forward contract used as a hedge when, at the maturity date, the net cash flows are absolutely certain irrespective of the "hypothetical" changes in fair value before the maturity date.

    If we're going to be so subjective about hypothetical transactions, we might as well impose subjective probability weights to short-term lease renewals rather than assume they will always be renewed until a wipeout trigger event transpires.

    Bob Jensen's threads on lease accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#Leases


    You Rent It, You Own It (at least while you're renting it)
    Not surprisingly, such companies are not overly enthusiastic about the preliminary leanings of FASB and the International Accounting Standards Board toward overhauling FAS 13. The rule update could, by some predictions, move hundreds of billions of dollars in assets and obligations onto their balance sheets. Many of them are hoping they can at least convince the standard-setters that the rule doesn't have to encompass all leases. Under the current rule, companies distinguish between capital lease obligations, which appear on the balance sheet, and operating leases (or rental contracts), which do not. Based on FASB's and IASB's discussion paper on the topic, released earlier this year, the new rule will likely require companies to also capitalize assets that have traditionally fallen under the "operating lease" category, making them appear more highly leveraged.
    Sarah Johnson, "Companies: New Lease Rule Means Labor Pains," CFO.com, July 21, 2009 --- http://www.cfo.com/article.cfm/14072875/c_2984368/?f=archives

    Under the current rule, companies distinguish between capital lease obligations, which appear on the balance sheet, and operating leases (or rental contracts), which do not. Based on FASB's and IASB's discussion paper on the topic, released earlier this year, the new rule will likely require companies to also capitalize assets that have traditionally fallen under the "operating lease" category, making them appear more highly leveraged.

    In addition, warns Ken Bentsen, president of the Equipment Leasing and Financing Association, the proposed changes could lead to higher costs for both capital and accounting. "Rather than simplifying [FAS 13], it ends up creating an extremely complex formula, which will put a great burden, particularly on smaller, nonpublic companies, and does not achieve what we believe is the ultimate goal of FASB and IASB, which is to improve financial reporting," he told CFO.com.

    Bentsen's trade association notes in a recent comment letter (the deadline for comments was last Friday) that the proposed changes will impose on smaller companies a disproportionate burden to apply the new accounting to their leases "for immaterial but required adjustments." According to ELFA, more than 90% of leases involve assets worth less than $5 million and have terms of two to five years.

    The 109-page discussion paper at least starts with what seems like a new simplified concept for lease accounting: lessees must account for their right to use a leased item as an asset and their obligation to pay future rental installments for that item as a liability.

    JCPenney claims it has been in that mindset all along. "Historically, we have managed our capital structure internally as if all real estate property leases were recognized on the balance sheet," wrote Dennis Miller, controller for the retailer, adding that lease obligations are considered long-term debt and have been disclosed in financial-statement footnotes.

    Dissidents to FASB's changing of lease accounting rules have all along said that rating agencies and analysts have referenced such disclosures in footnotes and made adjustments in their modeling to account for a company's leased assets.

    Still, as IASB chairman David Tweedie has noted, the current rules, for example, allow airlines' balance sheets to appear as if the companies don't have airplanes. One of the quibbles with the existing standard is its bright lines, which have legally allowed companies to restructure a leasing agreement so that it be considered an operating lease and not have its assets and liabilities fall onto the balance sheet. In 2005, the Securities and Exchange Commission staff estimated that publicly traded companies are in this way able to hide $1.25 trillion in future cash obligations.

    Critics of the rule-makers' discussion paper are hoping that they'll at least replace the deleted bright lines with some new ones, such as the exclusion of short-term leases. For instance, the Small Business Administration suggested companies should be able to expense rather than capitalize lease transactions of less than $250,000, and others said leases that last less than one year should be expensed. However, the discussion paper notes that such scenarios could give way to workarounds.

    Other common issues raised by respondents to the discussion paper: they want the standard-setters to also tackle lease accounting by lessors. The rule-makers had deferred thinking about lessors as the project continued to be delayed.

    In addition, some respondents pushed back against the suggestion that they should have to reassess each lease as "any new facts and circumstances" come to light. Exxon Mobil's controller, Patrick Mulva, said such reassessments — which would require a quarterly review — would be "excessively onerous" for his company, which has more than 5,000 "significant" operating leases and thousands of "low level" leases. Mulva called on the standard-setters to be more specific for when a reassessment would be required.


    At the FASB (Financial Accounting Standards Board), Bob Herz says he thinks "lease accounting is probably an area where people had good intentions way back when, but it evolved into a set of rules that can result in form-over substance accounting."  He cautions that an overhaul wouldn't be easy:  "Any attempts to change the current accounting in an area where people have built their business models around it become extremely controversial --- just like you see with stock options."
    Jonathan Weil, "How Leases Play A Shadowy Role In Accounting" (See below)  
    By the phrase form over substance, Bob Herz is referring to the four bright line tests of requiring leases to be booked on the balance sheet.  Over the past two decades corporations have been using these tests to skate on the edge with leasing contracts that result in hundreds of billions of dollars of debt being off balance sheets.  The leasing industry has built an enormously profitable business around financing contracts that just fall under the wire of each bright line test, particularly the 90% rule that was far too lenient in the first place.  One might read Bob's statement that after the political fight in the U.S. legislature over expensing of stock options, the FASB is a bit weary and reluctant to take on the leasing industry.  I hope he did not mean this.

    Jensen Comment
    One of the big controversies is lease renewal of relatively short term leases that under old standards were typically operating leases with no chance of ever owning the leased property. For example, those tiny, tiny retail "benches" in the middle of walkways in a Galleria mall may have leased 60 square feet of space for six months. There is no hope that those tiny retailers like cell phone vendors will ever be deeded ownership of 100 square feet of the walkway of a Galleria mall. And the present value of six month lease is relatively small relative to the plan of a retailer to renew the lease ad infinitum. Therein lies a huge problem of deciding how far to extend the cash flow horizon. Retailers are concerned over how lease renewal options will be accounted for, especially those options that can be broken with relatively small penalty payments by the Galleria management. The retailer may intend to stay in this walkway for over 20 years but the Galleria might renege on renewal options for a pittance.


    FASB Okays Project to Overhaul Lease Accounting
    The Financial Accounting Standards Board voted unanimously to formally add a project to its agenda to "comprehensively reconsider" the current rules on lease accounting. Critics say those rules, which haven't gotten a thorough revision in 30 years, make it too easy for companies to keep their leases of real estate, equipment and other items off their balance sheets. As such, FASB members said, they're concerned that financial statements don't fully and clearly portray the impact of leasing transactions under the current rules. "I think we have received a clear signal from the investing community that current accounting standards are not providing them with all the information they want," FASB member Leslie Seidman said before the vote.
    "FASB Okays Project to Overhaul Lease Accounting," SmartPros, July 20, 2006 --- http://accounting.smartpros.com/x53931.xml

    July 21 reply from Bob Jensen

    Hi Pat,

    I agree entirely with you and the new IASB/FASB standard that recognizes that for assets that depreciate, the lessees were gaming the system under either FAS 13 or IAS 17 so as to hide debt and reduce leverage. I’m all for the changes in the standards for depreciable assets.

    I have a bit more of a problem with such things as leased land or leased air space for a store inside a mall. Compare a 20-year lease on an airliner versus a 20-year lease on a shoe store in a Galleria. Even though the airline’s lease was gamed so as not be a capital lease under FAS 13, for all practical purposes the airline has used up much of the aircraft after 18 years. There’s not much difference between leasing and ownership in this case.

    But what has the shoe store used up after 18 years? A cube of air that regenerates every second of every day. The shoe store can never own that air space except in the unlikely event that the Galleria decides to sell all of its rentals as condos. Then the condo terms would all have to be written fresh anyway.

    The big distinction in my mind is the expected amount that would be a cash flow loss to the lessor if the lessee breaks the lease after 18 years. In the case of the aircraft, the loss is very, very substantial. In the case of the cube of air, the loss is minimal assuming the Galleria has equivalent rental opportunities when the lease is broken.

    Is there some type of distinction that should be made on the balance sheet between leased airliners and leased cubes of air?

    Bob Jensen

    July 21, 2009 reply from John Brozovsky [jbrozovs@VT.EDU]

    Probably no distinction should be made. The shoestore has purchased the right to park their hat in a prime location. In real estate it is location, location, location. The right to use an exclusive location is certainly an asset and the future payments a liability.

    John

    July 21, 2009 reply from Bob Jensen

    Hi John,

    One distinction arises if the shoe store can simply walk away from the lease contract with a trivial penalty payment. The airline probably will incur a non-trivial penalty for walking away from an aircraft lease before the lease contract matures.

    Perhaps this distinction is not important to modern accountants, but us old geezers still think the distinction is important on the balance sheet reporting of lease obligations. Interestingly, the exit value of the shoe store lease may be nearly zero even though the present value of remaining lease payments is sizeable. We may have to think differently about fair value accounting for air space leases if we broaden fair value accounting requirements.

    Exit value surrogates for fair value accounting may work better for aircraft than for air space. Or put another way, booking air space leases at present value of remaining cash flow payments may not be consistent with fair value accounting under FAS 157 where Level 1 estimation is the high God relative to inferior Level 3 present value estimation of fair value.

    If we book air space leases at exit values we may in effect be (gasp) accounting for them as operating leases.

    Thanks John,

    Bob Jensen


    Another One from That Ketz Guy

    "The Accounting Cycle:  CVS Caremark Leases Op/Ed," by: J. Edward Ketz, SmartPros, September 2008 ---
    http://accounting.smartpros.com/x67548.xml 

    The FASB is slowly -- very slowly -- looking at the accounting for leases. It is working with the IASB to improve accounting standards in this area. I am thankful for the action, because the off-balance sheet accounting has undermined good accounting for a long time.

    The Board issued a Discussion Paper “Leases: Preliminary Views” in March. In this document the FASB finally begins to follow the definitions specified in its own conceptual framework. Recall that assets are “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” and liabilities are “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” As leases grant lessees probable future economic benefits and generate probable future sacrifices, lessees have assets and liabilities they need to account for.

    Let us remind ourselves of how important this topic is by examining the case of CVS Caremark. Like most retailers, this corporation leases many of its stores throughout the country. The lease structures utilized by CVS Caremark allow it to categorize most of its leases as operating leases and thereby not disclose a significant amount of its liabilities.

    While this accounting is permitted under current FASB and IASB rules, it supplies not-so-little white lies to investors and creditors. It is time for corporate America (and the rest of the world) to tell the truth about leased assets and lease obligations. It would be a way of practicing ethics instead of just preaching about them.

    Employing the data disclosed in its last 10-K (2008), I recast the numbers as if the entity employed capital lease accounting. Performing these adjustments generates the following results for CVS Caremark (all numbers in millions of dollars).

    2008

    Reported

    Adjusted

    Current assets

    $16,256

    $16,526

    Long-term assets

     44,434

     53,703

    Total assets

    $60,960

    $70,229

     

     

     

    Current liabilities

    $13,490

    $15,135

    Long-term liabilities

     12,896

     26,700

    Stockholder’s equity

     34,574

     28,394

    Total capital

    $60,960

    $70,229

    The leased assets are included in the assets of the business enterprise, so long-term assets and total assets increase by $9.269 billion. This amount is clearly a significant amount of property rights not to include on the balance sheet.

    The current liabilities increase by $1.645 billion and the long-term liabilities by $13.804 billion. That’s a lot of debt to conceal from shareholders, creditors, and the general public.

    The stockholders’ equity has gone down because depreciation costs and interest expense replace rental charges. For this firm and this period, the cumulative depreciation and interest would have exceeded rental fees.

    In terms of some common ratios, the changes are also significant. The current ratio for reported numbers is 1.21 and for adjusted numbers 1.09. The ratio debt-to-capital is 43% for reported numbers, but jumps to 60% for adjusted numbers. Long-term-debt-to-capital is 21% for reported numbers, but almost doubles to 38% for adjusted numbers.

    However you slice it, these are some huge assets and liabilities playing hide-and-seek with the investment community.

    I am happy to report that the FASB and the IASB are leaning toward requiring business entities to report these assets and liabilities. I am not so happy with the discussions pertaining to options, lease terms, contingencies, and guaranteed and unguaranteed residual values. The FASB and the IASB should forget all of the minutiae dealing with implicit interest rates versus incremental borrowing rates, residual values, and contingencies. As they construct a new standard for lessee accounting, the FASB and the IASB need to forget all of the garbage in FAS 13 and IAS 17.

    Let the standard be simple: measure the capitalized asset at its fair value and measure the lease obligation at its present value. There is no need for the other trivia; let the auditors sort out the details. And let plaintiffs’ attorneys monitor the auditors.

    This approach would prove simple and rational. Companies would then supply relevant and reliable financial information. And it really would be principles-based.

    Jensen Comment
    Golly Ned! It's getting harder and harder to hide debt and manage earnings. But there's hope.

    Got to read deeper into that "onerous" provision in IAS 37.


    Lessor (Nope) Versus Lessee (Yup) Accounting Rules

    From WebCPA, July 31, 2008 --- http://www.webcpa.com/article.cfm?articleid=28636

    The Financial Accounting Standards Board has decided to defer the development of a new accounting model for lessors, saying the project will now only address lessee accounting.

    FASB also agreed with taking an overall approach to generally apply the finance lease model in International Accounting Standard 17, "Leases," adapted where necessary for all leases.

    The move is the latest in a long-running project for the board in setting standards for lease accounting. As FASB moves toward convergence of U.S. generally accepted accounting principles with International Financial Reporting Standards, it is also trying to make sure any new standards it approves match up as much as possible with the international ones.

    In the new lessee standards, FASB has decided to include options to extend or terminate the lease in the measurement of the right-of-use asset and the lease obligation based on the best estimate of the expected lease term. The board also agreed that contractual factors, non-contractual factors and business factors should be considered when determining the lease term.

    The board decided to require lessees to include contingent rentals in the measurement of the right-of-use asset and the lease obligation based on their best estimate of expected lease payments.

    FASB also decided that both the right-of-use asset and the lease obligation should be initially measured at the present value of the best estimate of expected lease payments for all leases. The board decided to require the best estimate of expected lease payments to be discounted using the lessee's secured incremental borrowing rate.

    FASB members discussed the subsequent measurement of both the right-of-use asset and the lease obligation, but the board was not able to reach a decision. The board also discussed whether there should be criteria to distinguish between leases that are in-substance purchases and leases that are a right to use an asset, but it was not able to reach a decision on that matter either.

     


    More Reasons Why Tom and I Hate Principles-Based Accounting Standards

    "Contingent Liabilities: A Troubling Signpost on the Winding Road to a Single Global Accounting Standard," by Tom Selling, The Accounting Onion, May 26, 2008 --- Click Here

    By the logic of others, which I can’t explain, fuzzy lines in accounting standards have come to be exalted as “principles-based” and bright lines are disparaged as “rules-based.” One of my favorite examples (actually a pet peeve) of this phenomenon is the difference in the accounting for leases between IFRS and U.S. GAAP. The objective of the financial reporting game is to capture as much of the economic benefits of an asset as possible, while keeping the contractual liability for future lease payments off the balance sheet; a win is scored an “operating lease,” and a loss is scored a “capital lease.” As in tennis, If the present value of the minimum lease payments turns out to be even a hair over the 90% line of the leased asset’s fair value, your shot is out and you lose the point.

    The counterpart to FAS 13 in IFRS is IAS 17, a putative principles-based standard. It’s more a less a carbon copy of FAS 13 in its major provisions, except that bright lines are replaced with fuzzy lines: if the present value of the minimum lease payments is a “substantial portion” (whatever that means) of the leased asset’s fair value, you lose operating lease accounting. If FAS 13 is tennis, then IAS 17 is tennis-without-lines. Either way, the accounting game has another twist: the players call the balls landing on their side of the net; and the only job of the umpire—chosen and compensated by each player—is to opine on the reasonableness of their player's call. So, one would confidently expect that the players of tennis-without- lines have a much lower risk of being overruled by their auditors… whoops, I meant umpires.

    Although lease accounting is one example for which GAAP is bright-lined and IFRS is the fuzzy one, the opposite is sometimes the case, with accounting for contingencies under FAS 5 or IAS 37 being a prime exaple. FAS 5 requires recognition of a contingent liability when it is “probable” that a future event will result in the occurrence of a liability. What does “probable” mean? According to FAS 5, it means “likely to occur.” Wow, that sure clears things up. With a recognition threshold as solid as Jell-o nailed to a tree and boilerplate footnote disclosures to keep up appearances, there should be little problem persuading one’s handpicked independent auditor of the “reasonableness” of any in or out call.

    IAS 37 has a similar recognition threshold for a contingent liability (Note: I am adopting U.S. terminology throughout, even though "contingent liabilities" are referred to as "provisions" in IAS 37). But in refreshing contrast to FAS 5, IAS 37 unambiguously nails down the definition of “probable” to be “more likely than not” —i.e., just a hair north of 50%. Naively assuming that companies actually comply with the letter and spirit of IAS 37, then more liabilities should find their way onto the balance sheet under IFRS than GAAP. And, IAS 37 also has more principled rules for measuring a liability, once recognized. But, I won’t get into that here. Just please take my word for it that IAS 37 is to FAS 5 as steak is to chopped liver.

    The Global Accounting Race to the Bottom

    And so we have the IASB’s ineffable ongoing six-year project to make a hairball out of IAS 37. If these two standards, IAS 37 and FAS 5, are to be brought closer together as the ballyhooed Memorandum of Understanding between IASB and FASB should portend, it would make much more sense for the FASB to revise FAS 5 to make it more like IAS 37. After all, convergence isn’t supposed to take forever; even if you don’t think IAS 37 is perfect, there are a lot more serious problems IASB could be working harder on: leases, pensions, revenue recognition, securitizations, related party transactions, just to name a few off the top of my head. But, the stakeholders in IFRS are evidently telling the IASB that they get their jollies from tennis without lines. And, the IASB, dependent on the big boys for funding, is listening real close.

    Basically, the IASB has concluded that all present obligations – not just those that are more likely than not to result in an outflow of assets – should be recognized. It sounds admirably principled and ambitious, but there’s a catch. In place of the bright-line probability threshold in IAS 37, there would be the fuzziest line criteria one could possibly devise: the liability must be capable of “reliable” measurement. We know that "probable" without further guidance must at least lie between 0 and 1, but what amount of measurement error is within range of “reliable”? The answer, it seems, would be left to the whim of the issuer followed by the inevitable wave-your-hands-in-the-air rubber stamp of the auditor.

    It’s not as if the IASB doesn’t have history from which to learn. Where the IASB is trying to go in revising IAS 37, we’ve already been in the U.S. The result was all too often not a pretty sight as unrecognized liabilities suddenly slammed into balance sheets like freight trains. As I discussed in an earlier post, retiree health care liabilities were kept off balance sheets until they were about to break unionized industrial companies. Post-retirement benefits were doled out by earlier generations of management, long departed with their generous termination benefits, in order to persuade obstreperous unions to return to the assembly lines. GM and Ford are now on the verge of settling faustian bargains of their forbearers with huge cash outlays: yet for decades the amount recognized on the balance sheet was precisely nil. The accounting for these liabilities had been conveniently ignored, with only boilerplate disclosures in their stead, out of supposed concern for reliable measurement. Yet, everyone knew that zero as the answer was as far from correct as Detroit is from Tokyo – where, as in most developed countries, health care costs of retirees are the responsibility of government.

    Holding the recognition of a liability hostage to “reliable” measurement is bad accounting. There is just no other way I can put it. If this is the way the IASB is going to spend its time as we are supposed to be moving to a single global standard, then let the race to the bottom begin.

    Bob Jensen's threads on principles-based standards versus rules-based standards --- http://faculty.trinity.edu/rjensen/Theory01.htm#Principles-Based

    Bob Jensen's threads on synthetic leases --- http://faculty.trinity.edu/rjensen/theory/00overview/speOverview.htm

    Bob Jensen's threads on intangibles and contingencies --- http://faculty.trinity.edu/rjensen/Theory01.htm#TheoryDisputes

     


    Question
    What's a "cookie-cutter" lease and why does it illustrate why accounting standards are not neutral?

    "FASB Launches Review of Accounting for Leases," AccountingWeb, June 12, 2006 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=102240

    The Financial Accounting Standards Board (FASB) has begun reviewing its guidance on one of the most complex areas of off-balance sheet reporting, accounting for leases, Chairman Robert Herz told Forbes. The Securities and Exchange Commission (SEC) had requested that FASB review off-balance sheet arrangements, special purpose entities and related issues in a staff report issued in June 2005. The most prominent topics for review were pension disclosure and accounting for leases.

    Having issued its Exposure Draft to Improve Accounting of Pensions and other Postretirement Benefits, FASB is now considering moving lease obligations from the current footnote disclosure to the balance sheet. But the sheer number of rules and regulations that relate to leases – hundreds, according to Business Week – offers experts plenty of opportunities to keep disclosure off the books and presents FASB with an enormous challenge.

    Companies are currently required to record future lease obligations in a footnote, but actual rent payments are deducted in quarterly income statements. Approximately 10 percent of leases are already disclosed on the balance sheet as liabilities because the company can purchase the equipment at the end of the lease, and therefore the lease is treated as a loan, or because lease payments add up to 90 percent of the value of the leased property.

    Robert Herz says, according to Business Week, that “cookie-cutter templates” have been created to design leases so that they don’t add up to more than 89 percent of the value of the property. And to add to the complexity, the AP says, if the contract describes a more temporary rental-type arrangement, it can be treated as an operating lease and recorded in the footnote.

    Leasing footnotes do not reveal the interest portion of future payments and require the analyst or investor to make assumptions about the number of years over which the debt needs to be paid, the AP says, as well as the interest rate the company will be paying. David Zion, an analyst from Credit Suisse told the AP that many professionals interpret the footnotes by multiplying a company’s annual rental costs by eight.

    Thomas J. Linsmeier, recently named a member of the FASB, said that the current rule for accounting for leases needed to be changed because it sets such specific criteria. “It is a poster child for bright-line tests,” he said, according to the New York Times.

    The SEC requested the review it said in a press release because “the current accounting for leases takes an “all or nothing” approach to recognizing leases on the balance sheet. This results in a clustering of lease arrangements such that their terms approach, but do not cross, “the bright lines” in the accounting guidance that would require a liability to be recognized. As a consequence, arrangements with similar economic outcomes are accounted for very differently.”

    Finding a way to define a lease for accounting purposes presents additional problems. Some accountants argue that since the lessor does not own the property and cannot sell it, the property should not be viewed as an asset, Business Week says. Others say that the promise to pay a rent is equal to any other liability.

    Of 200 companies reviewed by SEC staffers in 2005, 77 percent had off-balance-sheet operating leases, totaling about $1.25 trillion, the Wall Street Journal reported.

    Among the companies with the biggest lease obligations are Walgreen Co. with $15.2 billion, CVS Corp with $11.1 billion and Fedex Corp. with $10.5 billion, the AP reports. Walgreens owns less that one-fifth of its store locations and leases the rest. Fedex leases airplanes, land and facilities.

    Robert Herz, in an editorial response in Forbes to Harvey Pitt, former SEC chairman, acknowledged that FASB’s current projects, including the review of lease accounting, could generate controversy. But he says that the complexity and volume of standards impedes transparency, and that the FASB is working jointly with the IASB to develop more principles based standards.

    “Complexity has impeded the overall usefulness of financial statements and added to the costs of preparing and auditing financial statements – particularly for small and private enterprises – and it is also viewed as a contributory factor to the unacceptably high number of restatements,” Herz writes in Forbes.

    Herz does not expect the new rules to be completed before 2008 or 2009, Business Week says.


    Let me close by citing Harry S. Truman who said, "I never give them hell; I just tell them the truth and they think its hell!"
    Great Speeches About the State of Accountancy

    "20th Century Myths," by Lynn Turner when he was still Chief Accountant at the SEC in 1999 --- http://www.sec.gov/news/speech/speecharchive/1999/spch323.htm

    It is interesting to listen to people ask for simple, less complex standards like in "the good old days." But I never hear them ask for business to be like "the good old days," with smokestacks rather than high technology, Glass-Steagall rather than Gramm-Leach, and plain vanilla interest rate deals rather than swaps, collars, and Tigers!! The bottom line is—things have changed. And so have people.

    Today, we have enormous pressure on CEO’s and CFO’s. It used to be that CEO’s would be in their positions for an average of more than ten years. Today, the average is 3 to 4 years. And Financial Executive Institute surveys show that the CEO and CFO changes are often linked.

    In such an environment, we in the auditing and preparer community have created what I consider to be a two-headed monster. The first head of this monster is what I call the "show me" face. First, it is not uncommon to hear one say, "show me where it says in an accounting book that I can’t do this?" This approach to financial reporting unfortunately necessitates the level of detail currently being developed by the Financial Accounting Standards Board ("FASB"), the Emerging Issues Task Force, and the AICPA’s Accounting Standards Executive Committee. Maybe this isn’t a recent phenomenon. In 1961, Leonard Spacek, then managing partner at Arthur Andersen, explained the motivation for less specificity in accounting standards when he stated that "most industry representatives and public accountants want what they call ‘flexibility’ in accounting principles. That term is never clearly defined; but what is wanted is ‘flexibility’ that permits greater latitude to both industry and accountants to do as they please." But Mr. Spacek was not a defender of those who wanted to "do as they please." He went on to say, "Public accountants are constantly required to make a choice between obtaining or retaining a client and standing firm for accounting principles. Where the choice requires accepting a practice which will produce results that are erroneous by a relatively material amount, we must decline the engagement even though there is precedent for the practice desired by the client."

    We create the second head of our monster when we ask for standards that absolutely do not reflect the underlying economics of transactions. I offer two prime examples. Leasing is first. We have accounting literature put out by the FASB with follow-on interpretative guidance by the accounting firms—hundreds of pages of lease accounting guidance that, I will be the first to admit, is complex and difficult to decipher. But it is due principally to people not being willing to call a horse a horse, and a lease what it really is—a financing. The second example is Statement 133 on derivatives. Some people absolutely howl about its complexity. And yet we know that: (1) people were not complying with the intent of the simpler Statements 52 and 80, and (2) despite the fact that we manage risk in business by managing values rather than notional amounts, people want to account only for notional amounts. As a result, we ended up with a compromise position in Statement 133. To its credit, Statement 133 does advance the quality of financial reporting. For that, I commend the FASB. But I believe that we could have possibly achieved more, in a less complex fashion, if people would have agreed to a standard that truly reflects the underlying economics of the transactions in an unbiased and representationally faithful fashion.

    I certainly hope that we can find a way to do just that with standards we develop in the future, both in the U.S. and internationally. It will require a change in how we approach standard setting and in how we apply those standards. It will require a mantra based on the fact that transparent, high quality financial reporting is what makes our capital markets the most efficient, liquid, and deep in the world.

    Bob Jensen's threads on lease accounting are at
    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Leases


    From The Wall Street Journal Accounting Weekly Review on April 22, 2005

    TITLE: Lease Restatements Are Surging
    REPORTER: Eiya Gullapalli
    DATE: Apr 20, 2005
    PAGE: C4
    LINK: http://online.wsj.com/article/0,,SB111396285894611651,00.html 
    TOPICS: Accounting, Advanced Financial Accounting, Lease Accounting, Restatement, Sarbanes-Oxley Act

    SUMMARY: Last winter, "the Big Four accounting firms...banded together to ask the Security and Exchange Commission's chief accountant to clarify rules on lease accounting...Now about 250 companies have announced restatements for lease accounting issues..."

    QUESTIONS:
    1.) Why is it curious that so many companies are now restating previous financial statements due to lease accounting problems? What does the fact that companies must restate previous results imply about previous accounting for these lease transactions?

    2.) What industries in particular are cited for these issues in the article? How do you think this industry uses leases?

    3.) While one company, Emeritus Corp., disclosed significant impacts on previously reported income amounts, companies are "...for the most part, not materially affecting their earnings, analysts say..." Are you surprised by this fact? What is the most significant impact of capitalizing a lease on a corporation's financial statements?  In your answer, define the terms operating lease and capitalized lease.

    4.) How do points made in the article show that the Sarbanes-Oxley Act is accomplishing its intended effect?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Lease Restatements Are Surging:  Number Increases Daily; Accounting Experts Say GAAP Violations Are Rife," by Diya Gullapalli, The Wall Street Journal, April 20, 2005; Page C4 --- http://online.wsj.com/article/0,,SB111396285894611651,00.html

    When it comes to bookkeeping snafus, lease accounting may be the new revenue recognition.

    It all started in November, when KPMG LLP told fast-food chain CKE Restaurants Inc. that it had problems with the way CKE recognized rent expenses and depreciated buildings. That led CKE to restate its financials for 2002 as well as some prior years. CKE will also take a charge in its upcoming annual filing for 2003 through its just-ended 2005 fiscal year.

    By winter, the Big Four accounting firms had banded together to ask the Securities and Exchange Commission's chief accountant to clarify rules on lease accounting. Retail and restaurant trade groups began battling rule makers about the merits of issuing such guidance.

    Now, about 250 companies have announced restatements for lease-accounting issues similar to CKE's, and the number continues to rise daily.

    "We'd be shocked if this isn't the biggest category of restatements we've ever seen," says Jeff Szafran of Huron Consulting Group LLC, which tracks restatements.

    Given that so many publicly traded companies, especially retailers and restaurant chains, hold leases, it perhaps isn't surprising that lease restatements are snowballing. Accounting experts say the restatements also demonstrate that violations of generally accepted accounting principles still are widespread.

    "The whole subject has been a curiosity to me," says Jack Ciesielski, editor of the Analyst's Accounting Observer newsletter in Baltimore. "This was existing GAAP that hasn't changed, but I don't think we've seen the end of these restatements."

    Since many of the companies announcing restatements so far report on a January-ending fiscal year, Mr. Ciesielski and other accounting-industry watchers anticipate a slew of additional restatements in coming weeks as more companies prepare their books.

    Corporate-governance advocates say the volume of lease-problem restatements shows the Sarbanes-Oxley Act is doing its job. That 2002 law laid down guidelines for ensuring that companies had proper internal controls, systems to prevent accounting mistakes and improprieties. Indeed, many of the companies that have had to restate due to lease problems also have reported weakness in their internal controls.

    While Ernst & Young LLP clients Friendly Ice Cream Corp., Whole Foods Market Inc. and Cingular Wireless, a joint venture between SBC Communications Inc. and BellSouth Corp., all reported material weaknesses in internal controls in their latest annual reports due partly to lease issues, PricewaterhouseCoopers LLP client J. Jill Group Inc. says its lease-driven restatement didn't signal such significant internal-control problems.

    The main rule on lease accounting hasn't changed much. Issued in 1976, Statement of Financial Accounting Standards No. 13 is, in fact, one of the oldest rules written by the Financial Accounting Standards Board, which sets guidelines for publicly traded companies. While some parts of FAS 13 have been reinterpreted since then, auditors for the most part hadn't raised any concerns about clients' lease accounting -- until now.

    "Our industry has been accounting for leases using the same methodology for 20 years at least and had gotten clean opinions," says Carleen Kohut, chief financial officer of the National Retail Federation.

    The changes in lease accounting are "not the result of the discovery of new facts or information," reads a statement from Emeritus Corp., an assisted-living company that announced a restatement for lease accounting within a week of CKE.

    Had Emeritus correctly applied lease-accounting rules in 2003, it could have almost wiped out its profit. In a restated annual report released in January, the company said lease expenses and other adjustments lowered earnings to $204,000 for 2003 from the originally reported $4.5 million -- and such adjustments widened past years' losses even further.

    Emeritus didn't return calls for comment.

    Others companies such as home-furnishing store Bombay Co. announced a lease restatement in March and then withdrew the decision a week later, demonstrating lingering confusion over the matter.

    The SEC's letter released in February clarified three specific areas of lease accounting, focusing on leasehold improvement amortization, rent-expense recognition and tenant incentives.

    The bright side is that companies coming to grips with faulty lease accounting are, for the most part, not materially affecting their earnings, analysts say -- companies such as Emeritus being an exception. Rather, they say, the change is just a reshuffling of dollars across various line items.

    --- RELATED ARTICLES ---
     TITLE: FOOTNOTES: Recent US Earnings Restatements
    REPORTER: Dow Jones Newswires
    ISSUE: Apr 19, 2005
    LINK: http://online.wsj.com/article/0,,BT_CO_20050419_008924,00.html 

    A concise summary of the February 7, 2005 letter is provided at
    http://www.accountingobserver.com/blog/2005/02/secs-view-on-lease-accounting-do-overs/

    The complete February 7, 2005 letter from the SEC's Chief Accountant to Robert J. Kueppers is located at http://www.sec.gov/info/accountants/staffletters/cpcaf020705.htm

    In recent weeks, a number of public companies have issued press releases announcing restatements of their financial statements relating to lease accounting. You requested that the Office of the Chief Accountant clarify the staff's interpretation of certain accounting issues and their application under generally accepted accounting principles relating to operating leases. Of specific concern is the appropriate accounting for: (1) the amortization of leasehold improvements by a lessee in an operating lease with lease renewals, (2) the pattern of recognition of rent when the lease term in an operating lease contains a period where there are free or reduced rents (commonly referred to as "rent holidays"), and (3) incentives related to leasehold improvements provided by a landlord/lessor to a tenant/lessee in an operating lease. It should be noted that the Commission has neither reviewed this letter nor approved the staff's positions expressed herein. In addition, the staff's positions may be affected or changed by particular facts or conditions. Finally, this letter does not purport to express any legal conclusion on the questions presented.

    The staff's views on these issues are as follows:

    1. Amortization of Leasehold Improvements - The staff believes that leasehold improvements in an operating lease should be amortized by the lessee over the shorter of their economic lives or the lease term, as defined in paragraph 5(f) of FASB Statement 13 ("SFAS 13"), Accounting for Leases, as amended. The staff believes amortizing leasehold improvements over a term that includes assumption of lease renewals is appropriate only when the renewals have been determined to be "reasonably assured," as that term is contemplated by SFAS 13.
       
    2. Rent Holidays - The staff believes that pursuant to the response in paragraph 2 of FASB Technical Bulletin 85-3 ("FTB 85-3"), Accounting for Operating Leases with Scheduled Rent Increases, rent holidays in an operating lease should be recognized by the lessee on a straight-line basis over the lease term (including any rent holiday period) unless another systematic and rational allocation is more representative of the time pattern in which leased property is physically employed.
       
    3. Landlord/Tenant Incentives - The staff believes that: (a) leasehold improvements made by a lessee that are funded by landlord incentives or allowances under an operating lease should be recorded by the lessee as leasehold improvement assets and amortized over a term consistent with the guidance in item 1 above; (b) the incentives should be recorded as deferred rent and amortized as reductions to lease expense over the lease term in accordance with paragraph 15 of SFAS 13 and the response to Question 2 of FASB Technical Bulletin 88-1 ("FTB 88-1"), Issues Relating to Accounting for Leases, and therefore, the staff believes it is inappropriate to net the deferred rent against the leasehold improvements; and (c) a registrant's statement of cash flows should reflect cash received from the lessor that is accounted for as a lease incentive within operating activities and the acquisition of leasehold improvements for cash within investing activities. The staff recognizes that evaluating when improvements should be recorded as assets of the lessor or assets of the lessee may require significant judgment and factors in making that evaluation are not the subject of this letter.
       

    To the extent that SEC registrants have deviated from the lease accounting standards and related interpretations set forth by the FASB, those registrants, in consultation with their independent auditors, should assess the impact of the resulting errors on their financial statements to determine whether restatement is required. The SEC staff believes that the positions noted above are based upon existing accounting literature and registrants who determine their prior accounting to be in error should state that the restatement results from the correction of errors or, if restatement was determined by management to be unnecessary, state that the errors were immaterial to prior periods.

    Registrants should ensure that the disclosures regarding both operating and capital leases clearly and concisely address the material terms of and accounting for leases. Registrants should provide basic descriptive information about material leases, usual contract terms, and specific provisions in leases relating to rent increases, rent holidays, contingent rents, and leasehold incentives. The accounting for leases should be clearly described in the notes to the financial statements and in the discussion of critical accounting policies in MD&A if appropriate. Known likely trends or uncertainties in future rent or amortization expense that could materially affect operating results or cash flows should be addressed in MD&A. The disclosures should address the following:

    1. Material lease agreements or arrangements.
       
    2. The essential provisions of material leases, including the original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, leasehold improvement incentives, and unusual provisions or conditions.
       
    3. The accounting policies for leases, including the treatment of each of the above components of lease agreements.
       
    4. The basis on which contingent rental payments are determined with specificity, not generality.
       
    5. The amortization period of material leasehold improvements made either at the inception of the lease or during the lease term, and how the amortization period relates to the initial lease term.
       

    As you know, the SEC staff is continuing to consider these and related matters and may have further discussions on lease accounting with registrants and their independent auditors.

    We appreciate your inquiry and further questions about these matters can be directed to Tony Lopez, Associate Chief Accountant in the Office of the Chief Accountant (202-942-7104) or Louise Dorsey, Associate Chief Accountant in the Division of Corporation Finance (202-942-2960).


    From the FASB:  PROPOSED FASB STAFF POSITION No. FAS 157-a
    "Application of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive Accounting Pronouncements That Address Leasing Transactions" --- http://www.fasb.org/fasb_staff_positions/prop_fsp_fas157-a.pdf

    Objective

    1. This FASB Staff Position (FSP) amends FASB Statement No. 157, Fair Value Measurements, to exclude FASB Statement No. 13, Accounting for Leases, and its related interpretive accounting pronouncements that address leasing transactions.

    Background

    2. The Exposure Draft preceding Statement 157 proposed a scope exception for Statement 13 and other accounting pronouncements that require fair value measurements for leasing transactions. At that time, the Board was concerned that applying the fair value measurement objective in the Exposure Draft to leasing transactions could have unintended consequences, requiring reconsideration of aspects of lease accounting that were beyond the scope of the Exposure Draft.

    3. However, respondents to the Exposure Draft indicated that the fair value measurement objective for leasing transactions was generally consistent with the fair value measurement objective proposed by the Exposure Draft. Others in the leasing industry subsequently affirmed that view. Based on that input, the Board decided to include lease accounting pronouncements in the scope of Statement 157.

    4. Subsequent to the issuance of Statement 157, which changed in some respects from the Exposure Draft, constituents have raised issues stemming from the interaction

    Proposed FSP on Statement 157 (FSP FAS 157-a) 1 FSP FAS 157-a between the fair value measurement objective in Statement 13 and the fair value measurement objective in Statement 157.

    5. Constituents have noted that paragraph 5(c)(ii) of Statement 13 provides an example of the determination of fair value (an exit price) through the use of a transaction price (an entry price). Constituents also have raised issues about the application of the fair value measurement objective in Statement 157 to estimated residual values of leased property. These issues, as well as other issues related to the interaction between Statement 13 and Statement 157, would result in a change in lease accounting that requires considerations of lease classification criteria and measurements in leasing transactions that are beyond the scope of Statement 157 (for example, a change in lease classification for leases that would otherwise be accounted for as direct financing leases).

    6. The Board acknowledges that the term fair value will be left in Statement 13 although it is defined differently than in Statement 157; however, the Board believes that lease accounting provisions and the longstanding valuation practices common within the leasing industry should not be changed by Statement 157 without a comprehensive reconsideration of the accounting for leasing transactions. The Board has on its agenda a project to comprehensively reconsider the guidance in Statement 13 together with its subsequent amendments and interpretations.

     


    AICPA PROVIDES GUIDANCE ON LEASE ACCOUNTING ---
    http://accountingeducation.com/index.cfm?page=newsdetails&id=141809

    Bob Jensen's threads on lease accounting are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Leases


    Despite a Post-Enron Push, Companies Can Still Keep Big Debts Off Balance Sheets.
    "How Leases Play A Shadowy Role In Accounting," by Jonathan Weil, The Wall Street Journal, September 22, 2004, Page A1 --- http://online.wsj.com/article/0,,SB109580870299124246,00.html?mod=home%5Fpage%5Fone%5Fus 

    Despite the post-Enron drive to improve accounting standards, U.S. companies are still allowed to keep off their balance sheets billions of dollars of lease obligations that are just as real as financial commitments originating from bank loans and other borrowings.

    The practice spans the entire spectrum of American business and industry, relegating a key gauge of corporate health to obscure financial-statement footnotes, and leaving investors and analysts to do the math themselves. The scale of these off-balance-sheet obligations -- stemming from leases on everything from aircraft to retail stores to factory equipment -- can be huge:

    • US Airways Group Inc., which recently filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn't include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.

    • Drugstore chain Walgreen Co. shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.

    • For the companies in the Standard & Poor's 500-stock index, off-balance-sheet operating-lease commitments, as revealed in the footnotes to their financial statements, total $482 billion.

    Debt levels are among the most important measures of a company's financial health. But the special accounting treatment for many leases means that a big slice of corporate financing remains in the shadows. For all the tough laws and regulations set up since Enron Corp.'s 2001 collapse, regulators have left lease accounting largely untouched. Members of the Financial Accounting Standards Board say they are considering adding the issue to their agenda next year.

    "Leasing is one of the areas of accounting standards that clearly merits review," says Donald Nicolaisen, the Securities and Exchange Commission's chief accountant. The current guidance, he says, depends on rigidly defined categories in which a slight variation has a major effect and relies too much on "on-off switches for determining whether a leased asset and the related payment obligations are reflected on the balance sheet."

    A case in point is the "90% test," part of the FASB's 28-year-old rules for lease accounting. If the present value of a company's minimum lease payments equals 90% or more of a property's value, the transaction must be treated as a "capital lease," with accounting treatment akin to that of debt. If the figure is slightly less, say 89%, the deal is treated as an "operating lease," subject to certain other conditions, meaning the lease doesn't count as debt. The lease commitment appears not in the main body of the financial statements but in footnotes, often obscurely written and of limited usefulness.

    The $482 billion figure for the S&P 500 was determined through a Wall Street Journal review of the companies' annual reports. That's equivalent to 8% of the $6.25 trillion reported as debt on the 500 companies' balance sheets, according to data provided by Reuters Research. For many companies, off-balance-sheet lease obligations are many times higher than their reported debt.

    Given the choice between leasing and owning real estate or equipment, many companies pick operating leases. Besides lowering reported debt, operating leases boost returns on assets and often plump up earnings through, among other things, lower depreciation expenses.

    "It's nonsense," Trevor Harris, an accounting analyst and managing director at Morgan Stanley, says of the 90% rule. "What's the difference between 89.9% and 90%, and 85% and 90%, or even 70% and 90%? It's the wrong starting point. You've purchased the right to some resources as an asset. The essence of accounting is supposed to be economic substance over legal form."

    This summer, Union Pacific Corp. opened its new 19-story, $260 million headquarters in Omaha, Neb. The railroad operator is the owner of the city's largest building, the Union Pacific Center, in virtually every respect except its accounting.

    Under an initial operating lease, Union Pacific guaranteed 89.9% of all construction costs through the building's completion date. After completing the building, the company signed a new operating lease, which guarantees 85% of the building's costs. Unlike most operating leases, both were "synthetic" leases, which allow the company to take income-tax deductions for interest and depreciation while maintaining complete operational control. A Union Pacific spokesman declined to comment.

    Neither lease has appeared on the balance sheet. Instead, they have stayed in the footnotes, resulting in lower reported assets and liabilities. On its balance sheet, Union Pacific shows about $8 billion of debt, while its footnotes show about $3 billion of operating-lease commitments, including for railroad engines and other equipment.

    The 90% test goes to the crux of investor complaints that U.S. accounting standards remain driven by arbitrary rules, around which companies can easily structure transactions to achieve desired outcomes.

    It means different companies entering nearly identical transactions can account for them in very different ways, depending on which side of the 90% test they reside. Meanwhile, as with disclosures showing employee stock-option compensation expenses, most investors and stock analysts tend to ignore the footnotes disclosing lease obligations.

    Three years ago, Enron's collapse revealed how easily a company could hide debt. A big part of the energy company's scandal centered on off-balance-sheet "special purpose entities." These obscure partnerships could be kept off the books -- with no footnote disclosures -- if an independent investor owned 3% of an entity's equity. Responding to public outcry, FASB members eliminated that rule and promised more "principles-based" standards, which spell out concise objectives and emphasize economic substance over form, rather than a "check the box" approach with rigid tests and exceptions that can be exploited.

    The accounting literature on leasing covers hundreds of pages. The FASB's original 1976 pronouncement, called Financial Accounting Standard No. 13, does state a broad principle: A lease that transfers substantially all the benefits and risks of ownership should be accounted for as such. But in practice, critics say, FAS 13 amounts to all rules and no principles, making it easy to manipulate its strict exceptions and criteria as needed. One key rule says a lease is a "capital lease" if it covers 75% or more of the property's estimated useful life. One day less, and it can stay off-balance-sheet, subject to other tests.

    Continued in the article

    "Group (the IASB) to Alter Rules On Lease Accounting," The Wall Street Journal, September 23, 2004, Page C4

    BRUSSELS -- The International Accounting Standards Board next week will unveil plans to overhaul the rules on accounting for leased assets, the board's chairman said yesterday.

    Critics long have contended that the rules for determining whether leases should be included as assets and liabilities on a company's balance sheet are easy to evade and encourage form-over-substance accounting. "It's going to be a very big deal," Chairman Sir David Tweedie told Dow Jones Newswires after testifying to the European Parliament. International accounting rules on leasing exist already, but they are useless, Mr. Tweedie said.

    Airlines that lease their aircraft, for instance, rarely include their planes on their balance sheets, he said. "So the aircraft is just a figment of your imagination," Mr. Tweedie said. The board will convene a meeting next week to discuss changes to current rules, he said.

    The Wall Street Journal yesterday reported (see the above article) that the U.S. Financial Accounting Standards Board is considering adding lease accounting to its agenda of items for overhaul.

    From The Wall Street Journal's The Weekly Review: Accounting on September 24, 2004

    TITLE: Lease Accounting Still Has an Impact 
    REPORTER: Jonathan Weil 
    DATE: Sep 22, 2004 
    PAGE: A1 
    LINK: http://online.wsj.com/article/0,,SB109580870299124246,00.html  
    TOPICS: Financial Accounting, Financial Accounting Standards Board, Financial Statement Analysis, Lease Accounting, off balance sheet financing

    SUMMARY: The on-line version of this article is entitled "How Leases Play a Shadowy Role in Accounting." The article highlights the typical practical ways in which entities avoid capitalizing leases; reports on a WSJ analysis of footnote disclosures to assess levels of off-balance sheet debt; and comments on the difficulties the FASB may face in trying to amend Statement of Financial Accounting Standards No. 13.

    QUESTIONS: 

    1.) What accounting standard governs the accounting for lease transactions under U.S. GAAP? When was that accounting standard written and first put into effect?

    2.) When is the Financial Accounting Standards Board (FASB) considering working on improvements to the accounting for lease transactions? Why is the FASB likely to face challenges in any attempt to change accounting for leasing transactions?

    3.) What are the names of the two basic methods of accounting for leases by lessees under current U.S. standards? Which of these methods is he referring to when the author writes, "U.S. companies are...allowed to keep off their balance sheets billions of dollars of lease obligations..."

    4.) What are the required disclosures under each of the two methods of accounting for leases? What are the problems with financial statement users relying on footnote disclosures as opposed to including a caption and a numerical amount on the face of the balance sheet?

    5.) How do you think the Wall Street Journal identified the amounts of lease commitments that are kept off of corporate balance sheets? Specifically identify the steps you think would be required to measure obligations under operating leases in a way that is comparable to the amounts shown for capital leases recognized on the face of the balance sheet.

    6.) What four tests must be made in determining the accounting for any lease? Why do you think the author focuses on only one of these tests, the "90% test"?

    7.) What financial ratios are impacted by accounting for leases? List all that you can identify in the article, and that you can think of, and explain how they are affected by different accounting treatments for leases.

    8.) What is a "special purpose entity"? When are these entities used in leasing transactions?

    9.) What is a "synthetic lease"? When are these leases constructed?

    Reviewed By: Judy Beckman, University of Rhode Island


    This is Auditing 101:  Where were the auditors?

    "SEC Uncovers Wide-Scale Lease Accounting Errors," AccountingWeb, March 1, 2005 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=100600

    Where were the auditors? That is the question being asked as more than 60 companies face the prospect of restating their earnings after apparently incorrectly dealing with their lease accounting, Dow Jones reported.

    Companies in the retail, restaurant and wireless-tower industries are among those affected in what is being called the most sweeping bookkeeping correction in such a short time period since the late 1990s.

    Among the companies on the list are Ann Taylor, Target and Domino's Pizza. You can view a full listing of the affected companies.

    "It's always disturbing when our accounting is not followed," Don Nicolaisen, chief accountant at the Securities and Exchange Commission, said last week during an interview. He published a letter on Feb. 7 urging companies to follow accounting standards that have been on the books for many years, Dow Jones reported.

    Based on the charges and restatement announcements that have come in the wake of the SEC letter it seems companies have failed for years to follow what regulators see as cut-and-dried lease-accounting rules. The SEC has yet to go so far as to accuse companies of wrongdoing, but it has led people to wonder why auditors hired to keep company books clean could have missed so many instances of failure to comply with the rule.

    "Where were the auditors?" J. Edward Ketz, an accounting professor at Pennsylvania State University, said to Dow Jones. "Where were the people approving these things? This doesn't seem like something that really requires new discussion. If we have to go back and revisit every single rule because companies and their professional advisers aren't going to follow the rules, then I think we're in very serious trouble in this country."

    Tom Fitzgerald, a spokesman for auditing firm KPMG, declined to comment. Representatives for Deloitte & Touche LLP, PricewaterhouseCoopers LLC, and Ernst & Young LLP, didn't return several phone calls, Dow Jones reported.

    The crux of the issue is that companies are supposed to book these "leasehold improvements" as assets on their balance sheets and then depreciate those assets, incurring an expense on their income statements, over the duration of the lease. Instead, companies such as Pep Boys-Manny Moe & Jack had been spreading those expenses out over the projected useful life of the property, which is usually a longer time period, Dow Jones reported.

    As a result, expenses were deferred and income was added to the current period. McDonald's Corp. took a charge of $139.1 million, or 8 cents a share, in its fourth quarter to correct a lease-accounting strategy that it says had been in place for 25 years, Dow Jones reported, adding that Pep Boys said it would book a charge of 80 cents a share, or $52 million, for the nine months through Oct. 30, 2004.


    Debt Versus Equity

    Debt --- http://en.wikipedia.org/wiki/Debt

    History of Money and Debt --- http://en.wikipedia.org/wiki/History_of_money


    Deloitte:  Accounting Brief: Distinguishing Liabilities From Equity ---
    https://deloitte.wsj.com/cfo/2021/04/06/accounting-brief-distinguishing-liabilities-from-equity/?mod=djemCFO

    . . .

    ASC 480 is the starting point for determining whether an instrument must be classified as a liability. SEC registrants and non-SEC registrants that elect to apply the SEC’s guidance on redeemable equity securities must also consider the classification within equity. The relevant accounting guidance has existed for a number of years without substantial recent changes. In addition, we are not aware of any plans of the FASB or SEC to significantly change the guidance in the near future.

    Continued in article


    2019:  FASB makes 2nd effort to improve balance sheet debt classification ---
    https://www.journalofaccountancy.com/news/2019/sep/fasb-balance-sheet-debt-classification-201922019.html?utm_source=mnl:cpald&utm_medium=email&utm_campaign=13Sep2019

    Debt (booked by accountants) versus Entitlements (promises made that are not yet booked) ---
    http://en.wikipedia.org/wiki/Entitlement

    "We've Always Been Deadbeats:  Debt is not a new American way," by Scott Reynolds Nelson, Chronicle of Higher Education, September 10, 2012 ---
    http://chronicle.com/article/Borrowed-Dreams/134146/

    My father was a repo man. He did not look the part, which made him all the more effective. He alternately wore a long mustache or a shaggy beard and owned bell-bottoms in black, blue, and cherry red. His imitation-silk shirts were festooned with city maps, cartoon characters, or sailing ships. Dad sang in the car, at the top of his lungs, mostly obscure show tunes. His white Dodge Dart had Mach 1 racing stripes that he had lifted from a souped-up Ford Mustang. The "deadbeats" saw him coming, that's for sure, but they did not understand his profession until he walked into their homes and took away their televisions.

    Dad worked for Woolco, a company that lent appliances on an installment plan. When borrowers failed to pay, ignored the letters and phone calls, my father would come by. He often posed as a meter reader or someone with a broken-down car. If he saw a random object lying abandoned in the yard, he would pick it up and bring it to the door as if he were returning it. He was warm and funny, charming, but pushy. He did not carry a gun, but he was fearless under pressure and impervious to verbal abuse. If the door opened, he was inside; if he was inside, he shortly had his hands on the appliance; the rest was bookkeeping.

    . . .

    In each case, lenders had created complex financial instruments to protect themselves from defaulters like the ones I watched from the car. And in each case, the very complexity of the chain of institutions linking borrowers and lenders made it impossible for those lenders to distinguish good loans from bad.

    In 1837, for example, banks in the north of England discovered that the unpaid "cotton bills of exchange" in their vaults made them the indirect owners of slaves in Mississippi. In 2007, shareholders in DBS, the largest bank in Singapore, found themselves part owners of homes facing foreclosure in California, Florida, and Nevada. In both cases, efficient foreclosure proved impossible.

    In those crashes in America's past, perhaps a repo man in a Dodge Dart with a million gallons of gas could have visited every debtor, edged his way in, and decided who was good for it. (My dad did accept cash or money orders for Woolco's goods.) But big lenders have neither the time nor the capacity to act with the diligence of a repo man. Instead, such lenders (let's agree to call them all banks) try to unload debts, hide from their own creditors, go into bankruptcy, and call on state and federal institutions for relief. Banks have also routinely overestimated the collateral—the underlying asset—for the loans they hold. When those debts go unpaid or appear unpayable, banks quickly withdraw lending; the teller's window slams shut. A crisis on Wall Street becomes a crisis on Main Street. Money is tight. Loans are impossible: Crash.

    ***

    Scholarship on these financial downturns has its own long and checkered past.

    From the 1880s to the 1950s, scholars told the history of the nation's economic downturns as the history of banks. Such an approach was not entirely wrong, but it tended to focus on big personalities like J.P. Morgan or New York institutions; it tended to ignore the farmers, artisans, slaveholders, and shopkeepers whose borrowing had fed the booms and busts.

    Then, in the 1960s and 1970s, the so-called new economic historians (or cliometricians) came along with a different story. Using state and federal data, they tried to build mathematical models of the nation's financial health. Moving beyond banks, they emphasized what they termed the "real economy," by which they meant measurable indices of growth and profit. Taking the nation's health like a simple temperature reading, they used gross domestic product, gross income, or collective return on investment. Of course, none of those figures had been measured directly before the 1930s, and so the prognoses tended to vary widely.

    Such economic models of financial health, however scientific they looked, tended to be abstract representations of an economy that was, in fact, more complex and more interconnected than they pictured. The models, for example, often assumed that old banks were like modern banks, sharing common accounting principles, or that because banks first issued credit cards in the 1960s, they offered no consumer credit before then. Drilling into historical documents for seemingly relevant numbers, then plugging those numbers into a model of a world they understood rather than the economy they sought to describe, the cliometricians often produced ahistorical work. Hence, one economic historian assumed that American barrels of flour sent to New Orleans were consumed in the South, though most were bound for re-export to the Caribbean. Another calculated that railroads played little role in America's economic booms by modeling a scenario in which canals could have (somehow) crossed the arid plains into the Sierra Nevada mountains.

    Bear in mind, that same kind of intellectual hubris about models of economic behavior had awful effects in the recent past. Around 2000, Barclays Bank borrowed a simple diffusion model from physics (called the "Gaussian copula function") to suggest that foreclosures would have a relatively small effect on nearby property values. Economists tested it with two years of foreclosure and price data and agreed. Billions of investment in real-estate followed, often in indirect markets like real-estate derivatives and collateralized debt obligations. By 2008 the model proved shockingly inaccurate.

    If some historians focused on the temperature of the "real economy," economists were becoming obsessed with the money supply as the single factor explaining most American panics. Again, a certain kind of blindness to the history of debt and deadbeats ensued. The most important book here was Milton Friedman and Anna Jacobson Schwartz's seminal A Monetary History of the United States, 1867-1960 (1963). It urged economists to steer away from stories of speculation spun out by Keynesians like John Kenneth Galbraith.

    How, according to Friedman and Schwartz, can we separate speculation and investment? All loans are risky. The riskier they are, the higher the return. Some investments will fail. Markets need to clear, and those buyers who come along to sweep up bargains are not ruthless profiteers but simply maximizers who make markets work. Thus, the pair steered economists away from problems of risk and toward the problems of state intervention. They were the prophets of financial deregulation.

    Their story about past financial panics had the advantage of suggesting simple solutions: Use the Federal Reserve to inflate or deflate the currency. For them, financial crises were mostly monetary. Thus, the 1929 downturn started with a financial shock and then was prolonged by an overly tight monetary policy. After A Monetary History became gospel, economics textbooks dropped their numerous chapters on financial panics because the policy solution became so clear; economists trained after 1965 know little about financial downturns before the Great Depression.

    Yet a tripling of the money supply has still not fully pulled the United States and the rest of the world out of our current financial crisis—suggesting that our problems, and all the previous ones, were not just monetary. My dad would have pointed out that economists have misunderstood the problem. Crises are mostly about productive assets—the promises in his trunk.

    Social historians (and I count myself among them) tell a very different story about financial panics, but we have our own blind spots. Since the late 1960s, we have often discussed the American economy as if farmers were coherent families of self-sufficient yeomen surprised by the market economy. That story of a sudden revolution misses the early and intimate relationship between Americans and credit. It overlooks how American stores provided consumer credit to farmers, plantations owners, and renters who settled the West.

    Thus, American social historians have used the term "market revolution" to describe the period after the 1819 panic. Accordingly market forces rushed in as repo men like my dad became vanguards of a new capitalist order. The financial jeremiads of Jacksonian Democrats of the 1820s and 30s against bankers and paper money became the natural outgrowth of frontier farmers' anger at a capitalism they had never seen before. But the store system of Andrew Jackson's day borrowed practices from the colonial store system that goes back to the 17th century, if not earlier. It was how the fur-trading and East and West India companies prospered. John Jacob Astor and Andrew Jackson were cut from the same cloth. They made their fortunes from their stores, and their store system made settlement possible.

    Part of the reason we overlook the importance of credit in American history is our continued attachment to Marx's divide between precapitalist and capitalist forms of agriculture. That misses the relationship between farming and credit for most of the people who settled America. The more I study panics, the more I am persuaded that the pioneer American institution of the 18th and early 19th centuries was not the homestead or the trapper's shack but the store, an institution that sold foreign goods to farmers on credit, taking payment in easily movable settler products like furs, potash, barrel hoops, and butter.

    Rather than imagining some golden age of subsistence, scholars in the Marxist tradition should look more closely at anticapitalist movements in the wake of panics. I include here not just the utopian and religious communities like Quakers, Shakers, and Oneidans but also the early Mormons, the Grangers, and the Populists. Those people understood what it meant for banks, and then railroads, to extend credit through stores. Often regarding capital as a collective inheritance, they built their own associations to replace such institutions of credit (and the railroad was an institution of credit) with locally managed cooperatives that distributed agricultural benefits in a way that served the broader community. The temple, the elevator, and the cooperative were attempts to break the chain of debt without demonizing capital.

    From the perspective of business history, Joseph A. Schumpeter argued that business-cycle downturns came from periods of "creative destruction" in which new technologies undermined old ones. Outdated technologies, with millions invested in them, became instantly obsolete, leading to financial failures that cascaded to other industries. While Schumpeter, who died in 1950, once persuaded me, I think there is a mechanistic fallacy in the argument. Railroads, for example, have taken the blame for the 1857, 1873 and 1893 downturns. While there may be something there, the whole account seems reductive and technologically determinist. For example, canals, the Bessemer process, fractional distillation of oil, and washing machines are all revolutionary technologies that flourished during the American panics, not before them. They did sweep away older technologies, but rather than causing panics those technologies benefited by the uncertainty that panic created.

    In a very different camp, neo-Marxists like Giovanni Arrighi and David Harvey betray a similar kind of reductive history, a latter-day Schumpeterianism. Their work posits a "spatial fix," a center of capitalism that then organizes and draws tribute from the rest of the world. For the late Arrighi, it was a kind of pump that sucked assets from elsewhere as states were forming throughout the sweep of centuries. For Harvey it is an investment in a capital city (Amsterdam, London, New York) and a new communication technology (telegraph, telephone, the Internet) that drew higher profits from everywhere else. Dutch and British hegemony became American hegemony after World War II. That suggests that these scholars have not really considered the tremendous influence of the U.S. Federal Reserve in reorienting international trade between 1913 and the 1920s. Their story seems more or less political to me: American empire comes when Americans claim victory in World War II. The economic material seems to be used in the service of a story about the rise and decline of empires.

    If we follow the money, the American empire emerged during World War I, when the international flow of debt changed drastically. For Arrighi and Harvey, the International Monetary Fund and the World Bank are the pathbreakers of financial empire. But it is worth remembering that those institutions were explicitly designed to restrain the dirty tricks of financial empires of the 1920s and 1930s: No more American banks using gunboat diplomacy in Peru; no more Germans sending tanks into Poland to collect unpaid debts.

    ***

    As a historian, I have learned the most about financial disasters from long-dead historians whose work blended primary, secondary, and quantitative material. Rosa Luxemburg, William Graham Sumner, Frank W. Taussig, and Charles Kindleberger would never have agreed about anything. Luxemburg, a renegade Marxist who read in five languages, described how the dangerous mix of a hierarchical production process with the anarchy of international trade could lead manufacturers to block free trade and embrace higher prices for their raw materials in the wake of a panic. Sumner, a laissez-faire Social Darwinist who argued that income inequality benefited society, carefully explained how drastic economic changes could follow from tiny changes in international trade deals. Put in a room together, each would have retreated to a corner to begin throwing furniture. But they and the others were storytellers who used a mixture of sources. Telling a story by looking through the trunk of assets and watching the damage afterward makes more sense to me than simple models of financial contagion, money supply, technological watersheds, or global fixes.

    My father died before I started writing about financial panics, but my thoughts have grown out of our 30-year-long argument about financial downturns. Not surprisingly, he disliked "deadbeats," seeing them as the people whose false promises weakened our country. He probably had a point, and no doubt the executives of Woolco would agree. But I find much in them to admire, for defaulters are often dreamers. Viewing America's financial panics through the lens of numerous unfulfilled and forgotten debts that even the oldest banker cannot possibly remember can afford a perspective my dad would have appreciated: with my view from the Dodge Dart, the minute he rang the doorbell, when both debtor and creditor prepared their stories.

    Scott Reynolds Nelson is a professor of history at the College of William and Mary. His book A Nation of Deadbeats: An Uncommon History of America's Financial Disasters has just been published by Alfred A. Knopf.

    Video
    "Debt: The First 5,000 Years," by Paul Kedrosky , Kedrosky.com, September 10, 2011 --- Click Here
    http://paul.kedrosky.com/archives/2011/09/debt-the-first-5000-years.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+InfectiousGreed+%28Paul+Kedrosky%27s+Infectious+Greed%29

    The booked National Debt in August 2012 went over $16 trillion ---
    U.S. National Debt Clock --- http://www.usdebtclock.org/
    Also see http://www.brillig.com/debt_clock/
    The unbooked entitlements have a present value between $80 and $100 trillion. But who's counting?

    Pending Collapse of the United States --- http://faculty.trinity.edu/rjensen/Entitlements.htm

    Should we never pay down  (even partly) the U.S. National Debt or Spending Deficit? ---
    http://www.cs.trinity.edu/~rjensen/temp/NationalDeficit-Debt.htm


    Mezzanine Debt/Equity --- https://en.wikipedia.org/wiki/Mezzanine_capital

    Convertible Bond --- https://en.wikipedia.org/wiki/Convertible_bond

    Here's what coco bonds are and why investors are freaking out about them  ---
    http://www.businessinsider.com/what-are-coco-bonds-2016-2

    . . .

    Coco bonds are a type of debt with strings attached. The coco in the name is short for "contingent convertible," which means in some circumstances the debt converts into equity — rather than the bank owing you money, you suddenly own a little bit of the bank.

    The contingent part of the bonds depends on how much cash the banks have. If a bank's capital falls below a certain level the switch is flipped and the bonds turn into shares. Because of this risk, coco bonds carry a higher yield than normal bank bonds.

    Coco bonds were cooked up after the financial crisis as a way to prevent banks from needing any more state bailouts. If banks were getting into trouble and running low on cash, the bonds would convert, solving two problems — the bank's debt burden lessens and its capital buffers are boosted.

    Lloyds is the biggest coco-bond issuer in the UK, with $14.5 billion (£10.7 billion) of the paper issued from 2009 to 2015, according to Moody's.

    Why are people worried?

    Put simply, investors are worried they won't get their money back.

    There are growing fears that banks like Deutsche Bank and Santander won't be able to meet coupon payments — interest on the debt.

    The Independent writes:

    A recent move by the European Central Bank to publish an obscure test of bank risk, known as the Srep ratio, has driven the recent upset in the market. The results have stoked fears in the minds of credit analysts about whether recent market shocks — ranging from low oil prices to the slowdown in China — could inadvertently cause banks to breach rules which would prompt regulators to stop them paying Coco coupons.

    These same capital breaches could also turn the coco bonds into equity, which is falling in price and not something fixed-income investors want.

    As a result of these growing fears the price of coco bonds has plummeted in recent weeks. Meanwhile the price of credit-default swaps — a sort of insurance that pays out if banks don't pay up on the bonds — has jumped.

    Banks, meanwhile, have been defending their balance sheets and insisting everything is OK. Deutsche Bank's CEO, John Cryan, says the lender is "absolutely rock solid," while Credit Suisse's boss, Tidjane Thiam, has also been talking up his bank's balance sheet.

    Continued in article

     


    The Fuzzy Zone Between Debt and Equity
    From the CFO Journal's Morning Ledger on October 6, 2014

    U.S. companies including Tesla Motors Inc., Twitter Inc. and Priceline Group Inc. are selling bonds that can later be converted into stock shares at the fastest clip since 2008, the WSJ’s Mike Cherney reports. Businesses like to sell them because it gives them access to capital at lower rates, and the buyers like them because it provides the possibility of a considerable profit if the company’s share value increases.

    Violin Memory Inc., a data-storage firm in Santa Clara, Calif., for instance, sold $105 million in convertible notes last month. Chief Financial Officer Cory Sindelar said the company opted to sell the bonds instead of stock because it wanted to minimize the impact on existing shareholders, who would’ve seen their shares immediately diluted.

    Meanwhile, a group of 12 banks is aiming to streamline the process of buying corporate bonds by creating a one-stop-shop for the debt instruments, the WSJ’s Katy Burne reports. The initiative, called “Neptune,” won’t be for executing trades, but rather will link up banks and investors in the market, just as a mall would bring together several shops under one roof.


    "An Update on the FASB’s and IASB’s Joint Project on Financial Instruments With Characteristics of Equity,"  by Magnus Orrell and Ana Zelic, Deloitte & Touche LLP Heads Up, April 15, 2010 --- http://www.iasplus.com/usa/headsup/headsup1004liabequity.pdf

    Entities have long struggled with the question of whether instruments they issue to raise capital should be reported as liabilities or equity when those instruments possess characteristics of both debt and equity. The demand for a set of accounting principles that clearly distinguishes between equity and nonequity instruments is greater than ever in this era of increasing sophistication and rapid change in financial markets. The current accounting requirements governing the classification of financial instruments as liabilities or equity under both IFRSs and U.S. GAAP have been criticized for lacking a clear and consistently applied set of principles and for not distinguishing between equity and nonequity in a manner that best reflects the economics of the transactions involving those instruments.

    Responding to these concerns, in February 2006, as part of their Memorandum of Understanding, the IASB and FASB agreed to undertake a joint project on financial instruments with characteristics of equity to improve and simplify the financial reporting for financial instruments considered to have one or more characteristics of equity.1 In this project, the two boards have developed a new classification approach (see the Decisions Reached to Date section below) that we expect will be exposed for public comment in June 2010. The boards have agreed that the exposure draft will have a 120-day comment period and hope to publish a final standard in the first half of 2011; the effective date is yet to be determined.

    The classification approach contemplated by the two boards would, if finalized, significantly affect the manner in which entities determine whether to classify many financial instruments as liabilities or equity and account for exercises of options and conversions of debt into equity instruments. Entities are well-advised to begin assessing the implications of, and planning for, these changes and their effect on debt and equity, interest coverage, and other financial ratios; earnings; and compliance with debt covenants.

    Continued in article

    Bob Jensen's threads on debt versus equity are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FAS150


    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:

    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



    What if the mezzanine has more square feet than the rest of the hotel?

    Or put another way, what if neither the investor in a bond nor the borrower has the power to convert the debt into equity?
    In other words, what if Big Brother holds the sledge hammer?

     Here's what Tom Selling has to say about this.

    Accounting for a Sweet Co-Co

    Posted: 13 May 2010 11:23 PM PDT

    Prof. Robert Bloomfield of Cornell University posted an interesting accounting question on the FASRI (FASB Research Initiative) blog. I'm taking the liberty of repeating it here in its entirety:

    A policy proposal floating around these days is to require banks to issue contingent convertible debt:

    My [Mankiw's] favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

    A lawyer asks how these might be structured.  This accountant asks:  how would you account for them?  Note that unlike many contingent convertible securities, the event on which conversion is contingent is a regulatory action.

    I am attracted to the accounting question because I think the policy proposal itself is a brilliant idea; and because it dovetails nicely with my last post on the FASB/IASB deliberations on liabilities/equity classification. For the sake of the points I would like to make, I'm going to make three questions out of Rob's single question:

    1.       How would the contingent convertible debt (known in the trade as a Co-Co) be accounted for under current GAAP?

    2.       Would the answer change if current FASB proposals became final rules?

    3.       How should the Co-Co be accounted for?

    Current GAAP

    I could not find specific GAAP for a Co-Co, but I can't be sure that none exists -- in part because the FASB's Accounting Standards Codification is so darn hard to read! There are many redeeming qualities of the Codification; however, it seems to sacrifice readability for systematic presentation. I used to think that some of the pre-codification Original Pronouncements read like gibberish; but now, alas, I pine for them.

    So, here goes nothing.  I surmise that GAAP does not make a distinction between regulatory events and other events triggering conversion.  Thus, it would require that this particular Co-Co be accounted for as straight debt until conversion actually occurred. That accounting actually seems reasonable until we have a bank whose financial condition may actually be getting to the point where the regulator would flip the switch to convert the debt to equity. For simplicity, let's assume the debt was issued at par. Upon conversion that entire amount would have to be transferred to shareholders equity (probably through net income) in one fell swoop as of the date of conversion.

    A big one-time credit to equity smacks of a rule devoid of any intent to provide timely information to investors. The economic value of the debt would have been declining as conversion inexorably approached, and current GAAP wouldn't have cared less. So, in the period that the regulator flips the debt over to equity, the huge cumulative catch-up adjustment to the debt could swamp the operating losses of the current period, which surely must be occurring. If the debt had been marked to market whie the bank was heading toward its nadir, the trends in the earnings available to the pre-conversion equity holders would have been reflected in a more timely and relevant fashion.

    Future GAAP

    Of the accounting that would occur if certain current FASB projects came to fruition as planned, I am more certain.  Starting with the fair value project, the debt would be fair valued each period. That's a good thing, but the Co-Co also exposes a yet another (see my previous post) hole in the rules-based liability/equity project.

    Let's take a bank that has the following components to its capital structure: the Co-Co, call options on its common shares (which may only be settled by issuing common shares), and common shares. According to the FASB's current position, the options will be classified as equity; but the Co-Co, which also contains a conversion option) will be classified as debt unless converted. Although the Co-Co would be fair valued each period, such treatment will be inconsistent with the treatment of the call option, the opening value of which will sit in the equity section of the balance sheet like cream cheese on a bagel forevermore. The economic events that could cause a change in both the fair value of the Co-Co and the option would be ignored as to their impact on the option, but the impact on the Co-Co would be recognized.

    The accounting treatment for the option and the Co-Co would differ for no good reason.  Both would affect the economic position of the current shareholders, but only the effect caused by the change in the value of the Co-Co would be recognized.  This is just one of many reasons why the FASB should revert to its recently abandoned principled stance: it should classify all financial instruments as either assets or liabilities, except for common stock.

    Accounting Onion GAAP

    Rob Bloomfield correctly observes that lawyers would have to be consulted to precisely specify the Co-Co that Mankiw and others have envisaged. When considering current or future GAAP, I risked putting the cart before the horse by not anticipating key terms of the arrangement. That's because one of the huge problems with rules-based accounting (especially for financial instruments) is that the standards promulgators must ever be on the ready to publish new rules as those pesky financial engineers devise clever ways to circumvent those already in effect.   But, as I will demonstrate, there is no danger that a new financial instrument will threaten the sufficiency of truly principles-based standards.

    First, the Co-Co liability –and for that matter, all other financial instruments other than common shares—would be measured at an investor's replacement cost. (Thus, no inactive markets problem for determining the exit price; even if there are no current buyers, there are always sellers for the right price.)

    Second, any changes in replacement cost are to be reported through net income.

    Third, upon conversion, I would derecognize the Co-Co, increase paid-in capital for the market value of common stock immediately prior to the conversion, and record any difference in these two amounts in equity through net income. That's the amount that the holders of basic ownership interests gained or lost when the government pulled the trigger on its conversion option.

    Any questions? I have one: when is the FASB going to get some principles? Any and all changes that would make the Codification easier to read would be much appreciated!

    Off Topic  -- Tom on the Hot Seat

    I had the honor of responding to questions from participatns during a recent hour-long FASRI Roundtable dubbed "Perspectives on Standard Setting."  You can listen/watch a Second Life recording of my being grilled by some really smart folks slinging some really tough questions here.

    Article continued at Accounting for a Sweet Co-C

    http://feeds.feedburner.com/~r/typepad/theaccountingonion/~4/bhCxwMAyVdo?utm_source=feedburner&utm_medium=email

     

    From the CFO Journal's Morning Ledger on March 3, 2014

    Tesla convertible debt electrifies long-term investors
    Tesla Motors
    is showing that it’s more than just a plaything for day traders and ardent believers in electric cars,
    write the WSJ’s Matt Jarzemsky and Telis Demos. While the spotlight has focused on the frantic trading driving up Tesla’s share price in the past year, less visible have been the company’s efforts to tap big, sophisticated and long-term investors for cash that it needs to expand. The company raised $2 billion in a sale of convertible debt late last week, garnering an audience of big investors such as mutual funds and hedge funds. “The classic growth companies are the kind of thing the convert market loves,” said Eli Pars, who helps manage convertible holdings at Calamos Investments. “If they slip up, the stock may get taken down, but the convertible debt should hold up relatively well.”

    Jensen Comment
    This looks like a great example when teaching how to account for convertible debt under FASB and IASB standards.

    USA GAAP and International Financial Reporting Standards (IFRS) differ with respect to accounting for convertible debt? Under IFRS, convertible debt is divided into its liability and equity elements. Under US GAAP, the entire issue price is recorded as debt. Has this changed since I retired?



    Debt Versus Equity: Dense Fog on the Mezzanine Level
    Deloitte has submitted a Letter of Comment (PDF 277k) on the IASB's Discussion Paper: Financial Instruments with Characteristics of Equity. We strongly support development of a standard addressing how to distinguish between liabilities and equity. We do not support any of the three approaches outlined in the Discussion Paper, but we believe that the basic ownership approach is a suitable starting point. Below is an excerpt from our letter. Past comment letters are Here.
    IASPlus, September 5, 2008 --- http://www.iasplus.com/index.htm

    July 19, 2009 reply from John Anderson [jcanderson27@COMCAST.NET]

    Professor Jensen,

    Thanks for your very interesting post!  

    This peek into the work of the IASB illustrates much of what is happening within the IFRS iceberg … where 6/7th's of the activity is under the surface, or else seemingly ignored in the US press and perhaps intentionally under-reported by US professional organizations.  

    I have pulled the following excerpts from the IASB’s linked site in your post ---
    http://www.iasplus.com/dttletr/0809liabequity.pdf   

    The approach was prepared by staff of the Accounting Standards Committee of Germany on behalf of the European Financial Reporting Advisory Group (EFRAG) and the German Accounting Standards Board (GASB) under the Pro-active Accounting Activities in Europe Initiative (PAAinE) of EFRAG and the European National Standard Setters.

    The staff pointed out that the basic principle for the classification of equity and liability has been established but that all other components still represent work-in-progress.

    Also:

    The staff asked the Board whether there was agreement on acknowledging in the IASB's forthcoming discussion paper that the European Financial Reporting Advisory Group (EFRAG) had also issued a discussion paper on the distinction between equity and liabilities. Most Board Members disagreed with the staff's proposed wording and emphasised that the IASB should make it clear that it had not deliberated the final version of the EFRAG document, had therefore reached no final position on its merits and that the acknowledgement of the existence of the EFRAG paper should not be seen as the IASB endorsing the positions taken therein. It was decided to take the staff proposals offline to agree a suitable wording.

    Also:

     

    The FASB document describes three approaches to distinguish equity instruments and non-equity instruments:

    ·         basic ownership,

    ·         ownership-settlement, and

    ·         reassessed expected outcomes.

    The FASB has reached a preliminary view that the basic ownership approach is the appropriate approach for determining which instruments should be classified as equity. The IASB has not deliberated any of the three approaches, or any other approaches, to distinguishing equity instruments and non-equity, and does not have any preliminary view.

    The IASB's DP describes some implications of the three approaches in the FASB document for IFRSs. For instance:

    ·         Significantly fewer instruments would be classified as equity under the basic ownership approach than under IAS 32.

    ·         The ownership-settlement approach would be broadly consistent with the classifications achieved in IAS 32. However, under the ownership-settlement approach, more instruments would be separated into components and fewer derivative instruments would be classified as equity.

    The goal of the Discussion Paper is to solicit views on whether FASB's proposals are a suitable starting point for the IASB's deliberations. If the project is added to the IASB's active agenda, the IASB intends to undertake it jointly with the FASB. The IASB requests responses to the DP by 5 September 2008. Click for Press Release PDF 52k).

    My concerns are the following:

    1. About a year ago I understood that in IFRS most Preferred Stock would be classified as Debt, not Equity.  
    2. There was some question about Callable and Convertible Debt.  

    Today, going through the IASB’ abstract of all of their meetings on this subject, I cannot determine if the Germans in ERFAG are arguing for Preferred Stock to be classified as Equity or not.  Logically their issue of the Loss Absorbing nature of the Security should be the determining factor for classifications and therefore classify Preferred Stock as Equity or not.  This is critical in areas like Boston where many of our VC backed companies would be transformed into companies having little or no Equity under IFRS.  I have seen IFRS “experts” present on Route 128 in Boston and seemingly being unaware of this difference between US GAAP and IFRS.  Similarly, Tweedie’s stand-by illustrative company from Scotland that he loves to use is Johnnie Walker.  This would indicate to me that maybe McGreevy should introduce Tweedie to some of the Microsoft development now performed in Ireland, unless Johnnie Walker is about to enter the Technology Business.  

    As has been the theme in some of my prior posts, after correctly bringing the US position (FASB) into the discussions about a year ago, since then the IASB seems to have its hands full dealing with the Contingencies from the EU.  

    Clearly with 55 conventions in the EU, 2½ for each EU country, a key task for the IASB is the de-Balkanization of the EU’s Accounting.  During this necessary period of consolidation within the EU, we should not be required to mark time as the IASB planned during the EU conversion from 2005 throughout 2008.  (The Credit Crunch and Financial Meltdown in September 2008 threw  a monkey-wrench into these plans!)  

    As in their December 2008 Revenue Recognition “Discussion Paper” the IASB seems to have their hands full now introducing these revolutionary new concepts such as Equity Section Accounting and Revenue Recognition to their subscribing countries.  They are seemingly starting each exercise with a blank sheet.  Unfortunately this is no way conducive to their goal of converging with us in the US.  This methodology also will create excess fatigue within the EU’s apparently limited and diffused technical resources.  

    Given that the IASB has been struggling with Equity Accounting since 2005 this also confirms my fear of future lack of responsiveness to newly arising needs for new accounting regulations.  We are now down to only the FASB in this country.  I shudder to consider a world with only the IASB.  Could they handle Cash in 3 months, or would this require further study?  

    They were quick with Derivatives in 2008 Q4 and in recent threats to us in the US.  

    Apparently they can only be decisive in emotional moments of pique or fear!  

    Best Regards! 

     

    John

     

    John Anderson, CPA, CISA, CISM, CGEIT, CITP

    Financial & IT Business Consultant

    14 Tanglewood Road

    Boxford, MA 01921

     

    jcanderson27@comcast.net

    978-887-0623   Office

    978-837-0092   Cell

    978-887-3679    Fax


    From the CFO Journal's Morning Ledger on March 3, 2014

    Tesla convertible debt electrifies long-term investors
    Tesla Motors
    is showing that it’s more than just a plaything for day traders and ardent believers in electric cars,
    write the WSJ’s Matt Jarzemsky and Telis Demos. While the spotlight has focused on the frantic trading driving up Tesla’s share price in the past year, less visible have been the company’s efforts to tap big, sophisticated and long-term investors for cash that it needs to expand. The company raised $2 billion in a sale of convertible debt late last week, garnering an audience of big investors such as mutual funds and hedge funds. “The classic growth companies are the kind of thing the convert market loves,” said Eli Pars, who helps manage convertible holdings at Calamos Investments. “If they slip up, the stock may get taken down, but the convertible debt should hold up relatively well.”

    Jensen Comment
    This looks like a great example when teaching how to account for convertible debt under FASB and IASB standards.

    USA GAAP and International Financial Reporting Standards (IFRS) differ with respect to accounting for convertible debt? Under IFRS, convertible debt is divided into its liability and equity elements. Under US GAAP, the entire issue price is recorded as debt. Has this changed since I retired?

     


    The partition of debt versus equity is central to balance sheet theory throughout corporate accounting history, although complicated financing contracts have created problems in recent times, notably mezzanine debt that is part debt and part equity, Now the GM bankruptcy may further complicate accounting theory for debt versus equity.

    It also brings into question some of the provisions for accounting for pensions and post-employment benefits. I don't think accounting theorists and standard setters have yet focused enough on the GM Bankruptcy aftermath.

    "GM Bankruptcy Changes Business Rules?" by Beth Eiseman Grey, The American Thinker, July 19, 2009 --- http://www.americanthinker.com/2009/07/gm_bankruptcy_changes_business.html

    If I were teaching the GM and Chrysler bankruptcy cases at a law school in Chicago, I'd start off with something unexpected -- the famous case of Shlensky v. Wrigley. I'd hook the legal eagles with the story of William Shlensky, who decided to take on the Cubs when he was a 27-year-old Chicago attorney who had owned two shares of Cubs stock since age 14.

    Over four decades ago, Shlensky sued the Wrigleys and the other Cubs corporation board members to force them to install lights at Wrigley Field. He argued that the Cubs needed night games at home to stem years of operating losses. Wrigley allegedly resisted lighting the ballpark because he considered baseball to be a "'daytime sport'" and received a petition signed by 3,000 Wrigley Field neighbors who felt the lights would lead to community deterioration.

    The Illinois Appellate Court considered the question of whether judges should step in when personal or societal concerns drive business decisions. The Court ruled in favor of Wrigley, but did point out that there were no allegations as to the profitability of the other teams' night games. The Court also explained that concern for neighborhood Cubs fans could have had a positive financial impact on revenues. Presumably, the Court might have ruled differently if Wrigley's decision had no financial merit, or was tainted by a lack of integrity or by bad faith.

    A couple of recent articles in Harvard and University of Michigan publications detail the legal issues concerning the social and political motives for business decisions. I would have students look at those issues in the GM and Chrysler cases, with particular focus on the GM opinion.

    U.S. Bankruptcy Judge Robert E. Gerber approved GM's restructuring plan and a generous UAW benefits package, veering little from the path blazed a month earlier by Judge Arthur J. Gonzalez in the Chrysler case. In a 95-page opinion, the Judge remarked that the "only truly debatable issues" involved successor liability claims for pending tort cases. He used the exigencies of the Detroit meltdown to join the Chrysler Court in transforming the Obama Administration's politically-motivated social decisions into judicially-protected business judgments.

    As Judge Gerber acknowledged, "there must be some articulated business justification, other than appeasement of major creditors'" for fast-tracking a multi-billion dollar section 363(b) bankruptcy deal in which thousands of investors, retirees, suppliers, tort victims, and others face near-wipeouts. The unofficial bondholders' committee argued that the U.S. Treasury's political decisions did not amount to sound business judgment. They pointed out that especially with the alleged lack of enabling legislation for the funding in the case, Treasury was not driven and constrained by financial, investor, and regulatory boundaries.

    The taxpayer-funded bailout of the two companies and the UAW was no ordinary commercial investment, but a very generous gift from taxpayers, for which no private lender could find business justification. According to Barron's, there is little prospect for taxpayers "to come out whole" because "GM's equity value would have to approach $70 billion -- a very unlikely outcome" considering that "Ford . . . and BMW . . . each have market values of $20 billion."

    Judge Gerber agreed that the decision to rescue the automakers was hardly motivated by the "economic merit" of the investment, "but rather to address the underlying societal interests in preserving "jobs", the "auto industry," "suppliers," "and the health of the communities." Yet, like Judge Gonzalez, he still concluded that the fast-tracked restructuring plan was a good business decision because GM continued to deteriorate during the bankruptcy, without the TARP funds GM would have had to liquidate, and the bondholders and other creditors would have been worse off with liquidation. This analysis may go to the short-term prospects for GM and the creditors, but ignores questions about GM's continued viability, which is undermined by the plan's commercial weaknesses and political priorities.

    The Wall Street Journal reported that UAW President Ron Gettelfinger actually "boasted" that the UAW "'put pressure on" the Obama Administration and GM to "bar small-car imports from overseas." The Journal also pointed out that that decision will undermine GM because it will have to "retool its domestic plants" to make the green cars favored by the Obama Administration and Congress, for which demand is uncertain.

    As the Wall Street Journal also explained, the Obama Administration's agreement to preserve the lion's share of the UAW's health, retirement, and legacy pension benefits package was no "hard-nosed business decision," but a shrewd political calculation that will continue to threaten GM's long-term viability which "depends on making its cost structure competitive."

    Judge Gerber agreed with Judge Gonzalez that the UAW provided "unprecedented modifications" to its collective bargaining agreement. Judge Gonzalez pointed to changes in the UAW's previous deal, including a six-year no-strike clause. A no-strike clause, however, is an empty concession. As a new part-owner of the automakers, it would be against UAW's interest to strike.

    The UAW's other modifications were comparatively minor, including the loss of cost-of-living raises for the term of the agreement, performance bonuses for two years, one paid holiday for two years, tuition assistance, and a reduction in retiree prescription drug coverage and elimination of dental coverage.

    As the Washington Post explained, the bankruptcy plan was "not quite the radical change that a neutral bankruptcy judge might have allowed." The Post went on to point out that "[o]ther union concessions were ‘painful' only by the peculiar standards of Big Three labor relations." The Post noted that "[c]umbersome UAW work rules have only been tweaked" and the union retained health benefits and hourly wages "that are far better than those received by many American families upon whose tax money GM jobs now depend" although "according to the task force, GM's labor costs are now within ‘shooting distance' of those at nonunion plants . . . ."

    Even without many of the fringe benefits, Barron's emphasized that the UAW "pulled off a coup . . . with 60 cents to 70 cents on the dollar for its $20 billion claim for post-retirement health care for its members" and it will receive "$9 billion of new debt and preferred stock, plus a 17.5% equity stake."

    Especially in the current job market, the UAW should expect nothing more than market parity. As the Wall Street Journal reasoned, arguments that the UAW "won't show up for work on Monday" without their loaded benefits package and the legacy deals are "bluster" because "the UAW needs GM as much as GM needs workers."

    Treasury's failure to drive a harder bargain with the UAW raised questions as to the Administration's integrity. Judge Gerber found "no proof" of bad faith, and found evidence of "arms'-length" transactions with the UAW and others. Also, he rejected the remedy of equitable subordination because he found that the government did not act inequitably and that it derived no "special benefit" from its transactions with any of the parties.

    The break-neck pace at which the Administration pushed through its deal and the lack of transparency required under normal chapter 11 proceedings made it unreasonably difficult for objectors to prove their cases. After its original GM exchange offers expired on Tuesday, May 26th, the Treasury reported its revised deal to the SEC Thursday, May 28th. Treasury gave investors until 5:00pm on Saturday, May 30th to indicate their decision to support the plan. GM then filed for bankruptcy on Monday, June 1st. Objections to the plan were due eighteen days later. The three-day hearing for the 850 objectors started eleven days after that. Late Sunday night, July 5th, Judge Gerber entered his decision, only thirty-six days after the case was filed.

    As if that wasn't enough pressure, the Obama Administration threatened to withdraw further funding for GM without a court order validating the plan by July 10th. The bondholders argued that the July 10th deadline was "wholly fabricated" and "contrived." They cited public statements by the White House and GM CEO Fritz Henderson on the day the case was filed, that a 60-90 day timeline was expected.

    Judge Gerber refused to call the Administration's bluff, agreeing with GM's counsel that the Judge should not "play Russian Roulette" because he "would have to gamble on the notion that the U.S. Government didn't mean it when it said that it would not keep funding GM."

    Continued in article

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    As an aside, there are some real inequities in having the UAW own some of the companies it represents and no equity in other companies it represents.
    While acquiescing to the demands of its two major shareholders -- Washington and Big Labor -- GM did get concessions of its own. The UAW will allow the company to pay a majority of workers at Orion (in Michigan) lower, "second-tier" wages of $14-$16 an hour with no pension benefits. That will make Orion's wages competitive with the non-union Kia plant in Georgia (which makes SUVs).
    Henry Payne, "Will Small Be Beautiful for GM? Michigan's Orion plant has become a symbol of government run amok in the auto industry," The Wall Street Journal, July 18, 2009 --- http://online.wsj.com/article/SB124786970963060453.html
    Jensen Comment
    But there will be no UAW wage and  pension concessions for Ford Motor Company because Ford did not screw its shareholders/creditors and turn its ownership over to the UAW and the Federal Government.

    What I found interesting is a quotation from Page 11 in a letter written to the IASB by Deloitte on September 4, 2008 --- http://www.iasplus.com/dttletr/0809liabequity.pdf
    Deloitte was commenting upon an IASB exposure draft entitled "Financial Instruments with Characteristics of Equity."

    1.2 Classification Based on Priority in Liquidation
    In our view, another deficiency of the basic ownership approach in its current design is that it classifies financial instruments as liabilities or equity based on the assumption that the entity is being liquidated. We do not support a classification approach that focuses on the priority of an instrument in the event of liquidation. While disclosure of information about the priority of various claims in liquidation may be useful to readers of financial statements, when financial statements are prepared on the basis of a going concern assumption. We believe priority of an instrument is an important consideration but should not be a determinative factor in the classification. Rather we believe classification should be based on the economic characteristics and risks of an instrument considering the issuer is a going concern unless the entity is a finite-life entity or a going concern assumption is no longer appropriate.

    We note that an instrument that has priority to the assets of an issuer in the event of liquidation may not necessarily provide its holder with payment or settlement rights that are different from a common share absent liquidation.

    Continued on Page 11 Deloitte's letter --- http://www.iasplus.com/dttletr/0809liabequity.pdf

    It is important to note that GM itself was not liquidated and was never intended to be liquidated under its bailout agreement with the Federal Government in 2009. Bits and pieces were sold off, but GM continued as an operating company before and after bankruptcy that wiped out common shareholders and many creditors.

    In particular, many creditors (not quite all) that had "priority in liquidation claims in liquidation" ended up wiped out like common shareholders when the UAW pension rights ended up receiving higher priority than most creditors, including creditors that help mortgages on particular assets. This seems to confirm Deloitte's point that classification of debt versus equity on the basis of priority liquidation claims just is not a sufficient condition for classifying debt versus equity on the balance sheet. Priority claims in liquidation eventually had zero claims when liquidation was avoided. All the prior years that such creditor instruments were classified as debt proved to be misleading when Big Brother decided to screw many creditors in favor of the UAW pension protection.

    When GM managed to bury creditor priority claims, it shook up the entire world of finance and business law. When GM managed to bury creditor priority claims, I think it also should shake up accounting standard setters trying to set criteria for separating debt versus equity on the balance sheet.

     


    What is debt? What is equity? What is a Trup?
    Banks are going to create huge problems for accountants with newer hybrid instruments

    From Jim Mahar's Blog on February 6, 2005 --- http://financeprofessorblog.blogspot.com/

    The Financial Times has a very cool article on financial engineering and the development of securities that combine debt and equity-like features.

    FT.com / Home UK - Banks hope to cash in on rush into hybrid securities: "Securities that straddle the debt and equity worlds are not new. They combine features of debt such as regular interest-like payments and equity-like characteristics such as long or perpetual maturities and the ability to defer payments."

    "About a decade ago, regulated financial institutions started issuing so-called trust preferred securities, or Trups, which are functionally similar to preferred stock but can be structured to achieve extra benefits such as tax deductibility for the issuing company. Other hybrid structures have also been tried.

    But bankers were still searching for what several called the “holy grail” – an instrument that looked like debt to its issuer, the tax man and investors, but like equity to credit rating agencies and regulators.

    That goal came closer a year ago when Moody’s, the credit rating agency, changed its previously conservative policies, opening the door for it to treat structures with some debt-like features more like equity."

    The link to the Financial Times article ---
    http://news.ft.com/cms/s/e22d70f2-9674-11da-a5ba-0000779e2340.html


    Teaching Case on Preferred Stock Shares, Warrants, and Dividends

    From The Wall Street Journal Accounting Weekly Review on April 28, 2011

    Deal Journal: Warren Buffett's Profit on GE Investment: $1.2 Billion
    by: Shira Ovide
    Apr 22, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Dividends, Financial Statement Analysis

    SUMMARY: "In the financial crisis, Warren Buffett loaned out his halo of respectability to prop up sentiment about Goldman Sachs Group, Dow Chemical, General Electric and other blue-chip companies." He invested nearly $3 billion in GE in exchange for preferred stock and warrants issued together.

    CLASSROOM APPLICATION: The article is useful to cover a live example of issuing preferred stock and warrants, typically covered in a second semester intermediate financial accounting course. Questions also ask students to access the GE financial statements (2010 Form 10-K on its investor relations web site) to examine the presentation of the stock and warrants in stockholders' equity and the preferred stock dividends deducted in calculating earnings available for common shareholders in the statement of earnings.

    QUESTIONS: 
    1. (Introductory) According the news article, Warren Buffet's Berkshire Hathaway invested $3 billion in GE during the height of the financial crisies. What types of securities did GE issue to Berkshire Hathaway? What are the terms of that issuance?

    2. (Advanced) Summarize the accounting for the combined issuance of preferred stock and warrants.

    3. (Advanced) Access the GE 2010 annual report available through GE's investor relations web site at http://www.ge.com/investors/financial_reporting/index.html Click on Form 10-K 2010, locate the balance sheet and Note 15. Shareowners' Equity. Describe how the preferred stock and warrants issued to Berkshire Hathaway are presented in the GE financial statements.

    4. (Introductory) Return to the Statement of Earnings (Income Statement) in the 10-K filing. How are the preferred dividends that are described in the article presented in this statement?

    5. (Advanced) Based on the discussion in the article, do you think these dividends have been paid? Comment on the deduction of dividends to determine "Net earnings attributable to GE common shareowners" given your answer to question 3 above.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Deal Journal: Warren Buffett's Profit on GE Investment: $1.2 Billion," by: Shira Ovide, The Wall Street Journal, April 22, 2011 ---
    http://blogs.wsj.com/deals/2011/04/21/warren-buffetts-profit-on-ge-investment-1-2-billion/?mod=djem_jiewr_AC_domainid

    In the financial crisis, Warren Buffett loaned out his halo of respectability to prop up sentiment about Goldman Sachs Group, Dow Chemical, General Electric and other blue-chip companies. Those bets came with some heavy costs for the companies, and produced handsome profits for the Oracle of Omaha.

    GE reiterated today it plans to repay Buffett by October for his $3 billion investment in the conglomerate, an agreement struck in October 2008 when the financial world was coming apart at the seams.

    As in other reputation-bolstering investments Buffett made during that stretch, GE agreed to pay the Oracle a 10% annual dividend, or $300 million a year in GE’s case.

    The numbers-loving Buffett carried around a coin changer in his schoolboy days, and probably could tell you that his GE dividend amounts to $9.51 a second. (That buys about 41% of a sirloin dinner at Buffett hangout, Gorat’s Steak House.)

    When GE pays Buffett back, they will owe him 10% more than he paid, or $300 million on top of his $3 billion payback. Plus, Buffett will have accumulated $900 million in cumulative dividends, assuming GE repays the preferred-stock investment in October. All told, Buffett’s $3 billion investment will generate a total profit of $1.2 billion. Not too shabby.

    Now the bad news: Buffett’s investment also entitled him to buy 134.8 million shares of GE common stock at an exercise price of $22.25. With GE stock languishing below $20 a pop, those stock warrants are worthless — for now. But fear not. The warrants were good for five years, and GE shares can always move up and give Buffett an additional windfall (or move down and permanently deny Buffett the cherry atop his sundae of GE profit).

    Buffett already has been repaid for other investments he made during the financial crisis, including his purchase of Swiss Reinsurance debt, and his $5 billion preferred investment in Goldman Sachs. And Buffett, with a net worth of $50 billion, has sounded downright downbeat about it.

    “Goldman Sachs has the right to call our preferred on 30 days notice, but has been held back by the Federal Reserve (bless it!), which unfortunately will likely give Goldman the green light before long,” Buffett wrote in February, in his annual letter to Berkshire Hathaway investors.

    Since then, Goldman has indeed repaid Buffett, who can count roughly $3.7 billion in profits on his investment, including the value of his in-the-money warrants on Goldman stock. His Swiss Re investment padded Buffett’s wallet by roughly $1 billion.

    Continued in article


    Virtually every basic accounting course stresses the differences between property (e.g., cash) dividends versus stock dividends versus stock splits.

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

    Apple Pads Investor Wallets
    by: Jessica E. Vascellaro
    Mar 20, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Dilution, Dividend, Tax Avoidance, Tax Laws, Taxation

    SUMMARY: "Apple on Monday bowed to mounting pressure to return some of its roughly $100 billion in cash reserves to shareholders by saying it would issue a dividend and buy back stock....The last time Apple paid a dividend was in December 1995, a year before [Steve] Jobs returned....But following [Tim] Cook's appointment as CEO last August and the death of Mr. Jobs in October, Apple's approach changed...." The company will pay a $2.65 a share quarterly dividend beginning in July; "Apple's board also authorized a $10 billion share repurchase program to begin in the quarter starting Sept. 30...."

    CLASSROOM APPLICATION: The main article is useful to introduce dividend policy and stock buyback decisions when introducing those topics in financial accounting classes covering stockholders' equity. The related article highlights tax issues in repatriating overseas cash faced by many U.S. corporations.

    QUESTIONS: 
    1. (Introductory) Why is it so newsworthy that Apple will begin to pay dividends to its shareholders?

    2. (Introductory) Based on the discussion in the article, what are Mr. Cook's reasons for paying a dividend? What were the late Mr. Jobs's reasons for not doing so?

    3. (Advanced) How are stock repurchases similar to dividends?

    4. (Advanced) According to the article, what is the specific purpose of starting a stock repurchase plan? In your answer, define the term "dilution."

    5. (Advanced) Refer to the related article. Where is most of Apple's significant cash balance held?

    6. (Advanced) Again refer to the related article. Why is Apple, as are many U.S. based international companies, facing "significant tax consequences" if it decides to "repatriate" bring back overseas cash balances? How is Apple balancing this concern with its need for cash to continue to grow?

    7. (Advanced) How is Apple balancing its tax concern with its need for cash to continue to grow?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Apple's Move Puts Spotlight on Foreign Cash Holdings
    by Maxwell Murphy
    Mar 20, 2012
    Page: A6

     

    "Apple Pads Investor Wallets," by Jessica E. Vascellaro, The Wall Street Journal, March 20, 2012 ---
    http://online.wsj.com/article/SB10001424052702304724404577291071289857802.html?mod=djem_jiewr_AC_domainid

    Tim Cook is proving he's not simply the caretaker of Apple Inc. AAPL -0.53% and the unyielding strategies set forth by his predecessor, Steve Jobs.

    Apple on Monday bowed to mounting pressure to return some of its roughly $100 billion in cash reserves to shareholders by saying it would issue a dividend and buy back stock, marking the technology company's biggest break yet from Mr. Jobs's philosophy.

    The last time Apple paid a dividend was in December 1995, a year before Mr. Jobs returned to Apple. Mr. Jobs largely resisted returning cash to shareholders, whose clamoring for a cut of Apple's growing cash stockpile increased in recent years, according to people familiar with the matter.

    Mr. Jobs had long argued that Apple's cash—which at $97.6 billion as of Dec. 31 is the greatest of any nonfinancial U.S. corporation—should be used to invest in areas such as Apple's supply chain, retail stores, research and the rare acquisition. He spent little time with shareholders and rarely discussed it at all.

    Mr. Jobs was persuaded to do a buyback in the wake of the Sept. 11, 2001, terrorist attacks as the stock market fell, according to a person familiar with the matter. After that, several executives thought the company should continue to do buybacks because the stock price seemed very cheap, this person said. Journal Community

    Apple hired bankers to study the impact of a buyback, according to this person, who said Mr. Jobs rejected the idea before it went anywhere. He felt the company could use the money to expand the business by more than the bump to per-share earnings a buyback would provide, this person said.

    But following Mr. Cook's appointment as CEO last August and the death of Mr. Jobs in October, Apple's approach changed. At a company event honoring Mr. Jobs last Oct. 19, Mr. Cook recounted a conversation in which the co-founder told him to run Apple as he saw fit. "Just do what's right," Mr. Cook said he was told.

    WSJ's Spencer Ante and Jennifer Valentino discuss Apple CEO Tim Cook's emphasis on innovation and future products as part of the company's announcement of a stock dividend and buyback.

    Barron's associate editor Michael Santoli stops by Mean Street to discuss the impact of Apple's dividend and buyback announcement on the broader market. Photo: Reuters.

    Mr. Cook grew more forthcoming publicly on the cash topic. In a rare appearance at an investor conference in February, Mr. Cook acknowledged that the Apple board was actively discussing what to do with the cash, since the company had more than it needed to run its business.

    That led to Monday's conference call, in which the Cupertino, Calif., company announced it would pay a $2.65 a share quarterly dividend in its quarter beginning in July. That represents a 1.8% yield based on Apple's closing stock price before the news, roughly in line with the yield on the Standard & Poor's 500 index and in the middle of the pack of what some other dividend-issuing tech companies pay.

    Apple's board also authorized a $10 billion share repurchase program to begin in the quarter starting Sept. 30, largely to offset dilution from issuing new restricted-stock units to employees. Apple said the dividend and buyback programs would cost the company $45 billion in the first three years and that it would continue to evaluate it.

    "Even with these investments, we can maintain a war chest for strategic opportunities and have plenty of cash to run our business," Mr. Cook said Monday. "We have thought very deeply and very carefully about our cash balance."

    The package marked the most significant move to date by Mr. Cook in putting his own imprint on Apple and reflects how he has been more forthcoming with shareholders, investors say.

    While Mr. Jobs flouted usual business practices and outside influence, Mr. Cook's shift on cash removes Apple as one of the few dividend holdouts among large technology companies. Over the past decade, other tech behemoths such as Microsoft Corp., MSFT +0.27% Oracle Corp. ORCL -2.65% and Cisco Systems Inc. CSCO -0.59% had also begun payouts to shareholders as the companies matured.

    But unlike those companies—which were experiencing slower growth rates and whose initiation of a dividend was regarded as a sign that some of their fastest growth was behind them—Apple is still expanding rapidly. In its last reported quarter, Apple more than doubled its profits and increased revenue 73%, largely on the strength of sales of its hit iPad and iPhone devices.

    Some investors and analysts have said in interviews they wonder how long Apple's growth streak can last, particularly once the company has saturated some of its current growth engines, like smartphones. But Mr. Cook stressed Apple remains in a growth phase on Monday's call, saying "we don't see ceilings to our opportunities."

    Apple's cash shift is unlikely to have major ripple effects on Wall Street, however. Trading volumes for Apple's stock could increase as funds that have been shut out from holding the shares because it didn't issue a dividend now can now buy it, potentially boosting its price. Still, analysts noted the stock is already widely held and others said expectations for a dividend have been factored into the current stock price.

    Continued in article

    Bob Jensen's threads on Accounting Theory are at
    http://faculty.trinity.edu/rjensen/Theory01.htm


    Question
    How do you account for and bail out a company with over $1 trillion in assets that has ownership contracting that the best experts cannot untangle?
    Did you ever think Osama Bin Laden may be in for some of these bailout billions from our taxpayers?
    Corporate contracting is becoming incomprehensible!

    Denny Beresford forwarded this link to me.
    "The Professor’s Pop Quiz: Who Controls A.I.G.?" by Steven M. Davidoff, Dealbook.com, November 18, 2018 --- http://dealbook.blogs.nytimes.com/2008/11/18/the-professors-pop-quiz-who-controls-aig/?ei=5070&emc=eta1

    The terms of the government’s investment in the American International Group were released last week. After reading these terms, I have a multiple-choice question.

    Who controls A.I.G.? Is it:

    1) The Federal Reserve
    2) The Department of the Treasury
    3) The current shareholders of A.I.G. (but not the government)
    4) All of the above collectively
    5) No one knows

    The best answer I can discern right now is number 5. The deal has become much more complicated than it was before, but the control rights over A.I.G. appear to be as follows:

    1. In exchange for its $40 billion preferred share injection under the Emergency Economic Stabilization Act, the government is getting a 10 percent dividend on these shares (plus A.I.G.’s agreement to restrictions on lobbying), the same limitations on executive compensation as in other preferred equity injections, a further limitation on annual bonus pools for senior partners not to exceed 2007 and 2006 levels, and compliance with an expense policy. As for control rights — the $40 billion preferred is nonvoting except on certain major issues affecting the preferred. If A.I.G. misses dividend payments for four consecutive quarters, the Treasury has the right under the terms of this preferred stock to elect two directors and a number of directors (rounded upward) equal to 20 percent of the total number of directors after giving effect to such election.

    2. In exchange for the new $60 billion Federal Credit Facility (down from $85 billion), the Federal Reserve obtains the general rights of a creditor including senior security over A.I.G.’s unregulated subsidiaries, but no real governance rights except for some negative covenants limiting A.I.G.’s operations and expenditures.

    3. Finally, the government is receiving 100,000 Series C preferred shares convertible into 77.9 percent of A.I.G.’s outstanding common stock. This second preferred stock has a vote equal to 77.9 percent of A.I.G.’s share capital and is entitled to 77.9 percent of any dividends paid by A.I.G. on its common stock.

    Thus, whoever controls these Series C preferred shares controls A.I.G. These Series C shares, the stock that will vote and control A.I.G., will be owned by is a trust for the benefit of the Treasury Department. The trust is called the A.I.G. Credit Facility Trust. And who are the trustees of this trust and the controllers of A.I.G.? I have no idea nor have I seen any public disclosure on the issue except for news reports in October that these trustees would be appointed by the Fed and that there would be three of them. Moreover, under Section 5.11 of the original credit agreement, a provision that appears to be unamended in the new deal, A.I.G. “shall use all reasonable efforts to cause the composition of the board of directors of [A.I.G.] to be … satisfactory to the Trust in its sole discretion.”

    So, why this oddity? I must admit, I am puzzled. Perhaps it is related to accounting or some other legal requirement? But I also suspect it may be political — the government does not want to control A.I.G. directly. Rather, it is preserving some separation of ownership and control to bar future administrations from political meddling (read the Obama administration). This is probably a worthy goal — allowing A.I.G. to operate on an economic basis protected from political meddling.

    However, there should be adequate oversight of the trust and some mechanisms to prevent the trustees from obtaining their own private benefits from controlling A.I.G. and its $1 trillion in assets. In addition, the trustees themselves should be chosen for their acumen and ability to right the sinking A.I.G. ship. Here, the government could begin by disclosing the terms of this trust once they are drafted.

    Jensen Comment
    What's even more comical is that accounting standards for various purposes, such as when implementing securitization accounting under FAS 140, are heavily dependent upon the "degree of control" irrespective of actual number of equity shares owned. How do such standards get implemented when top experts have no idea who controls what? Real life just is not as simple as what we teach in Accounting 101.

    What do you want to bet that lucrative consulting contracts are being given to Andy Fastow to draft these ownership and control contracts? Here's an example of one that Andy cut his teeth on --- http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

     

     

  • Bob,

    I thought this was an interesting article because it raises some very legitimate questions about consolidation accounting. Perhaps those who teach Advanced Accounting or wherever consolidation policy is covered can make a mini-case out of it.

    I was told by a senior Treasury official that the 79.9% number for the common stock warrants was chosen to avoid having to apply change in control push down accounting to AIG and the other entities (Fannie Mae and Freddie Mac) where a similar approach was taken. If a higher number of warrants was given to the government, AIG's financial statements would have to be restated to full, fair value accounting, with even more devastating results shown.

    The government involvement at AIG is quite different than Fannie and Freddie in that the latter organizations are under a government operated Conservatorship and the most important governance decisions will be made by the regulator, the Federal Housing Finance Administration, rather than senior management or the corporate board. As I understand AIG, senior management and the board still make those decisions. While I suspect the company works closely with the government, as far as I know there isn't any direct participation in management or on the board of directors.

    Control, for purposes of consolidation, has been an elusive concept for as long as I've been in accounting (ARB 51 was issued at just about when I graduated from college and it's still highly relevant literature). The FASB has had this on its agenda for more than 25 years and has made only modest "progress." It's current project to modify SFAS 140 on securitizations and Interpretation 46R on consolidation of variable interest entities introduce new guidelines that probably would lead to more entities being included in consolidation but with very little if any in the way of persuasive theory supporting the approach. As former SEC Chairman David Ruder told me about 20 years ago, "The SEC has been trying to define control since the beginning of the Commission and it hasn't succeeded yet."

    The AIG and related cases show how hard this is and how little progress has been made over many, many years!

    Denny Beresford

     

    Bob Jensen's essay on the bailout mess is at http://faculty.trinity.edu/rjensen/2008Bailout.htm


    Another One from That Ketz Guy
    "Deferred Income Taxes (Accounting) Should be Put to Rest," by J. Edward Ketz , AccountingWeb, March 2010 ---
    http://accounting.smartpros.com/x68912.xml

    One of the silliest constructs in the world of accounting happens to be deferred income taxes. I don't understand why we bother with deferred tax liabilities and deferred tax assets because they are neither liabilities nor assets. If the FASB and the IASB are serious about principles-based accounting -- which I am becoming to believe is rhetoric without referents -- then they would eliminate these bastard accounts without delay.

    Consider Procter & Gamble’s annual report for 2009, for instance. They report deferred income tax assets (net) of $5.2 billion and deferred income tax liabilities of $13.7 billion. But, are the former really assets and the latter really debts?

    The FASB defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions.” The IASB defines them similarly as “a present obligation arising from a past event, the settlement of which results in an outflow of resources embodying future economic benefits.”

    Suppose a business enterprise uses accelerated depreciation for tax purposes and straight-line for financial reporting such that depreciation for tax purposes amounts to $320,000 and for financial purposes $200,000. There is a difference of $120,000 and, if we assume a tax rate of 25%, this leads to an increase in deferred income taxes of $40,000. But what is the nature of this $40,000?

    This $40,000 is not a probable future sacrifice—the sacrifice will be in the nature of future taxes paid to the U.S. and other governments. At most, the $40,000 helps one better to predict future cash flows for taxes. Yet that does not make this $40,000 a liability.

    Even if it were a probable future sacrifice, there is a bigger problem. This future sacrifice is not a present obligation of the firm. The incremental tax becomes a “present obligation” only when the next tax year rolls around. Taxes are statutory requirements that arise only in the year they are imposed. Just because taxes are an unending penalty for living in advanced societies doesn’t make any of them present obligations today (the boulder pushed up the mountain by Sisyphus was actually his income taxes).

    Furthermore, these deferred income tax liabilities are not a result of past transactions between the tax authority and the taxpayer. We have the transaction when the taxpayer purchased the plant or equipment and we have past tax transactions. But, it requires a lot of imagination to think that any of these transactions give rise to some present obligation.

    If they were liabilities, one would expect them to be discounted. All long-term obligations are measured at the present value of their future cash flows, including mortgages and bonds and long-term notes payable. I think the FASB does not require discounting of deferred tax liabilities because it knows that fundamentally the numbers used in the computation of deferred taxes are not cash flows. If they were, discounting would be meaningful; as they aren’t cash flows, discounting only compounds this monstrosity.

    I view Procter & Gamble’s $13.7 billion of deferred tax liabilities as not representing probable future sacrifices, nor present obligations, and certainly not resulting from past transactions. Even if they were, the number is vastly inflated because they are raw, undiscounted numbers.

    The FASB defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” The IASB’s definition is again quite similar: an asset is “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.”

    Suppose a firm has estimated warranty expense of $1 million but the tax expense is zero because nobody has filed a warranty claim by year-end. The FASB asserts that there is a deferred tax asset of $250,000 (assuming again the marginal tax rate is 25%) because these represent future deductible amounts.

    Note, however, they are not future economic benefits yet if for no other reason, the government’s tax laws can change. Even if they were, they are not the result of any past transactions or event. Nobody has made a warranty claim; there has only been an adjusting entry that the entity made within itself. It has not contracted or exchanged anything involving these warranties. And not requiring any discounting is again telling—there is no discounting because there is no event and no cash flows.

    A corporation must write down the supposed value of the deferred tax asset if it is more likely than not that it will not realize some of the asset. If this asset were real, where is the market valuation (mark-to-model)? As firms cannot conduct such a valuation (even as a Level 3 estimate per FAS 157), this valuation process is hollow.

    I do not view Procter & Gamble’s deferred income tax assets of $5.2 billion to be real. Just fluff and nonsense. And who knows what P&G’s valuation allowance of $104 million means. It certainly says nothing about valuation.

    Probably the most illogical aspect of deferred taxes occurs on the income statement. P&G determines for 2009 that earnings from continuing operations before income taxes is $15.3 billion. Then it records income tax expense of $4.0 billion. This close proximity gives the reader the idea that there is a relationship between the two, but of course, there is no association. The actual amounts owed to the IRS are computed on taxable income, not on the financial reporting earnings before taxes.

    Expenses are supposed to be sacrifices incurred during the operating activities of the entity. Ok, the current portion of the income tax expense is indeed a sacrifice. But, the deferred portion is clearly not a sacrifice of any resources of the firm. That’s why firms employ MACRS—they want to reduce their sacrifices to Uncle Sam.

    P&G shows the current portion of income tax expense in its tax footnote. The current portion is $3.4 billion and the deferred portion is $0.6 billion.

    I realize that academics have shown a statistical association between market returns and deferred income taxes; however, they usually overstate their conclusions. The correlation between market returns and deferred income taxes merely indicates that market agents find the disclosures useful in predicting future cash outflows to the IRS. This statistical association doesn’t make these constructs assets or liabilities. If the FASB wants to require these disclosures, it should require firms to stick them in a footnote rather than contaminate the balance sheet with their presence.

    Analysts and researchers have an easy time dealing with the problem of deferred income taxes, as the misinformation is in plain view. We just eliminate the phony assets and liabilities from the balance sheet and restate income tax expense to the current portion. Nevertheless, the FASB and the IASB still should eliminate these deferred accounts and clean up the balance sheet, especially if they are serious about principles-based accounting. It makes the financial statements more representationally faithful and thus more reliable.

    This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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

    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
     

     

    Teaching Case From The Wall Street Journal Accounting Weekly Review on February 11, 2005

    TITLE: Amazon's Net Is Curtailed by Costs 
    REPORTER: Mylene Mangalindan 
    DATE: Feb 03, 2005 
    PAGE: A3 
    LINK: http://online.wsj.com/article/0,,SB110735918865643669,00.html  
    TOPICS: Financial Accounting, Financial Statement Analysis, Income Taxes, Managerial Accounting, Net Operating Losses

    SUMMARY: Amazon "...had forecast that profit margins would rise in the fourth quarter, while Wall Street analysts had expected margins to remain about the same." The company's operating profits fell in the fourth quarter from 7.9% of revenue to 7%. The company's stock price plunged "14% in after-hours trading."

    QUESTIONS: 
    1.) "Amazon said net income rose nearly fivefold, to $346.7 million, or 82 cents a share, from $73.2 million, or 17 cents a share a year earlier." Why then did their stock price drop 14% after this announcement?

    2.) Refer to the related article. How were some analysts' projections borne out by the earnings Amazon announced?

    3.) One analyst discussed in the related article, Ken Smith, disagrees with the majority of analysts' views as discussed under #2 above. Do you think that his viewpoint is supported by these results? Explain.

    4.) Summarize the assessments made in answers to questions 2 and 3 with the way in which Amazon's operating profits as a percentage of sales turned out this quarter.

    5.) Amazon's results "included a $244 million gain from tax benefits, stemming from Amazon's heavy losses earlier in the decade." What does that statement say about the accounting treatment of the deferred tax benefit for operating loss carryforwards when those losses were experienced? Be specific in describing exactly how these tax benefits were accounted for.

    6.) Why does Amazon adjust out certain items, including the tax gain described above, in assessing their earnings? In your answer, specifically state which items are adjusted out of earnings and why that adjustment might be made. What is a general term for announcing earnings in this fashion?

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES --- 
    TITLE: Web Sales' Boom Could Leave Amazon Behind 
    REPORTER: Mylene Mangalindan 
    ISSUE: Jan 21, 2005 
    LINK: http://online.wsj.com/article/0,,SB110627113243532202,00.html 

    Bob Jensen's  threads on valuation are at http://faculty.trinity.edu/rjensen/roi.htm 


    From The Wall Street Journal Accounting Review on October 8, 2009

    Borrowing for Dividends Raises Worries
    by Liz Rappaport
    Oct 05, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Bonds, Debt, Dividends, Financial Accounting, Financial Analysis, Financial Statement Analysis, Mergers and Acquisitions

    SUMMARY: "Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds...to pay out special dividends, buy back stock, or finance acquisitions.... [In contrast,] most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash."

    CLASSROOM APPLICATION: The article can be used in covering bond issuances, ratio analysis particularly of debt-to-equity and interest versus earnings, dividend payments, and corporate acquisitions.

    QUESTIONS: 
    1. (Introductory) What was the effective interest rate for corporations with high credit ratings who issued bonds in September 2009? How does that rate compare to one year ago?

    2. (Introductory) What reasons for that change are given in the article? Do they have anything to do with changing creditworthiness of the borrowers?

    3. (Introductory) Compare the actions of Intel Corporation and TransDigm Group, Inc., with their debt issuance. How are they similar? How are they different?

    4. (Advanced) What is the impact on a corporate balance sheet of issuing debt? Describe the impact ignoring use of the proceeds, in essence assuming the company will "stockpile" the cash.

    5. (Introductory) Define the financial statement ratios of debt-to-equity and times interest earned.

    6. (Advanced) Describe the change in impact of debt issuance on a balance sheet equation and the two financial ratios if the proceeds are used to pay dividends to shareholders.

    7. (Advanced) Can a company issue bonds in order to "reduce debt" as the author says was done in during the recession and credit crisis? Explain, proposing a better term for such a transaction.

    8. (Introductory) The author uses two benchmarks to make clear the impact of TransDigm Group's debt issuance and dividend payment. What are these benchmarks? How does using them increase clarity about the size of the $425 million bond offering and the $7.50 to $7.70 per share special dividend?

    9. (Advanced) The author also includes use of bond proceed to finance acquisitions as a risky action. How have debt analysts reacted to Kraft's offer to buy Cadbury?

    10. (Advanced) Describe the impact of a business combination financed by debt on the total combined balance sheets of the firms entering into the business combination. How does this impact compare to using bond proceeds to pay dividends to shareholders? How does it differ?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Borrowing for Dividends Raises Worries," by Liz Rappaport, October 5, 2009 ---
    http://online.wsj.com/article/SB125470107157763085.html?mod=djem_jiewr_AC

    Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds to go on the offensive, even if that means rewarding shareholders at the expense of bondholders.

    The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.

    Eric Felder, global head of credit trading at Barclays Capital, says the lure of low rates and companies' stables of cash increases "the risk of non-bondholder friendly events."

    Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company.

    The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service.

    Moody's said the dividend "illustrates the company's aggressive financial policy." Moody's gave the new debt a junk rating of B3, even though the ratings firm said TransDigm's "strong operating performance will enable the company to service the increased debt level."

    Sean Maroney, director of investor relations at TransDigm, says the "stability of our business, high profit margins and consistent cash flow" give the company "the ability to support this level of leverage."

    Borrowing from bondholders to pay shareholder dividends is "a hallmark of an earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year.

    Companies like Dex Media Inc. took on debt to pay dividends to its private-equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe, before taking the companies public. Dex Media filed for bankruptcy earlier this year under a mountain of debt.

    With the federal-funds rate at 0% for nine months now and confidence returning to the stock and debt markets, investors have been driven to take on more risk. That is flooding the corporate-bond market with cash. Investors poured $43 billion into investment-grade corporate-bond funds in the second quarter and nearly $40 billion in the third quarter -- almost double previous peak quarters, according to Lipper AMG Data Services.

    The wave of buying drove down borrowing costs for the average highly rated corporation to about 5%, according to Merrill, a level not seen since 2005. In the heat of the crisis last October, such rates averaged 9%. Through the end of September, more than 1,000 high-rated companies borrowed a record $860 billion, according to Dealogic.

    In July, Intel Corp. sold $1.75 billion of convertible bonds, planning to use $1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined to comment.

    The computer-chip giant has a strong credit rating of single-A, so it doesn't carry a burdensome debt load. Still, the deal raised eyebrows among some analysts and investors, who say floating debt to buy back stock could become more common as companies regain confidence.

    And as merger-and-acquisition activity revs up, the cheaper cost of debt compared with equity is tempting companies to use bond sales as a deal-making war chest.

    Analysts are watching Kraft Foods Inc. in anticipation that the company would finance its proposed purchase of U.K. chocolate, candy and chewing gum maker Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was then valued at about $16.7 billion, but it could be weeks before Kraft submits a formal offer.

    Three major credit-ratings agencies have warned Kraft that they could slash the company's debt ratings if the company reaches a deal agreement with Cadbury. At the current offering price, Kraft would need to shell out at least $6 billion in cash, much of it likely from the debt markets, according to corporate-bond research firm Gimme Credit.

    "Kraft is committed to maintaining an investment-grade rating," a Kraft spokesman said, declining to comment further.

    So far in 2009, returns to high-grade bond investors are 19%, according to Merrill. "We've seen a feeding frenzy" because of low interest rates, says Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds recently to take profits from the rally. Loomis Sayles wants to have cash on the sidelines in case the Fed raises rates soon or Treasury bonds sell off.

    Jensen Comment
    If you buy into the Modigliani and Miller Theorem of capital structure, how the corporation is financed, including dividend payouts,

    The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

    Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

    Miller was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

    Video:  The Greek Economic Crisis Explained --- http://www.simoleonsense.com/video-the-greek-crisis-explained/

    Video Lunch with a Laureate: Famous Financial Researcher Robert Merton ---
    http://www.simoleonsense.com/lunch-with-a-laureate-famous-financial-researcher-robert-merton/

    Of course these days, the assumption of market efficiency is a big stretch ---
    http://faculty.trinity.edu/rjensen/theory01.htm#EMH

    Bob Jensen's threads on debt versus equity and capital structure (including investor earn out contracts) are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FAS150

    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 of the firm are at http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory01.htm 


    "Seeking True Financial Reform: Ending the Debt- Equity Distinction," by  Joseph B. Allen, William and Mary Business Law Review , Volume 3, Issue 1 ---
    Click Here
    http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1035&context=wmblr&sei-redir=1&referer=http%3A%2F%2Fwww.google.com%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3Dseeking%2520true%2520financial%2520reform%253A%2520ending%2520the%2520debt-equity%2520distinction%26source%3Dweb%26cd%3D1%26sqi%3D2%26ved%3D0CE0QFjAA%26url%3Dhttp%253A%252F%252Fscholarship.law.wm.edu%252Fcgi%252Fviewcontent.cgi%253Farticle%253D1035%2526context%253Dwmblr%26ei%3DV5PCT77kEuj3sQKM1ozhCQ%26usg%3DAFQjCNHrT51ZK1nKCvnFFcyJE8mHFtE1Cw#search=%22seeking%20true%20financial%20reform%3A%20ending%20debt-equity%20distinction%22

    This Note identifies the failure of Congress to address tax incentives for leverage as a principal cause of the recent financial crisis and a fundamental flaw of recent financial reform legislation. Specifically, the Internal Revenue Code provides substantially disparate tax treatment for debt and equity financing by allowing firms to deduct interest payments on indebtedness, but not providing an equivalent deduction for equity funding. This “debt-equity distinction” artificially reduces the cost of capital for debt financing relative to equity financing and encourages firms to over-employ leverage in their capital structure. This in turn increases financial distress costs and externalities to the economy and increases the volatility of capital markets. Though some scholars have proposed to allow firms a deduction for dividends paid, such a scheme would create additional distortions and introduce the potential for corporate managers to substantially manipulate their taxable income. This Note offers an alternative solution by proposing: (1) that the deduction for interest on business indebtedness be eliminated, and (2) that policymakers return to the idea of the Cost-of-Capital-Allowance (COCA). A COCA deduction better aligns the incentives of firms with those of capital markets and economies writ large, and encourages managers to seek out the absolute cheapest sources of capital while removing tax shelter considerations from the decision-making process.

    . . .

    Encouraging debt over equity has consequences other than increased volatility. The distinction also shifts investment capital away from innovative, high-risk startup companies and towards relatively safer and more stable firms in established industries.92 Michael Knoll, Co-Director of the Center for Tax Law and Policy at the University of Pennsylvania Law School,93 points out that high-risk startup firms have less capacity for leverage in their capital structure because they do not have a consistent earnings history or steady cash flow.94 More established companies are in better positions to employ the interest deduction in devising their capital structure, substantially lowering their cost of capital.95 The overall cost of capital of a firm can act as a “hurdle rate” for judging new ventures and projects; managers and investors will pursue only those projects with an expected rate of return above the cost of capital.96 The interest deduction thus encourages greater investment in stable firms past their rapid growth period, increasing competition for startups in acquiring capital.

    Jensen Comment
    This is more of an essay advocating elimination of interest deductions on corporate tax returns than it is a realistic paper on elimination of debt financial instruments. The author, for example, does not give adequate attention to the important role played by collateral (e.g., real estate mortgages and mortgages on jumbo jets) in debt financing. One of the reasons for lower cost of debt is that quality of the collateral contracted in that debt.

    Bondholders generally do better than shareholders in bankruptcy court. The debt may be restructured by the courts, but the shareholders stand a much better chance of getting nothing. This is one of the main reasons investors opt for bonds rather than equity shares.

    The author assumes that elimination of debt alternatives will ipso facto lower the cost of capital for high risk startup ventures. I just do not buy into his reasoning. Risk averse investors will avoid investing in the equity of risky ventures whether or not they have bond markets to turn to in making their portfolio selections.

    The author also avoids the issue of how towns, counties, states, and the federal government finance capital projects and developments with bonds. These "debt" alternatives for investors will most likely still exist even if we ban bond investing for business firms.

    The author also avoids the issue of global markets. The U.S. Congress cannot eliminate global bond markets. Eliminating bond markets in the U.S. will most likely mean that risk averse investors will increasingly seek more and more foreign bonds rather than plunge more money in risky equity investments.

    My general conclusion is that this is a very superficial article that does not tackle the toughest issues of debt versus equity.

    I would be more impressed if the author tied this article to the Modigliani-Miller Theorem ---
    http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem
    He shows no evidence of even being aware of M&M theory.

    Bob Jensen's threads on accounting and finance theory are at
    http://faculty.trinity.edu/rjensen/Theory.htm

     


    Question
    To what extent should the FASB and the IASB modify accounting standards for new theories of structured finance and securitization?

    "The Economics of Structured Finance," by Joshua D. Coval,  Jakub Jurek, and  Erik Stafford, Working Paper 09-060, Harvard Business School, 2008 ---
    http://www.hbs.edu/research/pdf/09-060.pdf

    The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

    We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. First, we show that most securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities’ default risks, and how likely defaults were to be correlated. Using the prototypical structured finance security – the collateralized debt obligation (CDO) – as an example, we illustrate that issuing a capital structure amplifies errors in evaluating the risk of the underlying securities. In particular, we show how modest imprecision in the parameter estimates can lead to variation in the default risk of the structured finance securities which is sufficient, for example, to cause a security rated AAA to default with reasonable likelihood.

    A second, equally neglected feature of the securitization process is that it substitutes risks that are largely diversifiable for risks that are highly systematic. As a result, securities produced by structured finance activities have far less chance of surviving a severe economic downturn than traditional corporate securities of equal rating. Moreover, because the default risk of senior tranches is concentrated in systematically adverse economic states, investors should demand far larger risk premia for holding structured claims than for holding comparably rated corporate bonds. We argue that both of these features of structured finance products – the extreme fragility of their ratings to modest imprecision in evaluating underlying risks and their exposure to systematic risks – go a long way in explaining the spectacular rise and fall of structured finance.

    For over a century, agencies such as Moody’s, Standard and Poor’s and Fitch have gathered and analyzed a wide range of financial, industry, and economic information to arrive at independent assessments on the creditworthiness of various entities, giving rise to the now widely popular rating scales (AAA, AA, A, BBB and so on). Until recently, the agencies focused the majority of their business on single-name corporate finance—that is, issues of creditworthiness of financial instruments that can be clearly ascribed to a single company. In recent years, the business model of credit rating agencies has expanded beyond their historical role to include the nascent field of structured finance.

    From its beginnings, the market for structured securities evolved as a “rated” market, in which the risk of tranches was assessed by credit rating agencies. Issuers of structured finance products were eager to have their new products rated on the same scale as bonds so that investors subject to ratings-based constraints would be able to purchase the securities. By having these new securities rated, the issuers created an illusion of comparability with existing “single-name” securities. This provided access to a large pool of potential buyers for what otherwise would have been perceived as very complex derivative securities.

    During the past decade, risks of all kinds have been repackaged to create vast quantities of triple-A rated securities with competitive yields. By mid-2007, there were 37,000 structured finance issues in the U.S. alone with the top rating (Scholtes and Beales, 2007). According to Fitch Ratings (2007), roughly 60 percent of all global structured products were AAA-rated, in contrast to less than 1 percent of the corporate issues. By offering AAA-ratings along with attractive yields during a period of relatively low interest rates, these products were eagerly bought up by investors around the world. In turn, structured finance activities grew to represent a large fraction of Wall Street and rating agency revenues in a relatively short period of time. By 2006, structured finance issuance led Wall Street to record revenue and compensation levels. The same year, Moody’s Corporation reported that 44 percent of its revenues came from rating structured finance products, surpassing the 32 percent of revenues from their traditional business of rating corporate bonds.

    By 2008, everything had changed. Global issuance of collateralized debt obligations slowed to a crawl. Wall Street banks were forced to incur massive write-downs. Rating agency revenues from rating structured finance products disappeared virtually overnight and the stock prices of these companies fell by 50 percent, suggesting the market viewed the revenue declines as permanent. A huge fraction of existing products saw their ratings downgraded, with the downgrades being particularly widespread among what are called “asset-backed security” collateralized debt obligations—which are comprised of pools of mortgage, credit card, and auto loan securities. For example, 27 of the 30 tranches of asset-backed collateralized debt obligations underwritten by Merrill Lynch in 2007, saw their triple-A ratings downgraded to “junk” (Craig, Smith, and Ng, 2008). Overall, in 2007, Moody’s downgraded 31 percent of all tranches for asset-backed collateralized debt obligations it had rated and 14 percent of those nitially rated AAA (Bank of International Settlements, 2008). By mid-2008, structured finance activity was effectively shut down, and the president of Standard & Poor’s, Deven Sharma, expected it to remain so for “years” (“S&P President,” 2008).

    This paper investigates the spectacular rise and fall of structured finance. We begin by examining how the structured finance machinery works. We construct some simple examples of collateralized debt obligations that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. We then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. We then conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.

    Manufacturing AAA-rated Securities

    Manufacturing securities of a given credit rating requires tailoring the cash-flow risk of these securities – as measured by the likelihood of default and the magnitude of loss incurred in the event of a default – to satisfy the guidelines set forth by the credit rating agencies. Structured finance allows originators to accomplish this goal by means of a two-step procedure involving pooling and tranching.

    In the first step, a large collection of credit sensitive assets is assembled in a portfolio, which is typically referred to as a special purpose vehicle. The special purpose vehicle is separate from the originator’s balance sheet to isolate the credit risk of its liabilities – the tranches – from the balance sheet of the originator. If the special purpose vehicle issued claims that were not prioritized and were simply fractional claims to the payoff on the underlying portfolio, the structure would be known as a pass-through securitization. At this stage, since the expected portfolio loss is equal to the mean expected loss on the underlying securities, the portfolio’s credit rating would be given by the average rating of the securities in the underlying pool. The pass-through securitization claims would inherit this rating, thus achieving no credit enhancement.

    By contrast, to manufacture a range of securities with different cash flow risks, structured finance issues a capital structure of prioritized claims, known as tranches, against the underlying collateral pool. The tranches are prioritized in how they absorb losses from the underlying portfolio. For example, senior tranches only absorb losses after the junior claims have been exhausted, which allows senior tranches to obtain credit ratings in excess of the average rating on the average for the collateral pool as a whole. The degree of protection offered by the junior claims, or overcollateralization, plays a crucial role in determining the credit rating for a more senior tranche, because it determines the largest portfolio loss that can be sustained before the senior claim is impaired.

    Continued in article

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    Spruce up your basic accounting courses with fresh illustrations of accounting for preferred stock
    Especially note the reasons for choosing preferred stock

    Lehman Wants To Short-Circuit Short Sellers
    by Susanne Craig
    The Wall Street Journal

    Apr 01, 2008
    Page: C1
    Click here to view the full article on WSJ.com
    http://online.wsj.com/article/SB120699998020978159.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Financial Accounting, Stock Price Effects

    SUMMARY: On Monday, March 31, 2008, Lehman Brothers Holdings Inc, "...announced it plans to $3 billion of preferred shares....'I think an issue of this size with the investors we have on board will put the false rumors about our capital position to rest,' said Lehman Chief Financial Officer Erin Callan."

    CLASSROOM APPLICATION: Financial accounting for stock issuances, particularly preferred stock can be covered with this article, providing a background to understand reasoning behind these transactions and the Chief Financial Officer's responsibility to communicate to outsiders about this transaction.

    QUESTIONS: 
    1. (Introductory) What is the difference between preferred stock and common stock?

    2. (Introductory) What is "short selling?" How is it having an impact on Lehman Brothers, Inc., common stock value?

    3. (Advanced) What is the strategic reason for Lehman Brothers to issue preferred stock? In your answer, comment on the "capital position" mentioned by Lehman CFO Erin Callan and the need to communicate the strategy to investors and other interested parties.

    4. (Advanced) Why do you think that Lehman chose to issue preferred stock rather than, say, a rights offering for additional shares of common stock?

    5. (Advanced) Define the notion of "dilution." How does the issuance of preferred stock dilute the interests of common shareholders?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    "Lehman Wants To Short-Circuit Short Sellers," by Susanne Craig, The Wall Street Journal, April 1, 2008; Page C1 --- http://online.wsj.com/article/SB120699998020978159.html?mod=djem_jiewr_AC

    Lehman Brothers Holdings Inc. has unveiled its latest attempt to try to shake the shorts.

    On Monday, the firm announced it plans to issue $3 billion of preferred shares, a move that will strengthen its balance sheet and that it hopes will dispel speculation that it is facing a capital crunch. The question now: Will it be enough? "I think an issue of this size with the investors we have on board will put the false rumors about our capital position to rest," said Lehman Chief Financial Officer Erin Callan.

    Not everyone is on board. The Wall Street brokerage has become a favorite target of short sellers, traders who make money by betting that a stock's price will fall. The shorts now will likely ask: If Lehman had enough capital, why did it need to do the new issue, which will dilute the stakes of existing shareholders by potentially increasing shares outstanding by about 5%?

    Thursday, the stock fell almost 9%. Two weeks ago, in the wake of the forced sale of Bear Stearns Cos. to J.P. Morgan Chase & Co., Lehman's stock took another nasty tumble, falling 19% to a 4½-year low. Some Lehman shareholders blamed the decline on heavy selling by short sellers, who borrow shares and sell them, hoping to buy them back at a lower price and lock in a profit.

    Monday, Lehman's stock fell 23 cents to $37.64 in 4 p.m. New York Stock Exchange composite trading. But in after-hours trading, the share price declined $1.12 to $36.52. Lehman maintains that the stock will rebound once investors learn both the terms of the offering and the fact that it has been "substantially" presold. Late last night, Lehman said there was $11 billion in investor demand for its offering.

    So far this year, Lehman's stock is down 43%, compared with 16% for the Dow Jones Wilshire U.S. Financial Services Index and 23% and 14%, respectively, for rivals Goldman Sachs Group Inc. and Morgan Stanley. Lehman says that over the past few months it has been trying to lower the amount of debt it takes on relative to its assets, both by selling assets and now by raising capital -- so the new offering isn't necessarily aimed at beating back the short sellers.

    Still, as of March 12, there were 46.6 million shares, 9.1% of Lehman's total float, sold short. That is up from 9.4 million shares at the beginning of the year, according to the NYSE. Investors also are loading up on Lehman options, another way to bet on a fall in the firm's stock.

    The firm says it has enough cash on hand to weather the current crisis, $31 billion in cash and cash equivalents and another $65 billion in assets it can easily borrow against. Furthermore, thanks to a recent change in the rules, it now has access for the first time to Federal Reserve funds, a move that gives Lehman access to an essentially unlimited pool of money at the same rate as commercial banks.

    Lehman is no stranger to the skeptics. The brokerage and its chairman, Richard Fuld Jr., fought off rumors about a cash crunch in 1998 that were triggered by the near-collapse of hedge fund Long Term Capital Management. At that time, the firm hired a private-investigation firm to get to the bottom of the speculation circling the company. Since then, Mr. Fuld has won praise for diversifying Lehman, long known as a bond house, into lucrative areas like stock trading and investment banking.

    This time around, the firm has publicly spoken out against the shorts. It has met with the Securities and Exchange Commission, and top management is actively trying to track down the source of rumors as they arise.

    The main concern: Lehman's still-sizable exposure to the mortgage market makes it easy for critics to draw comparisons to Bear. A recent Bank of America report notes that mortgages represent 29% of total assets at Lehman, roughly in line with Bear, which had one-third of its assets in mortgages, and much higher than Merrill Lynch & Co. and Goldman Sachs, both at 12%, and 13% at Morgan Stanley. Ms. Callan estimates Lehman's total real-estate exposure is closer to 20% and it is a skilled operator in managing real-estate assets.

    "Looking toward the remainder of 2008, Lehman investors will be nervously waiting to see if the firm, with its balance sheet loaded with $87 billion of troubled assets which are under pricing pressure and which can't be easily sold, will be able to navigate the continuing credit storm and the de-leveraging environment that we anticipate," wrote Brad Hintz, an analyst at Sanford C. Bernstein & Co. and a former chief financial officer at Lehman.

    Nearly $31 billion of its holdings are commercial-real-estate loans. Even as it cut way back on making home loans, Lehman continued to lend to buyers of office buildings and other assets, and analysts expect it will take a hit on these this year.

    A big concern is Lehman's 2007 investment in Archstone-Smith Trust, which it bought with Tishman Speyer Properties in May 2007, just as the real-estate market was beginning to melt. Lehman bought in at $60.75 a share. Archstone is now private, but shares of its publicly traded rivals are down substantially, suggesting Lehman's investment is underwater.

    During a conference call to discuss its first-quarter earnings, Lehman said it currently holds $2.3 billion of Archstone's non-investment-grade debt and $2.2 billion of equity, both of which Ms. Callan said are being carried "materially below par." She said Lehman is working to sell assets and improve Archstone's financial profile. Lehman says it has taken write-downs on this investment, but the size of the haircut isn't known because it doesn't release this data on individual investments.

    Continued in article


    Accounting for Gains on Debt Restructuring

    Ford turned a "profit" before the multi-billion Cash-For Clunkers welfare program for automobile manufacturers and dealers.
    By the way I cashed in my not-really-a-clunker (1989 Cad) for a new Subaru Forrester four hours before the Government's Clunker Fund ran out of money (four months early) for the first time on July 31, 2009. The salesman, Charlie, from Manchester Subaru brought the papers up to our hotel room where Erika and I somewhat reluctantly signed over our faithful Betsie Devella to the Clunker Crusher.

    From The Wall Street Journal's Accounting Weekly Review in July 30, 2009

     Ford Navigates Path to Profitability
    by Matthew Dolan and Jeff Bennett
    Jul 24, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Advanced Financial Accounting, Debt, Disclosure, Segment Analysis

    SUMMARY: Ford "...reported a profit of $2.3 billion [in the second quarter of 2009] though that came mainly from gains it recorded as part of efforts to restructure its debt...Excluding those gains, Ford would have reported a loss of $424 million...much better than Wall Street analysts were expecting."

    CLASSROOM APPLICATION: The treatment of early debt extinguishment is the primary usefulness of this article, though it also addresses Ford's geographic segment disclosures.

    QUESTIONS: 
    1. (Introductory) Summarize the main points described in this article regarding Ford Motor Company's performance in the second quarter of 2009. How is that performance attributed to the company's chief executive, Allan Mulally?

    2. (Advanced) What is a "cash burn rate"? How did Ford Motor improve this statistic? Is this improvement the same as improvement in earnings/reduction of losses? Explain your answer.

    3. (Advanced) Access the company's SEC filing for the second quarter of 2009 available at http://www.sec.gov/Archives/edgar/data/37996/000114036109016804/ex99.htm Review the financial results summary on the first page. State which captions correspond to performance as it is described in the WSJ article.

    4. (Advanced) Scroll to the details about the "special items" on pages 13-14 of the filing. What were the major special items in 2008 versus 2009?

    5. (Advanced) Refer again to pages 13-14 of the SEC filing. How is the information on these items organized? What accounting standard requires this disaggregation of information? Where do you find the profit that came from gains on restructuring debt, as it is described in the article?

    6. (Advanced) Describe the accounting for early debt extinguishments and debt restructurings. How does that accounting generate the results achieved by Ford Motor Company in the second quarter of 2009? Do you think that result is reflective of the chief executive's performance as discussed in answer to question 1? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    "Ford Navigates Path to Profitability:  Gain From Debt Restructuring Boosts Auto Maker Into the Black; Cash Burn Dramatically Slows," by Matthew Dolan and Jeff Bennett, The Wall Street Journal, July 24, 2009 ---
    http://online.wsj.com/article/SB124834005025175293.html?mod=djem_jiewr_AC

    Ford Motor Co. returned to profitability in the second quarter and showed signs of stabilizing as the company continued to win customers from its Detroit competitors.

    The car maker reported a profit of $2.3 billion, though that came mainly from gains it recorded as part of efforts to restructure its debt during the quarter. Excluding those gains, Ford would have reported a loss of $424 million, still narrower than a comparable loss of $1.03 billion a year earlier and much better than Wall Street analysts were expecting.

    The earnings suggest that the deep downturn in Detroit may have bottomed out and at least one member of the Big Three has figured out how to stabilize its business at a much lower sales volume.

    The results also underscore the assessment of Chief Executive Alan Mulally as a rising star in an industry he entered only three years ago.

    Ford remains on track to break even or make money in 2011 and has sufficient liquidity to fund its turnaround plan, Mr. Mulally, a former Boeing Co. executive, said Thursday.

    Once seen as the industry's sickest company, Ford underwent a wrenching cost-cutting period. It closed plants, shed brands and laid off more than 40,000 employees. It also borrowed $23.5 billion from private lenders by mortgaging almost everything of value at the company.

    In the last year, a leaner Ford was able to shun a government bailout and avoid bankruptcy, recasting itself as a U.S.-based car maker with enough new products and global reach to survive the auto-sales downturn.

    "This quarter's earnings show that Alan is emerging as one of the top CEOs in the industry," said Mike Jackson, CEO of AutoNation Inc., the largest U.S. chain of car dealerships and the largest Ford dealer by volume and locations.

    Ford shares rose 9.4% on the earnings news to $6.98 in 4 p.m. New York Stock Exchange composite trading.

    A key indicator of Ford's relative success has been its increasing ability to manage cash burn, the issue that caused General Motors Co. to stumble close to insolvency. Ford used about $1 billion in cash during the second quarter, far less than the $3.7 billion in the first quarter. That left the Dearborn, Mich., company with $21 billion in gross cash in its automotive operations.

    Ford's rate of cash use fell largely as a result of limited spending on buyer incentives and increased production at its North American plants.

    Ford has seen an uptick in U.S. market share, due in part to new models, as GM's and Chrysler's market shares have slipped. To be sure, Ford remains saddled by massive debt and declining sales in one of the worst auto markets in recent history. And Ford doesn't expect to repeat the one-time gains from debt restructuring.

    "Ford delivered exactly what we wanted to see -- lower cash burn," Shelly Lombard, an analyst at the Gimme Credit corporate bond research firm, wrote Thursday. "But it's still too early to tell whether Ford has got its swagger back since some of the improvement was due to market share and price gains that Ford probably picked up at General Motors and Chrysler's expense while they were in bankruptcy."

    For the recent quarter, Ford reported earnings of 69 cents a share, compared with a loss of $8.67 billion, or $3.89 a share, a year earlier. Revenue fell to $27.2 billion from $38.6 billion a year earlier. Ford blamed the slump on the 33% year-over-year drop in the annualized sales rate for the U.S. vehicle market.

    Nonetheless, Ford executives predicted a rosier second half of the year, saying for the first time that they expect to gain market share for 2009 in both the U.S. and Europe. Cash outflow also is expected to abate for the second half.

    Chief Financial Officer Lewis Booth cautioned that a slower-than-expected economic recovery or a disruption of the industry's parts supply could tamp down Ford's optimistic outlook.

    Alan Mulally The company's debt at the end of the second quarter totaled $26.1 billion. Ford's decision to decline U.S. aid or file for bankruptcy protection may have created consumer goodwill, but rival GM was able to eliminate about $40 billion in debt. Chrysler Group LLC similarly exited bankruptcy with lower financial obligations.

    But Mr. Mulally said the bankruptcy reorganizations and debt reductions at Ford's rivals haven't put his company at a disadvantage. Ford reduced its own debt by $10.1 billion in the second quarter while raising $1.6 billion through new stock. At the same time, it reduced the cost of running its business by $1.8 billion.

    "I think it's great cars and a very strong business" that are drawing more people to Ford, Mr. Mulally told analysts and journalists during a conference call.

    On a regional basis, Ford North America narrowed its pretax loss to $851 million from a loss of $1.3 billion a year earlier, while Ford Europe -- traditionally its strongest operation -- saw its pretax profit shrink to $138 million from $582 million a year earlier. For the first quarter, the North America unit had reported an operating loss of $637 million while Ford Europe had a $550 million loss.

    The results are Ford's first quarterly profit after posting four quarterly losses. Still, analyst Himanshu Patel of J.P. Morgan wrote that "this was clearly not the massive positive quarter some (including ourselves) were thinking was possible."

    According to Standard and Poor's, GM and Chrysler lost market share in the U.S. through the first six months of 2009, while Ford's rose slightly to 15.9% from 15.3%. GM's share for the first six months was 19.8%, compared to 21.5% in the same period in 2008. For Chrysler, the figure was 9.8%, down from 11.7%.

    And for the first time in about three years, Ford's internal data are showing that consumer opinion about the brand is improving by a significant margin.

    Many U.S. consumers have refused to consider a Ford, believing its vehicles are inferior to leading Japanese brands. But the company found that the number of people who have a favorable opinion of Ford grew by 17% between January and June. In addition, the number who said they would consider buying a Ford grew by 13%.

     


    Question
    What are shareholder "earn-out"contracts"?
    (Another example of the increasing complexity of classifying debt versus equity.)

    How did eBay make a $1.43 dollar (or more) mistake?

    "Skype CEO steps down and parent company:  eBay takes $1.43 billion charge," MIT's Technology Review, October 1, 2007 --- http://www.technologyreview.com/Wire/19466/?nlid=575

    EBay Inc. announced Monday that the co-founder and chief executive of its Skype division was stepping down, and that the parent company would take $1.43 billion in charges for the Internet phone service division.

    Of the charges to be taken in the current quarter, $900 million will be a write-down in the value of Skype, eBay said. That charge, for what accountants call impairment, essentially acknowledges that San Jose-based eBay, one of the world's largest e-commerce companies, drastically overvalued the $2.6 billion Skype acquisition, which was completed in October 2005.

    EBay also said Monday it paid certain shareholders $530 million to settle future obligations.

    In 2005, eBay wooed Skype investors by offering an ''earn-out agreement'' up to $1.7 billion if Skype hit specific targets -- including a number of active users and a gross profit -- in 2008 and the first half of 2009. The Skype shareholders holding those agreements received the $530 million in an early, one-time payout, eBay spokesman Hani Durzy said.

    EBay also announced that Skype CEO Niklas Zennstrom will become non-executive chairman of Skype's board and likely spend more time working on independent projects.

    Durzy said the resignation of Zennstrom, a Swedish entrepreneur who started Skype, was not related to the impairment charge or Skype's performance.

    ''Niklas left of his own volition,'' Durzy said. ''He is an entrepreneur first and foremost, and he wanted to spend more time on some of his new projects that he has been working on.''

    Skype, which allows customers to place long-distance calls using their computers, reported second-quarter revenue of $89.13 million, up 102 percent from a year ago. It was the second consecutive quarter of profitability for the newest eBay division.

    Zennstrom is likely to work on developing Joost, an Internet TV service he started in 2006 with Skype co-founder Janus Friis, relying on peer-to-peer technology to distribute TV shows and other videos over the Web.

    Joost had at least 1 million beta testers in July and will launch at the end of the year, Zennstrom said earlier this summer.

    One of the pair's first collaborations was the peer-to-peer file-sharing network KaZaA, which launched in March 2000 and is used primarily to swap MP3 music files over the Internet. Zennstrom also co-founded the peer-to-peer network Altnet and the venture capital firm Atomico.

    Continued in article


    From The Wall Street Journal Accounting Educators' Review on July 16, 2004

    TITLE: Possible Accounting Change May Hurt Convertible Bonds 
    REPORTER: Aaron Lucchetti 
    DATE: Jul 08, 2004 
    PAGE: C1 
    LINK: http://online.wsj.com/article/0,,SB108923165610057603,00.html  
    TOPICS: Bonds, Convertible bonds, Earnings per share, Emerging Issues Task Force, Financial Accounting, Financial Accounting Standards Board

    SUMMARY: The Emerging Issues Task Force is considering changing the requirements for including in the EPS calculation the potentially dilutive shares issuable from so-called CoCo bonds. These bonds have an interest-payment coupon and are contingently convertible, typically depending upon a specified percentage increase in the stock price.

    QUESTIONS: 

    1.) Describe the terms of CoCo Bonds. What do you think the term "CoCo" means? How do they differ from typical convertible bonds? Why do investors find typical convertible bonds attractive? Why do companies find it attractive to offer typical convertible bonds?

    2.) What is the Emerging Issues Task Force (EITF)? How can the organization of that task force help to resolve issues, such as the questions surrounding CoCo bonds, more rapidly than the issues can be addressed by the FASB itself?

    3.) In general, what is the accounting issue being addressed by the EITF? What is the proposed change in accounting? Does any of this have to do with the actual accounting for the bonds and their associated interest expense?

    4.) Explain in detail the effect of these bonds on companies' earnings per share (EPS) calculations. Will the amount of companies' net income change under the proposed EITF resolution of this accounting issue? What will change? Is it certain that the change in treatment of these bonds will have a dilutive effect on EPS? Explain.

    5.) Why might an EITF ruling require retroactive restatement of earnings by companies issuing these bonds? How else could any change in treatment of these bonds be presented in the financial statements?

    6.) One investment analyst states that "the new accounting doesn't change economics, but investors [are] still likely to care." Why is this the case?

    7.) Why does one analyst describe CoCo bonds as a gimmick? Why then would we "probably be better off without it"?

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


    Coke:  Gone Flat at the Bright Lines of Accounting Rules and Marketing Ethics
    The king of carbonated beverages is still a moneymaker, but its growth has stalled and the stock has been backsliding since the late '90s.  Now it turns out that the company's glory days were as much a matter of accounting maneuvers as of marketing magic. 
    Guizuenta's most ingenious contribution to Coke, the ingredient that added rocket fuel to the stock price, was a bit of creative though perfectly legal balance-sheet rejeiggering that in some ways prefigured the Enron Corp. machinations.  Known inside the company as the "49% solution," it was the brain child of then-Chief Financial Officer M. Douglas Ivester.  It worked like this:  Coke spun off its U.S. bottling operations in late 1986 into a new company known as Coca-Cola Enterprises Inc., retaining a 49% state for itself.  That was enough to exert de facto control but a hair below the 50% threshold that requires companies to consolidate results of subsidiaries in their financials.  At a stroke, Coke erased $2.4 billion of debt from its balance sheet.
    Dean Foust, "Gone Flat," Business Week, December 20, 2004, Page 77.  
    This is a Business Week cover story.
    Coca Cola's outside independent auditor is Ernst & Young

    There were other problems, some of which did not do the famed Warren Buffet's reputation any good.  See "Fizzy Math and Fishy Marketing Lawsuit, Probes Prove Damaging to Coke," by Margaret Webb Pressler, Washington Post, June 20, 2003 --- http://www.washingtonpost.com/ac2/wp-dyn?pagename=article&contentId=A14384-2003Jun19&notFound=true 

    Coca Cola's marketing tactics were unethical and unhealthy for kids --- http://www.econ.iastate.edu/classes/econ362/hallam/Coke%20Officials%20Beefed%20Up.pdf 

    Also see "The Ten Habits of Highly Defective Corporations," From The Nation --- http://www.greenmac.com/World_Events/thetenha.html 

     


    Contingent convertible bonds get a tax-treatment boost from a new IRS revenue ruling. But the window of opportunity may slam shut.
    "Cuckoo for Coco Puffs?" Robert Willens, Lehman Brothers, CFO.com, May 22, 2002
    Now the FASB intends to shut the loop-hole.  If the proposed rule (Section 404)  goes into effect, companies will have to record an increase in shares outstanding on the day they issue a Co-Co (Contingent Convertible Bond that can be converted only at threshold share prices), thus reducing EPS.  And the change would be retroactive, a step the board generally reserves for particularly egregious accounting practices, says Dennis Beresord, professor of accounting at the University of Georgia and FASB's former chief.
    "Too Much of a Good Thing," CFO Magazine, September 4, 2004, Page 21.


    From The Wall Street Journal Accounting Weekly Review on October 29, 2004

    TITLE: First Marblehead: Brilliance or Grade Inflation?
    REPORTER: Karen Richardson
    DATE: Oct 25, 2004
    PAGE: C3
    LINK: http://online.wsj.com/article/0,,SB109866115416054209,00.html 
    TOPICS: Advanced Financial Accounting, Allowance For Doubtful Accounts, Financial Statement Analysis, Securitization, Valuations

    SUMMARY: First Marblehead securitizes student loans and records assets based on significant estimates. Investors have significantly increased short selling on the stock because of concern over when the receivables recorded through securitization will ultimately be collected.

    QUESTIONS:
    1.) Define the term securitization. What purpose does securitization serve?

    2.) What does the author mean by "gain-on-sale" accounting? When are gains recognized in securitization transactions?

    3.) What standard governs the accounting requirements for securitization transactions? Why does that standard focus on a question of discerning liabilities from sales? Is that accounting question a point of difficulty in the case described in this article? Explain.

    4.) Why are critics arguing that "it will be at least five years before any significant cash starts rolling in" on First Marblehead's assets?

    5.) According to what is listed in the article, how many factors must be estimated to record the assets and revenues under First Marblehead's business model? How uncertain do you think the company may be in its estimates of these of these items?

    6.) Why will it take time until "the company's massive earnings growth can be verified"? What evidence will help to evaluate the validity of the estimates made in First Marblehead's revenue recognition process?

    7.) What is the process of short selling? Why is it telling that there has been a significant increase in the number of short-sellers on First Marblehead's stock?

    Reviewed By: Judy Beckman, University of Rhode Island


    FERF Newsletter, April 20, 2004

    Update on SFAS 150

    Halsey Bullen, Senior Project Manager at the Financial Accounting Standards Board (FASB), gave an update on SFAS 150.

    Private Net last discussed SFAS 150 and FASB Staff Position (FSP) 150-3 in the February issue: http://www.fei.org/newsletters/privatenet/pnet204.cfm 

    Bullen said that SFAS 150 was originally designed to account for "ambiguous" instruments, such as convertible bonds, puttable stock, Co-Co No-Nos (conditionally convertible, no coupon, no interest instruments), and variable share forward sales contracts. Mandatorily redeemable shares of ownership issued by private companies were then included in the accounting for this class of instruments.

    Bullen said that FSP 150-3 allowed private companies to defer implementation of SFAS 150 until 2005 with respect to shares that were redeemable on fixed dates for fixed or externally indexed amounts, and indefinitely for other mandatorily redeemable shares. (We will assume indefinite deferral for mandatorily redeemable ownership shares issued by private companies.)

    As an update, Bullen said that in Phase 2, the FASB was considering several alternatives for "bifurcating" the ambiguous instruments into equity and liability components: * Fundamental components approach, * Narrow view of equity as common stock, * IASB 32 approach: bifurcate convertibles and treat any other obligation that might require transfer of assets as a liability for the full amount, * Minimum obligation approach, and * Reassessed expected outcomes approach.

    Bullen said that the FASB has encountered a number of challenges in trying to account for these ambiguous instruments, not the least of which are just basic conceptual definitions of shareholder equity and liability. For example, should equity be defined as assets minus liabilities, or should liabilities be first defined as assets minus shareholder equity?

    One FEI member asked Bullen, "Where is the concept of simplicity?" Bullen responded, "Simplicity is as simplicity does." In other words, if the financial instrument is not simple, how can its accounting be simple?

    Bullen told the participants to expect an exposure draft in late 2004 or early 2005.


    The Controversy Between OCI versus Current Earnings

    In June 1997, the Financial Accounting Standards Board (FASB) issued FAS 130 on "Reporting Comprehensive Income" --- http://www.fasb.org/pdf/aop_FAS130.pdf

    FAS 130 created an equity account called Other Comprehensive Income (OCI) or Accumulated OCI (AOCI) to serve as a means of keeping various types of unrealized changes in asset and liability values from mixing in with current earnings. For example, changes in the value of available-for-sale securities are required in FAS 115 to be carried at fair value with offsets to changes in fair value going to some equity account other than Retained Earnings. FAS 130 named this account to be OCI. FAS 130 also requires a Statement of Comprehensive Income that summarizes all changes in AOCI balances during each accounting period.

    Later when FAS 133 required carrying of derivatives at fair value, the OCI account became the required offset to changes in derivative fair values if those derivatives are cash flow or foreign exchange (FX) hedges. OCI cannot be used for Fair Value hedges.

    Comprehensive income is part of a larger initiative of both the FASB and the International Accounting Standards Board (IASB) to provide options for and perhaps eventually require fair value accounting for all financial assets and liabilities (but not necessarily non-financial items).


    Ernst & Young
    Technical Line: Changes in reporting comprehensive income (OCI)

    Many companies will have to change how they present comprehensive income under Accounting Standards Updates 2011-05 and 2011-12. The new guidance is effective for public companies for fiscal years, and interim periods within those years, beginning after 15 December 2011. This means the first quarter of 2012 for calendar year-end public companies. For nonpublic companies, the amendments are effective for fiscal years ending after 15 December 2012 and interim and annual periods thereafter. Retrospective application is required. Early adoption is permitted. Our Technical Line publication describes the new requirements. ---
    http://www.ey.com/Publication/vwLUAssetsAL/TechnicalLine_BB2310_ComprehensiveIncome_8March2012/$FILE/TechnicalLine_BB2310_ComprehensiveIncome_8March2012.pdf

    "The Accounting Cycle Let's Scrap the Comprehensive Income Statement Op/Ed," by: J. Edward Ketz, SmartPros, June 2008 --- http://accounting.smartpros.com/x62289.xml

    The statement of comprehensive income, whether displayed as a separate financial statement or in conjunction with the income statement or as part of the statement of changes in shareholders' equity, has served its purpose. It is time to scrap the concept and incorporate these items where they actually belong -- in the income statement.

    Over the years the Financial Accounting Standards Board created a problem by allowing a variety of items to bypass the income statement, a result of te FASB's bias toward the balance sheet. In other words, FASB focused on reporting assets and liabilities of the business enterprise, but did not worry too much about the impact on the income statement. Included within the comprehensive income statement were foreign currency translation adjustments under the all-current method, holding gains and losses for investments under the available-for-sale category, gains and losses on derivatives if they are considered cash flow hedges, and losses if necessary to establish a minimum pension liability. If these things make sense to include on the balance sheet, surely their income statement effects are meaningful as well.

    The board sometimes justified this approach by claiming that these items had less reliability than other events and transactions included in the income statement. But, this argument loses water in today's world. Surely if the fair value changes recently booked in the accounts of financial institutions are reliable, then these other measurements are equally reliable. This follows because the fair value changes recently recognized are the result not of changes in market values but in changes in model estimates.

    Consider last year's 10-K for Merrill Lynch. The firm did not have a particularly good year, as witnessed by its 7.7 billion dollar loss. If the items in other comprehensive income are incorporated as well, the loss grows to almost 9 billion dollars.

    The foreign currently translation loss, net of taxes, is a mere 11 million dollar loss. Nonetheless, it is a real economic loss to shareholders and should be recognized as such.

    Merrill Lynch had losses on its investment securities considered available for sale of 2.5 billion dollars. Again, this is net of income taxes. As these securities reflect certain real changes of value, they too would be better displayed on the income statement.

    Merrill Lynch also shows deferred net gains of 81 million dollars on its cash flow hedges. Similarly, it would be more informative to users if they are reported in income.

    Finally, Merrill Lynch shows 240 million dollars of net actuarial gains and prior service costs. They too signify real economic flows and, therefore, they belong part of earnings.

    In 2007 we have reported losses of $7.7 billion versus comprehensive losses of $8.9 billion. In 2006 the two measures are the same, revealing an income of $7.5 billion. In 2005, however, the two measures have some differences as in 2007: net income is $5.1 billion while comprehensive net income is $4.7 billion.

    So why doesn't FASB scrap the comprehensive income statement? Surely the reliability of these items is as good as the reliability of the mark-to-model numbers that have recently hit the financials of corporate America. The more likely real reason for the comprehensive income concept is that it is a bargaining chip when creating new accounting policy. FASB gets what it wants, at least to some extent, on the balance sheet; in return, the compromise allows reporting entities not to announce lower incomes (or bigger losses) and it allows them to have less volatility in their annual earnings.

    Creditors and investors would be better served with a more accurate income statement. Let's renounce the reliability argument and show some political muscle. Scrap the notion of comprehensive income and strengthen the income statement.

    June 22, 2008 reply from David Albrecht [albrecht@PROFALBRECHT.COM]

    My response to Ed is that it is my understanding that the new financial statements, on which the income statement will include no bottom line, will include these CI items.

    Is my understanding wrong?

    MicroSoft has an interesting approach to reporting Accumulated OCI on the income statement and the statement of changes in SHE: it merges the two together. I've always thought that by so doing, MS was casting its vote that the two should be comingled together on the income statement.

    David Albrecht
    Bowling Green

    June 22, 2008 reply from Bob Jensen

    Hi David,

    Count me in as one who sees good things in OCI or something like OCI that separates realized gains and losses from those that have a 99.9999% chance never be realized if the company remains a viable going concern. It’s important to show the unlikely risks on the balance sheet, but I sure hate to see them be folded into earnings per share. In the case of hedging, this becomes a penalty for entering into good economic hedges that are certain to prevent losses. It’s a bad idea to penalize companies making good hedges with earnings volatility due to those hedges. That’s what companies pounded into the FASB when FAS 133 was being contemplated. It’s also the reason that FAS 133 went from 50 paragraphs to 524 paragraphs, because to keep changes in derivative contract fair values out of earnings the FASB had to invent what we now call “hedge accounting” (read that relief from unrealized earnings volatility due to hedging).

    For example, a cash sale is realized. A huge long-term gain in the value of an investment in Google’s common shares since its IPO stands a good chance of being realized but of course nothing is certain until the stock is sold. But changes in the value of an interest rate swap that’s a cash flow hedge is even more certain to never be realized.

    I repeat that the debits and credits to OCI from changes in the value of an interest rate swap used as a hedge, most likely will never be realized. Firstly, the swap is typically customized and unique for which there are not likely any buyers unless huge incentives are made to get out of the swap before it matures. Secondly, if the swap is held to maturity it’s certain that the accumulated OCI debits and credits for changes in value of the swap will sum up to zero. All debits and credits to OCI for a cash flow hedge are not important in the grand sum of things for derivatives held to maturity of the hedge and the hedged item.

    The only reason changes in value of a cash flow hedge are important on the balance sheet is to signal that there there’s risk/return from an unlikely premature settlement of a hedging derivative. Investors should know about these potential risks and returns at interim points in time since they truly exist in light of premature settlement. The signaling is on the balance sheet such as when an interest rate swap has a reported liability of $42,820,000 if the swap is terminated prematurely.

    At the same time, I would certainly hate to see the offsetting unrealized “loss” of $42,820,000 be mixed in with the realized earnings, because the probability of even a single dollar of this loss being ultimately realized is very, very unlikely if the company is truly a going concern.

    To illustrate these points consider the table in Paragraph 137 that depicts the journal entries of a cash flow hedge using an interest rate swap in Example 5 of Appendix B of FAS 133. Below I’ve reproduced Paragraph 137 table that also appears in http://www.cs.trinity.edu/~rjensen/133ex05.htm
    it also appears with footnotes that explain the calculations in the Excel workbook at http://www.cs.trinity.edu/~rjensen/133ex05a.xls

    Note especially how the debits and credits in the OCI column sum to zero. This was certain at the commencement of the swap. I would certainly hate to see debits like $42,820, $33,160, $21,850 and credits like ($24,850), ($73,800), ($85,910), and ($1,960) be folded in with realized components of earnings each quarter.

    Note how the swap has a liability of $42,820 on June 30, 20X2. This is a good estimate of what XYZ Company would owe if it breached its swap contract and was faced with a court judgment when sued by swap’s counterparty. But if XYZ Company does not breach the contract, it is known in advance that the swap begins and ends with a value of $0. All the changes in value at interim reset dates are transitory and will wash out unless the contract is settled prematurely.

    Hence we most certainly need changes in value of interest rate swaps being booked at fair values. We also need, in my viewpoint, something like OCI that prevents highly unlikely unrealized gains and losses from having volatile impacts on other more likely or realized gains and losses. Note how the Swap and OCI columns sum to zero. This was certain in advance unless the swap was breached prematurely.

     

    .

     

     

     

    Example 5 of FAS 133 Appendix B Paragraph 137

     

     

     

     

     

    Swap

    OCI

    Earnings

    Cash

    LIBOR

     

    Debit (Credit)

    Debit (Credit)

    Debit (Credit)

    Debit (Credit)

    5.56%

    7/1/X1

     $                  -  

     

     

     

     

     

     

     

     

     

     

    Interest accrued

     $                  -  

     

     

     

     

    Payment (Receipt)

                (27,250)

     

     

                  27,250

     

    Effect of change in rates

                  52,100

                (52,100)

     

     

     

    Reclassification to earnings

                         -  

                  27,250

                (27,250)

                         -  

    5.63%

    9/30/X1

                  24,850

                (24,850)

                (27,250)

                  27,250

     

     

     

     

     

     

     

    Interest accrued

     $                350

                     (350)

     

     

     

    Payment (Receipt)

                (25,500)

     

     

                  25,500

     

    Effect of change in rates

                  74,100

                (74,100)

     

     

     

    Reclassification to earnings

                         -  

                  25,500

                (25,500)

                         -  

    5.56%

    12/31/X1

                  73,800

                (73,800)

                (25,500)

                  25,500

     

     

     

     

     

     

     

    Interest accrued

     $             1,026

                  (1,026)

     

     

     

    Payment (Receipt)

                (27,250)

     

     

                  27,250

     

    Effect of change in rates

                  38,334

                (38,334)

     

     

     

    Reclassification to earnings

                         -  

                  27,250

                (27,250)

                         -  

    5.47%

    3/31/X2

                  85,910

                (85,910)

                (27,250)

                  27,250

     

     

     

     

     

     

     

    Interest accrued

     $             1,175

                  (1,175)

     

     

     

    Payment (Receipt)

                (29,500)

     

     

                  29,500

     

    Effect of change in rates

              (100,405)

                100,405

     

     

     

    Reclassification to earnings

                         -  

                  29,500

                (29,500)

                         -  

    6.75%

    6/30/X2

                (42,820)

                  42,820

                (29,500)

                  29,500

     

     

     

     

     

     

     

    Interest accrued

     $              (723)

                       723

     

     

     

    Payment (Receipt)

                    2,500

     

     

                  (2,500)

     

    Effect of change in rates

                    7,883

                  (7,883)

     

     

     

    Reclassification to earnings

                         -  

                  (2,500)

                    2,500

                         -  

    6.86%

    9/30/X2

                (33,160)

                  33,160

                    2,500

                  (2,500)

     

     

     

     

     

     

     

    Interest accrued

     $              (569)

                       569

     

     

     

    Payment (Receipt)

                    5,250

     

     

                  (5,250)

     

    Effect of change in rates

                    6,629

                  (6,629)

     

     

     

    Reclassification to earnings

                         -  

                  (5,250)

                    5,250

                         -  

    6.97%

    12/31/X2

                (21,850)

                  21,850

                    5,250

                  (5,250)

     

     

     

     

     

     

     

    Interest accrued

     $              (381)

                       381

     

     

     

    Payment (Receipt)

                    8,000

     

     

                  (8,000)

     

    Effect of change in rates

                  16,191

                (16,191)

     

     

     

    Reclassification to earnings

                         -  

                  (8,000)

                    8,000

                         -  

    6.57%

    3/31/X3

                    1,960

                  (1,960)

                    8,000

                  (8,000)

     

     

     

     

     

     

     

    Interest accrued

     $                  32

                       (32)

     

     

     

    Payment (Receipt)

                  (2,000)

     

     

                    2,000

     

    Rounding error

                           8

                         (8)

     

     

     

    Reclassification to earnings

                         -  

                    2,000

                  (2,000)

                         -  

     

    6/30/X3

                         -  

                           0

                  (2,000)

                    2,000

     

    PS
    The interest accruals in the above table differ from those in Paragraph 137 of FAS 133 because the FASB screwed up the calculations and failed to correct them even though I did reported these calculation errors in Example 5 to the FASB years ago. The FASB did compute the interest accruals correctly for Example 2 in Paragraph 117, so the FASB batted 50% on their interest rate accrual calculations in FAS 133. However, such accruals are only a minor part of this outstanding illustration.

    I think Example 5 is the most important illustration in all of FAS 133 and IAS 39. If you fully understand the 133ex05a.xls workbook calculations and the Hubbard and Jensen explanation of how to value the Example 5 interest rate swap, I will give you a Certificate of FAS 133 Merit. Once again the links to learn from are as follows:

    The swap valuation explanation is at http://www.cs.trinity.edu/~rjensen/133ex05.htm
    The hedge accounting is explained in the Excel workbook at http://www.cs.trinity.edu/~rjensen/133ex05a.xls

    My accounting theory students inevitably despised this illustration until they saw the light.
    You would be surprised at how many former students contact me thanking me for explaining how to value swaps, because nearly all auditors encounter interest rate swaps on the job and don’t want to be fired from the audit for the same reasons KPMG was fired by its client named Fannie Mae.

    I can’t tell you how many questions and compliments I’ve received over the past few years regarding one of the most frequently hit documents year in and year out at my Website --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
    That makes me feel good!

     

    June 22, 2008 reply from David Albrecht [albrecht@PROFALBRECHT.COM]

    Bob,
    At 06:31 PM 6/22/2008, Bob Jensen wrote:

     
    Hi David,
     
    Count me in as one who sees good things in OCI or something like OCI that separates realized gains and losses from those that have a 99.9999% chance never be realized if the company remains a viable going concern. It’s important to show the unlikely risks on the balance sheet, but I sure hate to see them be folded into earnings per share. In the case of hedging, this becomes a penalty for entering into good economic hedges that are certain to prevent losses. It’s a bad idea to penalize companies making good hedges with earnings volatility due to those hedges. That’s what companies pounded into the FASB when FAS 133 was being contemplated. It’s also the reason that FAS 133 went from 50 paragraphs to 524 paragraphs, because to keep changes in derivative contract fair values out of earnings the FASB had to invent what we now call “hedge accounting” (read that relief from unrealized earnings volatility due to hedging).

    Bob,

    I just don't think that in the evolution of GAAP/IFRS to fair market valuation for the balance sheet, that there is any escape for stretching the income statement all out of any semblance of understandability (eeeehhhhh, I'm not sure the income statement has every been that understandable) and doing away with items of Other Comprehensive Income (OCI) and finally being all-inclusive.

    In the context of fair value accounting, I'm pretty sure that realizability is no longer relevant.  I had a pretty interesting discussion in class last week with some students about a classic pose from financial accounting:  conservatism.  That is, accountants are quick to recognize losses/declines and slow to recognize gains/increases.  When combined with realization, it means that a gain can be recognized when the earnings process is thought to be complete, but not before.  You even refer to realization (BTW, realization has a very interesting etymology).

    But in the rush to fair value accounting, conservatism and realizability have become as socially acceptable as an old fart of an accountant or a professor.

    Ceteris paribus, I think that balance sheets can be thought of as naturally hedged.  For example, let's take a case where a company has a simple balance sheet of CA  30, Investments 20, PPE of 50,   CL of 25, LTL of 45 and SHE of 30.  Such a balance sheet reflects an assumed capital structure of long-term financing of 60% debt, and might be appropriate for a product/equipment manufacturer.  This balance sheet captures the essence of the company at a time when neither times are good nor times are bad.  Now, let's assume that the economy slides into the downward part of an economic cycle.  Two things happen simultaneously--the resources/assets lose some current fair value because of the downturn (perceived prospects have taken an economy-wide collective hit), and debt financing becomes harder to get and is rationed by higher interest rates. affecting all matters of debt financing.  The fair value of the assets go down (and there's a loss), the fair value of the liabilities go down (and there's a gain).  The balance sheet stays in balance and the measure of company profitability (the new income statement) stays in balance as the gains and losses cancel out.  Perfect hedging.

    If US GAAP was to have it right, then not only would the financial assets in the investment category be marked to market, but so would PPE AND all the liabilities.  SHE would tag along.  In the above example, CL becomes a weightier part of the balance sheet right hand side.

    A consistent problem with US GAAP is that the rule makers have only gone part way (marking financial assets to market).  Gains and losses can't be included in the income statement because the income statement is under-specified.  Hence the decades-old need for OCI and its predecessor, unrealized gains/losses.

    Unfortunately, economic downturns don't hit all companies ceteris paribus, and company-specific prospects can either improve or deteriorate as compared to the economy as a whole.

    Take the case of airlines (pick one, any one).  In the current economic downturn, the assets (gas-guzzling owned and leased assets) have lost value at a much faster pace relative generic assets in the economy.  In the current world order, the jets are less valuable because of their low fuel efficiency puts the airline's existence at risk, and the airline's cost of capital has just gone sky-high because of this increased business risk.  As a result of oil futures and the attendant economic downturn, the airlines have incurred a real impairment in asset value, and this should be reflected in the financials, including the current income statement.  At least this is my opinion.  On the other side, have an airline just try retiring some of its long-term debt on the market.  With higher interest rate valuations applied, the debt has a lower market value and the company can realize real gains if it were to retire the debt.  Many airlines have effectively retired the debt by choosing bankruptcy reorganization.  And if they haven't yet chosen bankruptcy, the threat is always there, hence the rationale for decreasing the recorded value of liabilities. The gains and losses cancel, but shouldn't the investor be informed in the financial statements?

    Now, in the generic example, I can see some appeal to keeping gains and losses off the income statement because they aren't ever going to be realized, but in the airline example, I can see every reason for putting all gains and losses on the income statement so that investors can see the good and bad.  The bad is that assets have lost value, and the good is that in a case of financial reorganization, there will be a gain that will cancel out all asset declines.

    Bob, how does one separate the economy wide effects from the industry effects or even the company effects?  There is simply too much commingling.  As a result, why not put everything on the income statement?  I think this is Ed Ketz's basic position.  Mine as well.  Make the income statement line a one-size fits all garment.

    Unfortunately, there is no place on the income statement (as currently constituted) or such gains and losses.  That is why the FASB has made such a historical push to revamp it and do away with the bottom line.

    Now, one other issue to attend to:  your underlying assumption that the reporting company is a going concern, and as a result gains/losses will reverse in the next economic upswing and nothing will ever be realized.  The world is a complex environment, and such an assumption as going concern may no longer be relevant.  Ask Bear Stearns.  An auctioneer would say that its going concern went going-going-gone.

    In the current financial world, going concern takes on a whole new meaning.  Historically, auditors have never been effective in flagging going-concern problems.  I don't seen anything structural being done to audit markets that would make auditors more effective in this area.

    David Albrecht

    June 22, 2008 reply from Bob Jensen

    Hi David,

    But you and Ed miss my major point.

    There are some unrealized gains and losses that “may” reverse with economic swings such as the unrealized gain or loss of that Google stock you bought five years ago. You and Ed make good points about such items, although I think Section 3 of the IASB’s exposure draft makes an excellent case on the other side of the coin in favor of fair value reporting of financial items --- http://faculty.trinity.edu/rjensen/Theory01.htm#UnderlyingBases

    And this is coming from a guy who has been skeptical of fair value accounting all along --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue
    I’m not so certain anymore as long as we don’t do dumb things with unrealized gains and losses.

    Section 3 of the IASB exposure draft makes a lot of sense to me --- "Reducing Complexity in Reporting Financial Instruments" that for a very limited time may be downloaded without charge from the International Accounting Standards Board (IASB) --- http://snipurl.com/ias39simplification  [www_iasb_org]

    The point you miss is that there are some gains and losses that are certain to reverse contractually, and they are 99.99999% likely to be perfectly reversed irrespective of market swings because these contracts in reality are not likely to be breached or otherwise settled prematurely. A customized and unique interest rate swap is this type of contract where unrealized gains and losses are nearly always perfectly reversed at maturity.

    We must show the fair value of the swap at interim points in time because this is what the courts will declare we owe or are owed in case of a contract breach. But we should not show changes in these amounts in current earnings because the likelihood of our breaching this contract is miniscule. OCI is a very good vehicle for showing the changes in value of a cash flow hedging swap on the balance sheet without showing the unlikely realization of these amounts on the balance sheet.

    My point with an interest rate swap is that when the swap matures, the ultimate impact on realized earnings will be zero no matter how the market swings during the hedging period. Interim unrealized gains and losses on the swap should not be posted to current earnings if they are certain to wash out.

    Hence my illustration of Example 5 from FAS 133 --- http://faculty.trinity.edu/rjensen/Theory01.htm#OCI

    I hope you and Ed will carefully study the IASB’s Section 3 of  http://snipurl.com/ias39simplification
    Section 3 is making more of a believer out of me for financial instruments (but not non-financial instruments).

    Bob Jensen

    June 23, 2008 reply from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    I am primarily an investor and investor advocate with respect to financial reporting issues. I have recently returned to university teaching after 11 years with the CFA Institute. (That gives some context to my remarks.)

    As an investor, I want to see fair value information in both the balance sheet and the income statement. I understand this creates volatility and I'm willing to live with it to get a better understanding of economic reality (if such exists at all in corporate financial statements.) I also understand that this makes measurement more difficult. If the measurement is truly "unreliable", rather than simply "not the number management wants", then IFRS permits companies to make that claim and avoid, in most instances, reporting that number in the income statement. If you read any of the commentary that users of the financial statements (those whose own money or that of their clients) is on the line when they rely of financial statements to make investment and credit decisions, you will see that they are by and large in favor of fair value (price) accounting. The "academic accountants" are not the ones pushing for this.

    (As an aside, if banks do not believe the "fair value" of their loans is a reliable measure then why don't they feel the same way about the fair value of the underlying real estate.)

    I also am a firm believer in Comprehensive Income and see no reason why this needs to be arbitrarily divided into NI and OCI. In my view, transactions and events recorded in OCI are those that belong on the Income Statement but company management managed to negotitate with the standard-setting to hide them on the balance sheet. Simply, makes the investor's job more difficult.

    On Disclosure vs Reporting in the Financial Statements: I might agree with the person who said he had no problem with disclosure of certain information, just don't put it in the financial statements. Unfortunately, my experience is that managements often do not take disclosure information as seriously as recognized information. They just aren't as concerned about measurement reliability. This was emphasized to me in a presentation on this issue with respect to stock comp that I attended. The presenter admitted that information in the footnote was relied on and used by investors but that it just couldn't be moved to the income statement because it wasn't reliable.

    Unfortunately, in my view, the only way to improve measurement reliability is to require the information to be recognized and measured in the financial statements. Investors can make sense of this information.

    Regards, Patricia Walters, PhD, CFA
    Fordham University

    Jun3 23, 2008 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    All of you have a wonderful opportunity to express your views on the subject of relevance vs. reliability to the FASB and IASB. The exposure draft on "The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information" is available at http://www.fasb.org/draft/ed_conceptual_framework_for_fin_reporting.pdf

    Comments are being solicited through September 29. I commented on the Preliminary Views document that preceded this exposure draft and probably will comment on this exposure draft too. This document is a key building block for the future of financial reporting and I urge all of you to consider participating formally in the debate.

    Denny Beresford

    For more on fair value accounting, go to http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    Multi-Column Earnings and OCI reporting

    "New Black Box Metrics Challenge Accountants' Creativity and Investor Intelligence," by Anthony H. Catanach Jr., Grumpy Old Accountants Blog, February 15, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/2/15/new-black-box-metrics-challenge-accountants-creativity-and-investor-intelligence

    According to Merriam Webster, a black box is broadly defined as “anything that has mysterious or unknown internal functions or mechanisms.”  How appropriate that Jonathan Weil called our attention to an “unconventional profitability metric” used by Black Box (the Company) to report third quarter performance in its January 29th press release (Form 8-K, Exhibit 99.1).   As usual, Jon got right to the point, and suggested that using the term “adjusted Ebitda (as adjusted)” was just another ploy to make “earnings look better.”  While I generally agree with Jon’s conclusion, I am particularly stunned by the lack of creativity exhibited by the Company’s accountants in naming their performance metrics.  After all, even a bean counter should be able to come up with something better.  As a grumpy old accountant, I'd recommend using Lynn Turner’s “everything but bad stuffEBS title (coined over a decade ago)…now that might have been more appropriate!  But why did Black Box’s accountants just give up?  Well, after a bit of digging, I think I know why.  I also discovered that this was just one of five non-GAAP measures used by the Company in its press release, but not in its current 10-Q or 10-K.  And finally, Black Box omitted a very important income statement disclosure in its press release that was included in its 10-Q and prior year 10-K.  All of this raises questions about the transparency of the Company’s most recent financial disclosures, and what is prompting the recent move to non-GAAP metrics.

    But first, even though I have little or no respect for most performance based non-GAAP metrics, I must confess that Black Box’s “unconventional profitability metric” appears to comply with the policies of the U.S. Securities and Exchange Commission (SEC). The SEC outlines its rules for such measures in its Final Rule on Non-GAAP Financial Measures, as well as its Compliance and Disclosure Interpretations on Non-GAAP Financial Measures.  In fact, the Company’s cumbersome EBITDA moniker is likely due to SEC guidance to use the word “adjusted” when reconciling net income to a non-standard definition of EBITDA.  However, Black Box adopted two separate non-GAAP EBITDA metrics: EBITDA as adjusted and the hilarious “adjusted EBITDA (as adjusted)” term, the two of which differed only by stock compensation expense.  The table below shows how these two non-GAAP measures relate to each other, as well as to the more traditional notion of EBITDA.  The first column reflects income statement data for the Company’s nine months of operations for the current fiscal year (3QYTD13) as reported in the January 29th press release (8-K, Exhibit 99.1, page 10), while the other three columns reflect related P&L data from prior Company 10-K’s.

    . . .

    In summary, the Company’s “adjusted Ebitda (as adjusted)” metric appears to be the tip of a financial reporting iceberg. Instead of improving financial reporting transparency, Black Box may really be a Pandora’s Box of non-GAAP metrics that obfuscate “true” performance.

    Continued in article

    This is remotely related to OCI reporting where earnings are adjusted for non-recurrent and unrealized value changes.

    "Academic Research and Standard-Setting: The Case of Other Comprehensive Income," by Lynn L. Rees and Philip B. Shane, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 789-815. ---
    http://aaajournals.org/doi/full/10.2308/acch-50237 

    This paper links academic accounting research on comprehensive income reporting with the accounting standard-setting efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). We begin by discussing the development of reporting other comprehensive income, and we identify a significant weakness in the FASB's Conceptual Framework, in the lack of a cohesive definition of any subcategory of comprehensive income, including earnings. We identify several attributes that could help allocate comprehensive income between net income, other comprehensive income, and other subcategories. We then review academic research related to remaining standard-setting issues, and identify gaps in academic research where hypotheses could be developed and tested. Our objectives are to (1) stimulate standard-setters to better conceptualize what is meant by other comprehensive income and to distinguish it from earnings, and (2) stimulate researchers to develop and test hypotheses that might help in that process.

    . . .

    Potential Alternative Definitions of Earnings

    Table 1 summarizes and categorizes various standard-setting issues related to reporting comprehensive income, and provides the organizing structure for our literature review later in the paper. The most important of these issues is the definition of earnings, or what makes up earnings and how it is distinguished from OCI. This is a “cross-cutting” issue because it arises when the Boards deliberate on various topics. The Boards cooperatively initiated the financial statement presentation project intending, in part, to solve the comprehensive income composition problem, but the project was subsequently delayed.

    Table 2 presents a list of the specific comprehensive income components under current U.S. GAAP that require recognition as OCI. The second column presents the statement that provided financial reporting guidance for the OCI component, along with its effective date. The effective dates provide an indication as to how the OCI components have expanded over time. Since the issuance of Statement No. 130, which established formal reporting of OCI, new OCI-expanding requirements were promulgated in Statement No. 133. Financial instruments, insurance, and leases are three examples of topics currently on the FASB's agenda where OCI has been discussed as an option to report various gains and losses. In all these discussions, a framework is lacking that can guide standard-setter decisions. The increased use of accumulated OCI to capture various changes in net assets and the likely expansion of OCI items reinforce the notion that standard-setters must eventually come to grips with the distinction between OCI and earnings, or even whether the practice of reporting OCI with recycling should be retained.7

    Presumably, elements with similar informational attributes should be classified together in financial statements. It is unclear what attributes the items listed in Table 2 possess that result in their being characterized differently from other components of income. Notably, the basis for conclusions of the FASB standards gives little to no economic reasoning for the decision to place these items in OCI. While not exhaustive, Table 2 presents four attributes that standard-setters could potentially use to distinguish between earnings and OCI: (1) the degree of persistence of the item, (2) whether the item results from a firm's core operations, (3) whether the item represents a change in net assets that is reasonably within management's control, and (4) whether the item results from remeasurement of an asset/liability. We discuss in turn the merits and potential problems of using these attributes to form a reporting framework for comprehensive income.

    Degree of Persistence.

    The degree of persistence of various comprehensive income components has significant implications for firm value (e.g., Friedman 1957; Kormendi and Lipe 1987; Collins and Kothari 1989). Ohlson's (1995, 1999) valuation model places a heavy emphasis on earnings persistence, which suggests that a reporting format that facilitates identifying the level of persistence across income components could be useful to investors. Examples abound as to how the concept of income persistence has been used in standard-setting, including separate presentation in the income statement for one-time items, extraordinary items, and discontinued operations. Standard-setters have justified several footnote disclosures (segmental disclosures) and disaggregation requirements (e.g., components of pension expense) on the basis of providing information to financial statement users about the persistence of various income statement components.

    Thus, the persistence of revenue and expense items potentially could serve as a distinguishing characteristic of earnings and OCI. Table 2 shows that we regard all the items currently recognized in OCI as having relatively low persistence. However, several other low-persistence items are not recognized in OCI; for example, gains/losses on sale of assets, impairments of assets, restructuring charges, and gains/losses from litigation. To be consistent with this definition of OCI, the current paradigm must change significantly, and the resulting total for OCI would look substantially different from what it is now.

    Using persistence of an item to distinguish earnings from OCI would create significant problems for standard-setters. Persistence can range from completely transitory (zero persistence) to permanent (100 percent persistence). At what point along this range is an item persistent enough to be recorded in earnings? While restructuring charges are typically considered as having low persistence, if they occur every two to three years, is this frequent enough to be classified with other earnings components or infrequent enough to be classified with OCI? Furthermore, the relative persistence of an item likely varies across industries, and even across firms.

    In spite of these inherent difficulties, standard-setters could establish criteria related to persistence that they might use to ultimately determine the classification of particular items. In addition, standard-setters would not be restricted to classifying income components in one of two categories. As an example, highly persistent components could be classified as part of “recurring earnings,” medium-persistence items could go to “other earnings,” and low-persistence items to OCI (or some other nomenclature). Standard-setters could create additional partitions as needed.

    Core Operations.

    Classifying income components as earnings or OCI based on whether they are part of a firm's core operations is intuitively appealing. This criterion is related to income persistence, as we would expect core earnings to be more persistent than noncore income items. Furthermore, classifying income based on whether it is part of core operations has a long history in accounting.

    In current practice, companies and investors place primary importance on some variant of earnings. However, it is not clear which variant of earnings is superior. Many companies report pro forma net income, which presumably provides investors with a more representative measure of the company's core income, but definitions of pro forma earnings vary across firms. Similarly, analysts tend to forecast a company's core earnings (Gu and Chen 2004). Evidence in prior research indicates that pro forma earnings and actual earnings forecasted by analysts are more closely associated with share prices than income from continuing operations based on current U.S. GAAP (e.g., Bradshaw and Sloan 2002; Bhattacharya et al. 2003).

    The problems inherent with this attribute are similar to those of the earnings-persistence criterion. No generally accepted definition of core operations exists. At what point along a continuum does an activity become part of the core operations of a business? As Table 2 indicates, classifying gains/losses from holding available-for-sale securities as part of core earnings depends on whether the firm operates in the financial sector. Different operating environments across firms and industries could make it difficult for standard-setters to determine whether an item belongs in core earnings or OCI.8 In addition, differences in application across firms may give rise to concerns about comparability and potential for abuse on the part of managers in exercising their discretion (e.g., Barth et al. 2011).

    The FASB's (2010) Staff Draft on Financial Statement Presentation tries to address the definitional issue by using interrelationships and synergies between assets and liabilities as a criterion to distinguish operating (or core) activities from investing (or noncore) activities. Specifically, the Staff Draft states:

    An entity shall classify in the operating category:

    Assets that are used as part of the entity's day-to-day business and all changes in those assets Liabilities that arise from the entity's day-to-day business and all changes in those liabilities.

    Operating activities generate revenue through a process that requires the interrelated use of the entity's resources. An asset or a liability that an entity uses to generate a return and any change in that asset or liability shall be classified in the investing category. No significant synergies are created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity. An asset or a liability classified in the investing category may yield a return for the entity in the form of, for example, interest, dividends, royalties, equity income, gains, or losses. (FASB 2010, paras. 72, 73, 81)

    The above distinction between operating activities and investing activities could similarly be used to distinguish between core activities and noncore activities. Alternatively, standard-setters might develop other definitions. Similar to the degree of persistence attribute, standard-setters would not be restricted to a simple core versus noncore dichotomy when using this definition.

    Another possible solution is to allow management to determine which items belong in core earnings. Companies exercise this discretion today when they choose to disclose pro forma earnings. Furthermore, the FASB established the precedent of the “management approach” when it allowed management to determine how to report segment disclosures. In several other areas of U.S. GAAP, management is responsible for establishing boundaries that define its operating environment. FASB Accounting Standards Codification Topic 320 (formerly Statement 115) permits different measurements for identical investments based on management's intent to sell or hold the instrument. Other examples where U.S. GAAP allows for management discretion include determining the rate to discount pension liabilities, defining reporting units, and determining whether an impairment is other than temporary. However, the management approach accentuates the concern about comparability and potential for abuse.

    Management Control.

    Given a premise that evaluating management's stewardship is a primary role of financial statements, a possible rationale for excluding certain items from earnings is that they do not provide a good measure to evaluate management.9 Management can largely control the firm's operating costs and can influence the level of revenues generated. However, some decisions that affect comprehensive income can be established by company policy or the company mission statement and, thus, be outside the control of management. For example, a company policy might be to invest excess cash in marketable securities with the objective of maximizing returns. Once the board of directors establishes this policy, management has little influence over how market-wide fluctuations in security prices affect earnings, and hedging the gains/losses would be inconsistent with the objective of maximizing returns. Similarly, a company's mission statement might include expansion overseas, or prior management might have already decided to establish a foreign subsidiary. The resulting gains/losses from foreign currency fluctuations would seemingly be out of management's control, and hedging these gains/losses would not make economic sense if the subsidiary's functional currency is its local currency and the parent has no intention of repatriating the subsidiary's cash flows.

    Of course, determining what is and is not ostensibly under management's control becomes highly subjective and would probably differ across industries, and perhaps even across firms within industries. For example, gains/losses from investment holdings might not be relevant in evaluating management of some companies, but might be very relevant for managers of holding companies. In addition, the time horizon affects what is under management's control. That is, as the time horizon lengthens, more things are under management's control.

    In Table 2, we classify items as not under management's control if they are based on fluctuations in stock prices or exchange rates, which academic research shows to be largely random within efficient markets. Using this classification model, most, but not all, of the OCI items listed in Table 2 are classified as not under the management's control. Some of the pension items currently recognized in OCI are within the control of management, because management controls the decision to revise a pension plan. While management has control over when to harvest gains/losses on available-for-sale (AFS) securities by deciding when to sell the securities, it cannot control market prices. Thus, under this criterion, unrealized gains/losses on AFS securities are appropriately recognized in OCI. However, gains/losses on trading securities and the effects of tax rate changes are beyond management's control, and yet, these items are currently included as part of earnings. Thus, “management control” does not distinguish what is and is not included in earnings under current U.S. GAAP.

    Remeasurements.

    Barker (2004) explains how the measurement and presentation of comprehensive income might rely on remeasurements. The FASB's (2010) Staff Draft on Financial Statement Presentation defines remeasurements as follows:

    A remeasurement is an amount recognized in comprehensive income that increases or decreases the net carrying amount of an asset or a liability and that is the result of:

    A change in (or realization of) a current price or value A change in an estimate of a current price or value or A change in any estimate or method used to measure the carrying amount of an asset or a liability. (FASB 2010, para. 234)

    Using this definition, examples of remeasurements are impairments of land, unrealized gains/losses due to fair value changes in securities, income tax expenses due to changes in statutory tax rates, and unexpected gains/losses from holding pension assets. All of these items represent a change in carrying value of an already existing asset or liability due to changes in prices or estimates (land, investments, deferred tax asset/liability, and pension asset/liability, respectively).

    Table 3 reproduces a table from Barker (2004) that illustrates how a firm's income statement might look using a “matrix format” if standard-setters adopt the remeasurement approach to reporting comprehensive income. Note that the presentation in Table 3 does not employ earnings as a subtotal of comprehensive income; however, the approach could be modified to define earnings as the sum of all items before remeasurements, if considered useful. Tarca et al. (2008) conduct an experiment with analysts, accountants, and M.B.A. students to assess whether the matrix income statement format in Table 3 facilitates or hinders users' ability to extract information. They find evidence suggesting that the matrix format facilitates more accurate information extraction for users across all sophistication levels relative to a typical format based on IAS 1.

     

    Table 3:  Illustration of Matrix Reporting Format

     

    Employing remeasurements to distinguish between earnings and other comprehensive income largely incorporates the criterion of earnings persistence. Most remeasurements result from price changes, where the current change has little or no association with future changes and, therefore, these components of income are transitory. In contrast, earnings components before remeasurements generally represent items that are likely more persistent.

    Perhaps the most significant advantage of the remeasurement criterion is that it is less subjective than the other criteria previously discussed. Most of the other criteria in Table 2 are continuous in nature. Drawing a bright line to differentiate what belongs in earnings from what belongs in OCI is challenging and will likely be susceptible to income manipulation. In contrast, determining whether a component of income arises from a remeasurement is more straightforward.

    Yet another advantage of this approach is it allows for a full fair value balance sheet that clearly discloses the effects of fair value measurement on periodic comprehensive income, while also showing earnings effects under a modified historical cost system (i.e., before remeasurements). This approach could potentially provide better information about probable future cash flows.

    Other.

    The attributes standard-setters could use to classify income components into earnings or OCI are not limited to the list in Table 2. Ketz (1999) suggests using the level of measurement uncertainty. As an example, gains/losses from Level 1 fair value measurements might be viewed as sufficiently certain to include in earnings, while Level 3 fair value measurements might generate gains/losses that belong in OCI. Song et al. (2010) provide some support for this partition in that they document the value relevance of Level 1 and Level 2 fair values exceeds the value relevance of Level 3 fair values.

    Another potential attribute might be the horizon over which unrealized gains/losses are ultimately realized. That is, unrealized gains/losses from foreign currency fluctuations, term life insurance contracts, or holding pension assets that will not be realized for many years in the future might be disclosed as part of OCI, whereas unrealized gains/losses from trading and available-for-sale securities could be part of earnings.

    As previously discussed, the attributes of measurement uncertainty and timeliness create similar problems in determining where to draw the line. Which items are sufficiently reliable (or timely) to include in earnings, and will differences in implementation across firms and industries impair comparability?

    The overriding purpose of the discussion in this subsection is to point out that several alternative attributes could potentially guide standard-setters in establishing criteria to differentiate earnings from OCI. Ultimately, the choice regarding whether/how to distinguish net income from OCI is a matter of policy. However, academic research can inform policy decisions, as described in the fourth and fifth sections.

    Summary

    Reporting OCI is a relatively recent phenomenon that presumes financial statement users are provided with better information when specific comprehensive income components are excluded from earnings-per-share (EPS), and recycled back into net income only after the occurrence of a specified transaction or event. The number of income components included in OCI has increased over time, and this expansion is likely to continue as standard-setters address new agenda items (e.g., financial instruments and insurance contracts). The lack of a clear definitional distinction between earnings and OCI in the FASB/IASB Conceptual Frameworks has led to: (1) ad hoc decisions on the income components classified in OCI, and (2) no conceptual basis for deciding whether OCI should be excluded from earnings-per-share (EPS) in the current period or recycled through EPS in subsequent periods. In this section, we discussed alternative criteria that standard-setters could use to distinguish earnings from OCI, along with the advantages and challenges of each criterion. Further, due to the inherent difficulties in drawing bright lines between earnings that are persistent versus transitory, core versus noncore, under management control or not, and amenable to remeasurement or not, standard-setters might consider eliminating OCI; that is, they might decide to adopt an all-inclusive income statement approach, where comprehensive income is reporte

    . . .

    Continued in article

    Jensen Comment
    I like this paper. Table 3 could be improved by adding bottom line net earnings before and after remeasurement.

    The paper does not provide all the answers, but it is well written in terms of history up to this point in time and alternative directions for consideration.


    From the CFO Journal's Morning Ledger on July 22, 2013 (Congratulations Tony)

    The dark side of non-GAAP metrics
    Over on the Grumpy Old Accountants blog, Villanova University Prof. Anthony Catanach takes aim at the growing use of non-GAAP metrics—noting a recent article by CFOJ’s Emily Chasan highlighting the trend. Prof. Catanach argues that in most cases, companies using nontraditional metrics actually mask real operating performance. “I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all.  I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures.  Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures,” he writes.

    "Non-GAAP Metrics: Is It Time to Toss Out the SEC's Reg G?" by Anthony H. Catanach Jr., Grumpy Old Accountants Blog, July 20, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/7/20/non-gaap-metrics-is-it-time-to-toss-out-the-secs-reg-g

    It’s been over a decade, 12 years to be exact, since Isaac C. Hunt, Jr. then Commissioner of the SEC, delivered his seminal "Accountants as Gatekeepers" speech.  Those of you with gray hair (or no hair) will recall this speech for Hunt’s attack on managed earnings and “pro forma” financials.”  In venting his frustration with non-GAAP metrics (today’s descriptor for bad financial metrics), he reminded securities issuers of their responsibilities to “make full and fair disclosure of all material information.” Hunt’s speech is particularly noteworthy as it points out that “federal securities laws, to a significant extent, make accountants the ‘gatekeepers’ to the public securities markets.  

    Recently, several articles have appeared in the popular press highlighting “new” ways that companies are reporting performance. In one, “New Benchmarks Crop Up in Companies Financial Reports,” Emily Chasan discusses how some firms are complementing financial reports with nontraditional performance benchmarks. What’s my beef you ask?  Well, my objections this time are consistent with my recent rants about Black Box’s new metrics, and Citigroup’s new performance measurement system.  Simply put, these supposedly innovative and insightful performance measures are neither!  In fact, in most cases, they are quite the opposite, and actually mask real operating performance

    My grumpiness on this “new” disclosure business has reached the boiling point.  I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all.  I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures.  Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures. But there is one hitch: none of the operating metrics I have in mind can use, or be based in any way on any financial statement data, or any combination of numbers that come from the general ledger system!  Let me explain further.

    As Ms. Chasan reports, some companies are beginning to disclose relevant operating data, particularly as it relates to customers (e.g., paid membership rates, active users, cumulative customers, etc.).  Unfortunately, many more CFOs continue to try to sell us the same old “snake oil,” namely, “innovative” metrics that are nothing more than repackaged financial statement-based illusions.  You know them well, EBITDA, adjusted EBITDA, and the like. And this deception has continued unabated for years…some of us even remember a wonderful piece by Jonathan Weil titled “Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate.” Nevertheless, the result is the same: financially-based, non-GAAP performance measures that have less to do with the nuts and bolts of daily operating processes, and more to do with today’s troubled accounting “standards.”

    Why do so many CFOs promote the use of these non-GAAP metrics?  They maintain that these metrics are needed because financial statements prepared in accordance with generally accepted accounting principles (GAAP), particularly the income statement, don’t provide a complete and accurate picture of a company’s performance. But are CFOs really being driven to more non-GAAP metrics so as to present a clearer picture of the future direction of a business as recently suggested by Professors Paul Bahnson of Boise State and Paul Miller of UC – Colorado Springs?  

    Continued in article

     


    No Bottom Line

    Question
    Is a major overhaul of accounting standards on the way?
    Hint
    There may no longer be the tried and untrusted earnings per share number to report!
    Comment
    It would be interesting to see a documentation of the academic research, if any, that the FASB relied upon to commence this blockbuster initiative. I recommend that some astute researcher commence to probe into the thinking behind this proposal.

    "Profit as We Know It Could Be Lost With New Accounting Statements," by David Reilly, The Wall Street Journal, May 12, 2007; Page A1 --- http://online.wsj.com/article/SB117893520139500814.html?mod=DAT

    Pretty soon the bottom line may not be, well, the bottom line.

    In coming months, accounting-rule makers are planning to unveil a draft plan to rework financial statements, the bedrock data that millions of investors use every day when deciding whether to buy or sell stocks, bonds and other financial instruments. One possible result: the elimination of what today is known as net income or net profit, the bottom-line figure showing what is left after expenses have been met and taxes paid.

    It is the item many investors look to as a key gauge of corporate performance and one measure used to determine executive compensation. In its place, investors might find a number of profit figures that correspond to different corporate activities such as business operations, financing and investing.

    Another possible radical change in the works: assets and liabilities may no longer be separate categories on the balance sheet, or fall to the left and right side in the classic format taught in introductory accounting classes.

    ACCOUNTING OVERHAUL

    Get a glimpse of what new financial statements could look like, according to an early draft recently provided by the Financial Accounting Standards Board to one of its advisory groups. The overhaul could mark one of the most drastic changes to accounting and financial reporting since the start of the Industrial Revolution in the 19th century, when companies began publishing financial information as they sought outside capital. The move is being undertaken by accounting-rule makers in the U.S. and internationally, and ultimately could affect companies and investors around the world.

    The project is aimed at providing investors with more telling information and has come about as rule makers work to one day come up with a common, global set of accounting standards. If adopted, the changes will likely force every accounting textbook to be rewritten and anyone who uses accounting -- from clerks to chief executives -- to relearn how to compile and analyze information that shows what is happening in a business.

    This is likely to come as a shock, even if many investors and executives acknowledge that net income has flaws. "If there was no bottom line, I'd want to have a sense of what other indicators I ought to be looking at to get a sense of the comprehensive health of the company," says Katrina Presti, a part-time independent health-care contractor and stay-at-home mom who is part of a 12-woman investment club in Pueblo, Colo. "Net income might be a false indicator, but what would I look at if it goes away?"

    The effort to redo financial statements reflects changes in who uses them and for what purposes. Financial statements were originally crafted with bankers and lenders in mind. Their biggest question: Is the business solvent and what's left if it fails? Stock investors care more about a business's current and future profits, so the net-income line takes on added significance for them.

    Indeed, that single profit number, particularly when it is divided by the number of shares outstanding, provides the most popular measure of a company's valuation: the price-to-earnings ratio. A company that trades at $10 a share, and which has net profit of $1 a share, has a P/E of 10.

    But giving that much power to one number has long been a recipe for fraud and stock-market excesses. Many major accounting scandals earlier this decade centered on manipulation of net income. The stock-market bubble of the 1990s was largely based on investors' assumption that net profit for stocks would grow rapidly for years to come. And the game of beating a quarterly earnings number became a distraction or worse for companies' managers and investors. Obviously it isn't known whether the new format would cut down on attempts to game the numbers, but companies would have to give a more detailed breakdown of what is going on.

    The goal of the accounting-rule makers is to better reflect how businesses are actually run and divert attention from the one number. "I know the world likes single bottom-line numbers and all of that, but complicated businesses are hard to translate into just one number," says Robert Herz, chairman of the Financial Accounting Standards Board, the U.S. rule-making body that is one of several groups working on the changes.

    At the same time, public companies today are more global than local, and as likely to be involved in services or lines of business that involve intellectual property such as software rather than the plants and equipment that defined the manufacturing age. "The income statement today looks a lot like it did when I started out in this profession," says William Parrett, the retiring CEO of accounting firm Deloitte Touche Tohmatsu, who started as a junior accountant in 1967. "But the kind of information that goes into it is completely different."

    Along the way, figures such as net income have become muddied. That is in part because more and more of the items used to calculate net profit are based on management estimates, such as the value of items that don't trade in active markets and the direction of interest rates. Also, over the years rule makers agreed to corporate demands to account for some things, such as day-to-day changes in the value of pension plans or financial instruments used to protect against changes in interest rates, in ways that keep them from causing swings in net income.

    Rule makers hope reformatting financial statements will address some of these issues, while giving investors more information about what is happening in different parts of a business to better assess its value. The project is being managed jointly by the FASB in the U.S. and the London-based International Accounting Standards Board, and involves accounting bodies in Japan, other parts of Asia and individual European nations.

    The entire process of adopting the revised approach could take a few years to play out, so much could yet change. Plus, once rule makers adopt the changes, they would have to be ratified by regulatory authorities, such as the Securities and Exchange Commission in the U.S. and the European Commission in Europe, before public companies would be required to follow them.

    As a first step, rule makers expect later this year to publish a document outlining their preliminary views on what new form financial statements might take. But already they have given hints of what's in store. In March, the FASB provided draft, new financial statements at the end of a 32-page handout for members of an advisory group. (See an example.)

    Although likely to change, this preview showed an income statement that has separate segments for the company's operating business, its financing activities, investing activities and tax payments. Each area has an income subtotal for that particular segment.

    There is also a "total comprehensive income" category that is wider ranging than net profit as it is known today, and so wouldn't be directly comparable. That is because this total would likely include gains and losses now kept in other parts of the financial statements. These include some currency fluctuations and changes in the value of financial instruments used to hedge against other items.

    Comprehensive income could also eventually include short-term changes in the value of corporate pension plans, which currently are smoothed out over a number of years. As a result, comprehensive income could be a lot more difficult to predict and could be volatile from quarter to quarter or year to year.

    As for the balance sheet, the new version would group assets and liabilities together according to similar categories of operating, investing and financing activities, although it does provide a section for shareholders equity. Currently, a balance sheet is broken down between assets and liabilities, rather than by operating categories.

    Such drastic change isn't likely to happen without a fight. Efforts to bring now-excluded figures into the income statement could prompt battles with companies that fear their profit will be subject to big swings. Companies may also balk at the expense involved.

    "The cost of this change could be monumental," says Gary John Previts, an accounting professor at Case Western Reserve University in Cleveland. "All the textbooks are going to have to change, every contract and every bank arrangement will have to change." Investors in Europe and Asia, meanwhile, have opposed the idea of dropping net profit as it appears today, David Tweedie, the IASB's chairman, said in an interview earlier this year.

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

    Such opposition doesn't surprise many accounting experts. Net income is "the basis for bonuses and judgments about what a company's stock is worth," says Stephen A. Zeff, an accounting professor at Rice University. "I just don't know what the markets would do if companies stopped reporting a bottom line somewhere." In the U.S., professional investors and analysts have taken a more nuanced view, perhaps because the manipulation of numbers was more pronounced in U.S. markets.

    That said, net profit has been around for some time. The income statement in use today, along with the balance sheet, generally dates to the 1940s when the SEC laid out regulations on financial disclosure. But many companies have included net profit in one form or another since the 1800s.

    In its fourth annual report, General Electric Co. provided investors with a consolidated balance sheet and consolidated profit-and-loss account for the year ended Jan. 31, 1896. The company, whose board at the time included Thomas Edison, generated "profit of the year" -- what today would be called net income or net profit -- of $1,388,967.46.

    For the moment, net profit will probably exist in some form, although its days are likely numbered. "We've decided in the interim to keep a net-income subtotal, but that's all up for discussion," the FASB's Mr. Herz says.

    Bob Jensen's summary of accounting theory is at http://faculty.trinity.edu/rjensen/Theory01.htm


    Question
    What do CFO's think of Robert Herz's (Chairman of the FASB) radical proposed  format for financial statements that have more disaggregated financial information and no aggregated bottom line?

    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Before reading the article below you may want to first read about radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    "A New Vision for Accounting:  Robert Herz and FASB are preparing a radical new format for financial, CFO Magazine, by Alix Stuart, February 2008, pp. 49-53 --- http://www.cfo.com/article.cfm/10597001/c_10711055?f=home_todayinfinance

    Last summer, McCormick & Co. controller Ken Kelly sliced and diced his financial statements in ways he had never before imagined. For starters, he split the income statement for the $2.7 billion international spice-and-food company into the three categories of the cash-flow statement: operating, financing, and investing. He extracted discontinued operations and income taxes and placed them in separate categories, instead of peppering them throughout the other results. He created a new form to distinguish which changes in income were due to fair value and which to cash. One traditional ingredient, meanwhile, was conspicuous by its absence: net income.

    Kelly wasn't just indulging a whim. Ahead of a public release of a draft of the Financial Accounting Standards Board's new format for financial statements in the second quarter of 2008, the McCormick controller was trying out the financial statements of the future, a radical departure from current conventions. FASB's so-called financial statement presentation project is ostensibly concerned only with the form, or the "face," of financial statements, but it's quickly becoming clear that it will change and expand their content as well. "This is a complete redefinition of the financial statements as we know them," says John Hepp, a former FASB project manager and now senior manager at Grant Thornton.

    Some of the major changes under discussion: reconfiguring the balance sheet and the income statement to follow the three categories of the cash-flow statement, requiring companies to report cash flows with the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value changes. Companies will also likely have to report more about their segments, possibly down to the same level of detail as they currently report for the consolidated statements. Meanwhile, net income is slated to disappear completely from GAAP financial statements, with no obvious replacement for such commonly used metrics as earnings per share.

    FASB, working with the International Accounting Standards Board (IASB) and accounting standards boards in the United Kingdom and Japan, continues to work out the precise details of the new financial statements. "We are trying to set the stage for what financial statements will look like across the globe for decades to come," says FASB chairman Robert Herz. (Examples of the proposed new financial statements can be viewed at FASB's Website.) If the standard-setters stay their course, CFOs and controllers at every publicly traded company in the world could be following Kelly's lead as soon as 2010.

    It's too early to predict with confidence which changes will ultimately stick. But the mock-up exercise has made Kelly wary. He considers the direct cash-flow statement and reconciliation schedule among the "worst aspects" of the forthcoming proposal, and expects they would require "draconian exercises" from his finance staff, he says. And he questions what would result from the additional details: "If all of a sudden your income statement has 125 lines instead of 25, is that presentation more clarifying, or more confusing?"

    Other financial executives share Kelly's skepticism. In a December CFO survey of more than 200 finance executives, only 17 percent said the changes would offer any benefits to their companies or investors (see "Keep the Bottom Line" at the end of this article). Even some who endorsed the basic aim of the project and like the idea of standardizing categories across the three major financial statements were only cautiously optimistic. "It may be OK, or it may be excessive." says David Rickard, CFO of CVS/Caremark. "The devil will be in the details."

    Net Loss From the outset, corporate financial officers have been ambivalent about FASB's seven year-old project, which was originally launched to address concerns that net income was losing relevance amid a proliferation of pro forma numbers. Back in 2001, Financial Executives International "strongly opposed" it, while executives at Philip Morris, Exxon Mobil, Sears Roebuck, and Microsoft protested to FASB as well.

    (Critics then and now point out that FASB will have little control over pro forma reporting no matter what it does. Indeed, nearly 60 percent of respondents to CFO's survey said they would continue to report pro forma numbers after the new format is introduced.)

    Given the project's starting point, it's not surprising that current drafts of the future income statement omit net income. Right now that's by default, since income taxes are recorded in a separate section. But there is a big push among some board members to make a more fundamental change to eliminate net income by design, and promote business income (income from operations) as the preferred basis for investment metrics.

    "If net income stays, it would be a sign that we failed," says Don Young, a FASB board member. In his mind, the project is not merely about getting rid of net income, but rather about capturing all income-related information in a single line (including such volatile items as gains and losses on cash-flow hedges, available-for-sale securities, and foreign-exchange translations) rather than footnoting them in other comprehensive income (OCI) as they are now. "All changes in net assets and liabilities should be included," says Young. "Why should the income statement be incomplete?" He predicts that the new subtotals, namely business income, will present "a much clearer picture of what's going on."

    Board member Thomas Linsmeier agrees. "The rationale for segregating those items [in OCI] is not necessarily obvious, other than the fact that management doesn't want to be held accountable for them in the current period," he says.

    Whether for self-serving or practical reasons, finance chiefs are rallying behind net income. Nearly 70 percent of those polled by CFO in December said it should stay. "I understand their theories that it's not the be-all and end-all measure that it's put up to be, but it is a measure everyone is familiar with, and sophisticated users can adjust from there," says Kelly. Adds Rickard: "They're treating [net income] as if it's the scourge of the earth, which to me is silly. I think the logical conclusion is to make other things available, rather than hiding the one thing people find most useful."

    . . .

     

    Bob Jensen's threads on this proposed "radical change" in financial reporting are at http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay 

    Jensen Comment
    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Bob Jensen's threads on the radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay


    From the CFO Journal's Morning Ledger on July 22, 2013 (Congratulations Tony)

    The dark side of non-GAAP metrics
    Over on the Grumpy Old Accountants blog, Villanova University Prof. Anthony Catanach takes aim at the growing use of non-GAAP metrics—noting a recent article by CFOJ’s Emily Chasan highlighting the trend. Prof. Catanach argues that in most cases, companies using nontraditional metrics actually mask real operating performance. “I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all.  I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures.  Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures,” he writes.

    "Non-GAAP Metrics: Is It Time to Toss Out the SEC's Reg G?" by Anthony H. Catanach Jr., Grumpy Old Accountants Blog, July 20, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/7/20/non-gaap-metrics-is-it-time-to-toss-out-the-secs-reg-g

    It’s been over a decade, 12 years to be exact, since Isaac C. Hunt, Jr. then Commissioner of the SEC, delivered his seminal "Accountants as Gatekeepers" speech.  Those of you with gray hair (or no hair) will recall this speech for Hunt’s attack on managed earnings and “pro forma” financials.”  In venting his frustration with non-GAAP metrics (today’s descriptor for bad financial metrics), he reminded securities issuers of their responsibilities to “make full and fair disclosure of all material information.” Hunt’s speech is particularly noteworthy as it points out that “federal securities laws, to a significant extent, make accountants the ‘gatekeepers’ to the public securities markets.  

    Recently, several articles have appeared in the popular press highlighting “new” ways that companies are reporting performance. In one, “New Benchmarks Crop Up in Companies Financial Reports,” Emily Chasan discusses how some firms are complementing financial reports with nontraditional performance benchmarks. What’s my beef you ask?  Well, my objections this time are consistent with my recent rants about Black Box’s new metrics, and Citigroup’s new performance measurement system.  Simply put, these supposedly innovative and insightful performance measures are neither!  In fact, in most cases, they are quite the opposite, and actually mask real operating performance

    My grumpiness on this “new” disclosure business has reached the boiling point.  I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all.  I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures.  Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures. But there is one hitch: none of the operating metrics I have in mind can use, or be based in any way on any financial statement data, or any combination of numbers that come from the general ledger system!  Let me explain further.

    As Ms. Chasan reports, some companies are beginning to disclose relevant operating data, particularly as it relates to customers (e.g., paid membership rates, active users, cumulative customers, etc.).  Unfortunately, many more CFOs continue to try to sell us the same old “snake oil,” namely, “innovative” metrics that are nothing more than repackaged financial statement-based illusions.  You know them well, EBITDA, adjusted EBITDA, and the like. And this deception has continued unabated for years…some of us even remember a wonderful piece by Jonathan Weil titled “Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate.” Nevertheless, the result is the same: financially-based, non-GAAP performance measures that have less to do with the nuts and bolts of daily operating processes, and more to do with today’s troubled accounting “standards.”

    Why do so many CFOs promote the use of these non-GAAP metrics?  They maintain that these metrics are needed because financial statements prepared in accordance with generally accepted accounting principles (GAAP), particularly the income statement, don’t provide a complete and accurate picture of a company’s performance. But are CFOs really being driven to more non-GAAP metrics so as to present a clearer picture of the future direction of a business as recently suggested by Professors Paul Bahnson of Boise State and Paul Miller of UC – Colorado Springs?  

    Continued in article

     

     


    Accrual Accounting and Estimation

    A Very Practical Application of 'Dollar-Value Lifo

    "The IPIC Method Revisited: A Simplified Explanation and Illustration of the Inventory Price Index Computation (IPIC) Method"
    by CPA Valuation Specialist William Brighenti [william_brighenti@yahoo.com]
    http://www.cpa-connecticut.com/IPIC.html

    Like Delphic oracles of antiquity, the Treasury Department has a reputation for issuing statements veiled in ambiguity and incomprehensibility to the uninitiated, keeping tax attorneys and tax accountants—the high priestesses of the tax mysteries—gainfully employed. And its regulation §1.472-8, “Dollar-Value Method of Pricing LIFO Inventories,” was no different when it was first issued, specifically in regard to the use of the inventory price index computation (IPIC) method, wherein the taxpayer computes an inventory price index (IPI) based on the consumer price indexes (CPI) or producer price indexes (PPI) published by the United States Bureau of Labor Statistics (BLS). Therein one previously found esoteric provisions, such as an arbitrary reduction of the inventory price index by 20 percent, the requirement of the 10 percent categories, the use of BLS weights to prioritize the categories, the use of a weighted harmonic mean for computing the inventory price index instead of a weighted arithmetic mean, ad infinitum ad nauseam. Adding to the confusion was the use of terminology imprecisely, if not ambiguously, defined, leaving it to the tax preparer to divine the technical meanings of and distinctions between an inventory item, category, or pool: neither the Code nor the regulations define what constitutes an item [see Wendle Ford Sales, Inc. v. Commissioner, 72 T.C. 447 (1979)]; a category is categorically dismissed as an accounting method, subject to approval after an IRS audit; and a pool is nebulously defined as the inventory of a “natural” business unit.

    Ultimately, public outcry over some of the above-mentioned provisions caused the Treasury Department to issue Treasury Decision 8976 on December 20 2001, simplifying the computation of the IPI under the IPIC method by no longer requiring 10 percent categories and the reduction of the inventory price index by 20 percent, as well as clarifying other provisions of its regulation. In spite of this simplification on the part of the Treasury Department, many companies still struggle over the proper application of the IPIC method. Some of the errors typically made include the improper calculation of the weighted harmonic average, the failure to assign inventory items correctly to BLS categories, the use of a very general, if not incorrect, index for the entire inventory, or the incorrect set up of pools, among others. Because it is such an opportune time to switch to LIFO from other inventory cost flow methods, with commodity prices rising dramatically over the past year, and because the IPIC method is probably the least costly method in terms of recordkeeping to implement for so many companies, perhaps an expliquer of its methodology—highlighting and illustrating its basic computational steps—is warranted at this time.

    According to Federal Regulation § 1.472-8, the IPI computation involves four steps:

    1. Selection of a BLS table and an appropriate month

    2. Assignment of items in a dollar-value pool to BLS categories

    3. Computation of category inflation indexes for selected BLS categories

    4. Computation of the IPI.

    For most “small”, nonpublic companies, determining LIFO pools is not a major problem, since most are within one product line (or related product lines) or consist of one operating business unit: that is, most have one pool. Furthermore, § 1.472-8 allows the company to use multiple pooling; however, multiple pools increase the risk of erosion of LIFO layers, and should be avoided at all cost. Of course, companies having gross receipts less than $5,000,000 on average may use one pool. Likewise, for most small, nonpublic companies, choosing an appropriate month is not difficult. Usually at its year-end, when an inventory count is undertaken, that is often the month of choice.

    Similarly, the selection of a BLS table for manufacturers, processors, wholesalers, jobbers, and distributors is not a difficult choice: Table 6 is ordinarily required (retailers may select BLS price indexes from Table 3).

    And the assignment of inventory items should not be an overtaxing matter, too. According to the regulation, “a taxpayer’s selection of a BLS category for a specific item is a method of accounting.” Given the various categories provided in table 6 for the various commodities, the taxpayer would decompose its inventory items into the provided categories in a logical and systematic manner; however, the implicit constraint is that, once selected, the inventory items should be categorized consistently in the same fashion from year to year.

    The next step in the computation of an IPI for a dollar-value pool—the computation of category inflation indexes for selected BLS categories—is the step that has given small, nonpublic companies the greatest difficulty. There are two methods of implementing the computation: double-extension IPIC method; and link-chain IPIC method. The major difference between the two methods is that the former employs a cumulative index from the first year of LIFO use; while the latter uses an index based on the index of the preceding year. More precisely, under the double-extension method, the category inflation index for a BLS category is the quotient of the BLS price index of the current year divided by that of the base year; whereas, under the link-chain method, the category inflation index for a BLS category is the quotient of the BLS price index of the current year divided by that of the prior year.

    Once a method is selected and the individual inflation indexes of the categories are calculated, then the next step would be to derive the IPI for a dollar-value pool by computing the “weighted harmonic mean” of the category inflation indexes. The regulation provides the following literal formula for its calculation:

    “Sum of Weights/Sum of (Weight/Category Inflation Index).” Although it may

    appear somewhat imposing at first glance:, the calculation of the weighted harmonic mean consists of four steps.

    1. To compute the “Sum of Weights”, after assigning all inventory items to categories, total all dollar values of inventory items by category, and sum all of these dollar values of the categories. The dollar values of each category comprise the “Weights” referred to in the numerator or dividend of the above formula.

    2. Next calculate the category inflation indexes for each category by dividing either the base year’s index (double-extension method) or the prior year’s index (link-chain method) into the current year’s index.

    3. Then divide each category’s total value by its respective category inflation index. The quotient of this division is the “Weight/Category Inflation Index” variable in the denominator of the above formula. Simply add all of these quotients to arrive at the “Sum of (Weight/Category Inflation Index)” value of the denominator.

    4. Now divide the “Sum of Weights” computed in step 1 by the “Sum of (Weight/Category Inflation Index)” computed in step 3 to yield the weighted harmonic mean.

    For the double-extension method, the weighted harmonic mean is also the IPI; however, because the link-chain method uses the prior period’s category inflation indexes and not those of the base year, its weighted harmonic mean needs to be multiplied by the prior year’s IPI in order to reflect the cumulative inflation effect since the inception of LIFO to arrive at the current year’s IPI.

    A simple example may help to illustrate IPI’s computation.
    This example appears at http://www.cpa-connecticut.com/IPIC.html

    Mr. Breghenti's home page is at http://www.cpa-connecticut.com

    Mr. Brehenti also has a page on estimation of the value of employee stock options under FAS 123R rules of booking options when they vest and carrying them at fair value --- http://www.cpa-connecticut.com/sfas123r.html
    For more details and alternatives on valuing stock options go to http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Updated ideas and cases on accrual accounting and estimation ---
    http://faculty.trinity.edu/rjensen/theory01.htm#AccrualAccounting


    Problems With Absorption Costing

    "Lots of Trouble:  U.S. automakers used a common accounting practice to justify huge run-ups in inventories, but the downside risks offer lessons for all manufacturers," by Marielle Segarra, CFO Magazine, March 2012, pp. 29-31 ---
    http://www.cfo.com/article.cfm/14620031?f=search

    It's no secret that in the years leading up to the Great Recession, the Big Three automakers were producing vehicles in excess of market demand, leading to large inventories on dealers' lots across the country. Now, some researchers say they know why the automakers acted as they did, and they are warning other manufacturers to avoid the same temptation.

    By coupling excess production with absorption costing, managers at GM, Ford, and Chrysler were able to boost profits and meet short-term incentives, according to professors at Michigan State University and Maastricht University in the Netherlands. (Their study on the topic was recognized in January for its contribution to management accounting by the American Institute of Certified Public Accountants and other groups.) Ultimately, however, the practice hurt the automakers, in part by driving up advertising and inventory holding costs and possibly causing a decline in brand image, the researchers say.

    From 2005 to 2006, long before GM and Chrysler filed for bankruptcy and appealed for federal aid, the automakers had abundant excess capacity. Then as now, they had enormous fixed costs, from factories and machinery to workers whose contracts protected them from layoffs when demand was low, says Karen Sedatole, associate professor of accounting at Michigan State and a co-author of the study.

    To "absorb" those massive costs, the automakers churned out more cars while using absorption costing, a widely used system that calculates the cost of making a product by dividing total manufacturing costs, fixed and variable, by the number of products produced. The more vehicles they made, the lower the cost per vehicle, and the higher the profits on the income statement. In effect, the automakers shifted costs from the income statement to the balance sheet, in the form of inventory.

    Under Statement of Financial Accounting Standards No. 151, companies can use absorption costing for "normal capacity" but must treat "abnormal" excess capacity as a period cost, according to Sedatole. But the standard doesn't clearly define what's normal, leaving room for companies to overproduce in order to lower unit cost. Companies that do so "are, in a way, managing earnings upward by trapping costs on the balance sheet as inventory, so they won't hit the income statement," she says.

    Eroding Brand Image But business leaders should think twice before adopting this tactic, cautions Sedatole. Even though they can make their companies appear more profitable in the short term by concealing excess capacity costs on the balance sheet, holding so much excess inventory can exact a price.

    "When [the dealers] couldn't sell the cars, they would sit on the lot," says Sedatole. "They'd have to go in and replace the tires, and there were costs associated with that." The companies also had to pay to advertise their cars, often at discounted prices. And by making their cars cheaper and more readily available, they may have turned off potential customers, she adds.

    "If you see a $12,000 car in a TV ad is being auctioned off for $6,000 at your local dealer, that affects your image of that vehicle," says Sedatole. This effect on brand image is difficult to quantify, but the researchers correlated 1% of rebate with a 2% decline in appeal in the J.D. Power and Associates Automotive Performance Execution and Layout Index.

    Some might argue that it's good strategy for a company already obligated to pay salaries to make products up to its capacity. "An economist would say as long as I could sell the car for more than its variable cost, I'm better off selling it," Sedatole says. But, she adds, "that's a very, very short-term way of thinking" because it neglects the costs that come with having a lot of excess inventory.

    Lessons Learned Using absorption costing to monitor efficiency can lead companies to make poor production decisions, says Ranjani Krishnan, professor of accounting at Michigan State and a co-author of the study (along with Alexander Brüggen, an associate professor at Maastricht University). A company that does this could seem to be growing less efficient when demand decreases. If a factory makes fewer cars this year than last year, for instance, its cost per car will look higher, and it may then overproduce in order to present itself more favorably to shareholders, consumers, and analysts.

    Instead, Krishnan suggests, companies should record the cost of excess capacity as an expense on their internal income statements, a practice that may help give them perspective.

    Another way to avoid overproduction is to change the way executives are paid. Like many companies, the automakers put their managers under pressure to deliver in the short term by structuring compensation incentives around metrics like labor hours per vehicle, which the industry's Harbour Report uses to compare automaker productivity. With fixed labor hours, the only way to look more efficient under this measure is to produce more cars.

    "A lot of this behavior was frankly driven by greed," says Krishnan. "If you look at the type of managerial incentives [the automakers] had during the time of our study, the executive-committee deliberations, it was all about meeting short-term quarterly traffic numbers or meeting analysts' forecasts so that they could get their bonuses."

    Continued in article

    Bob Jensen's threads on cost and managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    A grandmother who "oversees a team of 13 who track every penny spent
    on the massive effort [to fight California's wildfires] --- Cost Accounting

    From The Wall Street Journal Accounting Weekly Review on September 17, 2009

    In Fighting Wildfires, They Also Serve Who Keep the Books
    by Tamara Audi
    Sep 16, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Cost Accounting, Cost Management, Cost-Basis Reporting, Governmental Accounting

    SUMMARY: The story details the activities of a grandmother who "oversees a team of 13 who track every penny spent on the massive effort [to fight California's wildfires], from a rolling medical center ($2,900 a day), to an outdoor bank of 12 sinks ($2,600 a day). They also make sure every firefighter is paid. The bean counters live and work alongside firefighters in sprawling fire camps, sleeping, waking before dawn and showering in a tractor-trailer."

    CLASSROOM APPLICATION: The article highlights an unusual accounting position and can be used to help students in introductory accounting classes to think about the ways that all talents can be used in emergencies and volunteer service.

    QUESTIONS: 
    1. (Introductory) Why is an accounting function, or 'bean counter' to use the derogatory term, needed in fighting California's wildfires?

    2. (Introductory) What expenditures are the accounting clerks controlling?

    3. (Introductory) What revenues are used to cover those expenditures?

    4. (Advanced) How do the accountants use the records maintained to determine which revenues must be allocated to cover which costs?

    5. (Advanced) Do you think you would be able to volunteer services in this way? Why or why not?

    Reviewed By: Judy Beckman, University of Rhode Island

    "In Fighting Wildfires, They Also Serve Who Keep the Books:  Mrs. Fork's Band of Bean Counters Lives, Works in Firefighter Camps; 'Mommy, Nana's at a Fire'," by Tamara Audi, The Wall Street Journal, September 16, 2009 ---
    http://online.wsj.com/article/SB125304485991513201.html?mod=djem_jiewr_AC

    Hours before sunrise, Teresa Fork rolled out of her tent, laced up her boots and got to work on the biggest fire in Los Angeles County history.

    There were glitches to fix in a new expense-tracking computer program, two land-use contracts to renegotiate and a colorful pie chart to review.

    Mrs. Fork is in fire finance.

    Since it erupted on Aug. 26, the Station fire -- named for the Angeles National Forest ranger station near where it started -- has consumed 160,577 acres and $95.9 million. At the fire's peak, more than 4,500 firefighters and support people from as far away as Tennessee were working on it. As of Tuesday, the fire was 91% contained and firefighters were hoping to extinguish it by Saturday.

    Hundreds of firefighters hacked through the wilderness to create firebreaks and beat back the blaze at its southern edge in order to protect houses. Two firefighters were killed; thousands of homes were evacuated. A menacing plume of white smoke hung over Los Angeles for days, and flames created an ominous orange glow just beyond the city.

    Back at fire base camp, Mrs. Fork's U.S. Forest Service team calculated the laundry bill. On Sept. 5, 1,914 pounds of clothes were washed, at a cost of $1 a pound, plus $2,150 a day for washers and dryers.

    Mrs. Fork oversees a team of 13 who track every penny spent on the massive effort, from a rolling medical center ($2,900 a day), to an outdoor bank of 12 sinks ($2,600 a day). They also make sure every firefighter is paid. The bean counters live and work alongside firefighters in sprawling fire camps, sleeping in tents, waking before dawn and showering in a tractor-trailer.

    "Long after the fire is out, you'll still be dealing with the finance side," said Station fire commander Mike Dietrich. "Bills have to be paid. And you have to figure out who's paying."

    On the Station fire, finances are especially complicated. A big map in a finance trailer shows green straight lines outlining the boundary of the Angeles National Forest, which is the responsibility of the U.S. Forest Service. A jagged black line shows the fire, which has spilled outside the forest and into county, city and state territories. Who pays often depends on where the fire is burning.

    With dozens of crews from different agencies, untangling the fire's cost requires some intricate accounting. Moreover, local fire departments facing tight budgets are eager to collect for their services. For example, Los Angeles sent an ambulance to the fire camp and the U.S. Forest Service agreed to reimburse the city.

    California has already burned through $123.7 million of its $182 million fire-suppression budget for the 2009-10 fiscal year. It plans to get some of that money back through grants from the federal government.

    Mrs. Fork trudges through dusty, mostly male fire camps wearing glasses and a gold heart pendant around her neck that says "Nana" -- a gift from her 5-year-old grandson. One of her chores is getting the exhausted, soot-covered firefighters to fill out time cards as they exit a burning forest. Many are from federal "hotshot" crews -- firefighters dropped into the hottest and most dangerous fire zones.

    "These are our problem children," she says, pointing to a white poster board with a list of names written in black marker -- firefighters who have not filled out time cards, or whose handwriting is difficult to read.

    Nathan Stephens, captain of the Blue Ridge hotshot crew based in Happy Jack, Ariz., stepped into the finance trailer fresh off the fire line to fill out time cards for his crew. His face was coated with ash from three days in the burning wilderness, where the crew slept in "the black" -- burnt-out areas close to the active fire.

    For many firefighters and private contractors, fire season is an economic lifeline. "Our time and pay is pretty much the most important thing for my crew," said Mr. Stephens. Federal firefighter salaries range from around $12 an hour to more than $22. Many firefighters work just part of the year. "We don't really make a whole lot of money so we look forward to the overtime through the summer," he said.

    Each firefighter on Mr. Stephens's crew of 22 made 125 hours of overtime fighting the Station fire, Mr. Stephens said.

    "I wasn't thinking about cost or anything like that when I was out there cutting a line and sleeping by the fire. You're hot, you're sweaty, you're tired," said Kim Ann Parsons, who has fought forest fires herself and now generates the daily pie chart breaking down costs. As of Tuesday, $14.8 million, or 15% of the total budget, has been spent on aircraft.

    The finance team is at times exposed to hazards when fire has roared close to their camps. In case they need to flee quickly, they keep all the files in storage containers near the door. Like the thousands of firefighters at the Station camp, the finance team sleeps in tents crowded over the vast lawn of the Santa Fe Dam Recreation Area. Ants have been a problem lately.

    Continued in article

    Jensen Comment
    Without trying to throw a wet blanket over Grandma Fork's efforts, she does face the daunting task of dealing with the systemic problems of accounting, particularly joint and indirect costs --- http://faculty.trinity.edu/rjensen/FraudConclusion.htm#BadNews

    • Systemic Problem:  All Aggregations Are Arbitrary
    • Systemic Problem:  All Aggregations Combine Different Measurements With Varying Accuracies
    • Systemic Problem:  All Aggregations Leave Out Important Components
    • Systemic Problem:  All Aggregations Ignore Complex & Synergistic Interactions of Value and Risk
    • Systemic Problem:  Disaggregating of Value or Cost is Generally Arbitrary
    • Systemic Problem:  Systems Are Too Fragile
    • Systemic Problem:  More Rules Do Not Necessarily Make Accounting for Performance More Transparent
    • Systemic Problem:  Economies of Scale vs. Consulting Red Herrings in Auditing
    • Systemic Problem:  Intangibles Are Intractable

     


    Question
    What are banks doing creatively to hide their non-performing loans in the 21st Century?

    Smells like old wine in new bottles.

    Banks Find New Ways to East Pain of Bad Loans
    by David Enrich
    The Wall Street Journal

    Jun 19, 2008
    Page: C1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB121383327218786693.html?mod=djem_jiewr_AC
     

    TOPICS: Business Ethics, Ethics, GAAP

    SUMMARY: Banks are revising internal accounting policies to mask their troubles. The maneuvers are legal but could deepen suspicion about the sector.

    CLASSROOM APPLICATION: This article illustrates how a company can change its policies and the resulting impact of those changes on the company's accounting records. Sometimes those actions violate GAAP, but in the situations presented in the article, the changes are perfectly legal. The bad part of these actions is that those changes can present a very different picture of the banks' financial condition to the users of the financial statements.

    QUESTIONS: 
    1. (Advanced) What did these companies change that resulted in changes to their financial statements?

    2. (Advanced) Why are these changes allowed, even though they cause differences on the financial statements?

    3. (Introductory) Do the policy changes result in a permanent change over time on the financial statements? Why or why not?

    4. (Introductory) What is the regulatory impact of moving some loans to a new subsidiary? What is the impact on the financial statements? Why are these different?

    5. (Advanced) What are the public relations issues involved with these kinds of actions? Should the banks be concerned? Why or why not?

    6. (Advanced) What are the ethics of the actions of the banks in this article? What would be the ethical way to handle this reporting? If the reporting as stated is acceptable, should the banks add any additional information to the notes to the financial statement? If not, why not? If so, what should be added?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

     

    "Banks Find New Ways To Ease Pain of Bad Loans," by David Enrich, The Wall Street Journal,  June 19, 2008; Page C1 --- http://online.wsj.com/article/SB121383327218786693.html?mod=djem_jiewr_AC

    In January, Astoria Financial Corp. told investors that its pile of nonperforming loans had grown to about $106 million as of the end of last year. Three months later, the thrift holding company said the number was just $68 million.

    How did Astoria do it? By changing its internal policy on when mortgages are classified on its books as troubled. The Lake Success, N.Y., company now counts home loans as nonperforming when the borrower misses at least three payments, instead of two.

    Astoria says the change was made partly to make its disclosures on shaky mortgages more consistent with those of other lenders. An Astoria spokesman didn't respond to requests for comment. But the shift shows one of the ways lenders increasingly are trying to make their real-estate misery look not quite so bad.

    From lengthening the time it takes to write off troubled mortgages, to parking lousy loans in subsidiaries that don't count toward regulatory capital levels, the creative maneuvers are perfectly legal.

    Yet they could deepen suspicion about financial stocks, already suffering from dismal investor sentiment as loan delinquencies balloon and capital levels shrivel with no end in sight.

    "Spending all the time gaming the system rather than addressing the problems doesn't reflect well on the institutions," said David Fanger, chief credit officer in the financial-institutions group at Moody's Investors Service, a unit of Moody's Corp. "What this really is about is buying yourself time. ... At the end of the day, the losses are likely to not be that different."

    Still, as long as the environment continues to worsen for big and small U.S. banks, more of them are likely to explore such now-you-see-it, now-you-don't strategies to prop up profits and keep antsy regulators off their backs, bankers and lawyers say.

    At Wells Fargo & Co., the fourth-largest U.S. bank by stock-market value, investors and analysts are jittery about its $83.6 billion portfolio of home-equity loans, which is showing signs of stress as real-estate values tumble throughout much of the country.

    Until recently, the San Francisco bank had written off home-equity loans -- essentially taking a charge to earnings in anticipation of borrowers' defaulting -- once borrowers fell 120 days behind on payments. But on April 1, the bank started waiting for up to 180 days.

    'Out of Character'

    Some analysts note that the shift will postpone a potentially bruising wave of losses, thereby boosting Wells Fargo's second-quarter results when they are reported next month. "It is kind of out of character for Wells," says Joe Morford, a banking analyst at RBC Capital Markets. "They tend to use more conservative standards."

    Wells Fargo spokeswoman Julia Tunis says the change was meant to help borrowers. "The extra time helps avoid having loans charged off when better solutions might be available for our customers," she says. In a securities filing, Wells Fargo said that the 180-day charge-off standard is "consistent with" federal regulatory guidelines.

    BankAtlantic Bancorp Inc., which is based in Fort Lauderdale, Fla., earlier this year transferred about $100 million of troubled commercial-real-estate loans into a new subsidiary.

    That essentially erased the loans from BankAtlantic's retail-banking unit. Since that unit is federally regulated, BankAtlantic eventually might have faced regulatory action if it didn't substantially beef up the unit's capital and reserve levels to cover the bad loans.

    Because the BankAtlantic subsidiary that holds the bad loans isn't regulated, it doesn't face the same capital requirements. But the new structure won't insulate the parent company's profits -- or shareholders -- from losses if borrowers default on the loans, analysts said.

    Alan Levan, BankAtlantic's chief executive, declined to comment on how much the loan transfer bolstered the regulated unit's capital levels. "The reason for doing it is to separate some of these problem loans out of the bank so that they can get special focus in an isolated subsidiary," he said.

    Other lenders have been considering the use of similar "bad-bank" structures as a way to cleanse their balance sheets of shaky loans. In April, Peter Raskind, chairman and CEO of National City Corp., said the Cleveland bank "could imagine...several different variations of good-bank/bad-bank kinds of structures" to help shed problem assets.

    Two banks that investors love to hate, Wachovia Corp. and Washington Mutual Inc., troubled some analysts by using data from the Office of Federal Housing Enterprise Oversight when they announced first-quarter results. Other lenders rely on a data source that is more pessimistic about the housing market.

    Charter Switch

    Another eyebrow raiser: switching bank charters so that a lender is scrutinized by a different regulator.

    Last week, Colonial BancGroup Inc., Montgomery, Ala., announced that it changed its Colonial Bank unit from a nationally chartered bank to a state-chartered bank, effective immediately.

    That means the regional bank no longer will be regulated by the Office of the Comptroller of the Currency, which has become increasingly critical of banks such as Colonial with heavy concentrations of loans to finance real-estate construction projects.

    Instead, Colonial's primary regulators now are the Alabama Banking Department, also based in Montgomery, and the Federal Deposit Insurance Corp. The change probably "is meant to distance [Colonial] from what is perceived as the more aggressive and onerous of the bank regulators," said Kevin Fitzsimmons, a bank analyst at Sandler O'Neill & Partners.

    Colonial spokeswoman Merrie Tolbert denies that. Being a state-chartered bank "gives us more flexibility" and will save the company more than $1 million a year in regulatory fees, she said.

    Trabo Reed, Alabama's deputy superintendent of banking, said his examiners won't give Colonial a free pass. "There's not going to be a significant amount of difference" between the OCC and state regulators, he says.

     


    From The Wall Street Journal Accounting Weekly Review on May 19, 2006

    TITLE: With Special Effects the Star, Hollywood Faces New Reality
    REPORTER: Merissa Marr and Kate Kelly
    DATE: May 12, 2006
    PAGE: A1
    LINK: http://online.wsj.com/article/SB114739949943750995.html 
    TOPICS: Accounting, Budgeting, Cost-Volume-Profit Analysis, Managerial Accounting

    SUMMARY: Special effects are driving a lot of movies to become box office hits. However, "in the area of special effects, technology can't deliver the kind of efficiencies to Hollywood that it generally provides to other industries...Amid the excitement, studios are beginning to realize that relying on special effects is financially risky. Such big budget films tend to be bonanzas or busts."

    QUESTIONS:
    1.) The author notes that studios are beginning to realize that films utilizing a lot of special effects might tend to be "bonanzas or busts." In terms of costs, why is this the case? In your answer, refer to the high level of costs associated with special effects work.

    2.) Why do special effects teams tend to amass significant costs? In your answer, define the terms "cost management" and "costs of quality" and explain how these cost concepts, that are typically associated with product manufacturing, can be applied to movie production.

    3.) Define the term "fixed cost." How does this concept relate to the financial riskiness of movies with significant special effects and resultant high cost? Also include in your answer a discussion of the formula for breaking even under cost-volume-profit analysis.

    4.) Define the term "variable cost." Cite some examples of variable costs you expect are incurred by studios such as Sony Pictures, Universal Pictures, and others.

    5.) Now consider firms such as Industrial Light & Magic, "a company set up by director George Lucas in 1975 to handle the special effects for his 'Star Wars' movies." Based on the discussion in the article, describe what you think are these firms' fixed and variable costs.

    6.) What manager do you think is responsible for costs of quality and cost control in producing movies? Suppose you are filling that role. What steps would you undertake to ensure that your hoped-for blockbuster film will have the greatest possible chance of financial success?

    Reviewed By: Judy Beckman, University of Rhode Island


    Casino Accounting:  The All Events Test Versus The Economic Performance Test

    "FASB Hits the Jackpot:  Question While casinos are only a small percentage of U.S. business, an update to an accounting rule on jackpots brings a welcome degree of uniform practice to accrual accounting," by Robert Willens, CFO.com,  May 10, 2010 ---
    http://www.cfo.com/article.cfm/14497136/c_14497565?f=home_todayinfinance

    There is apparently a wide diversity in practice regarding the manner in which a casino operator accounts for slot-machine and other jackpots. With the issuance of Accounting Standards Update No. 2010-16, Accounting for Casino Jackpot Liabilities, the Financial Accounting Standards Board has introduced a welcome degree of uniformity to this issue.

    The ASU provides that an entity shall accrue a liability, and charge a jackpot, at the time the entity has the obligation to pay the jackpot. Some slot machines, the ASU notes, may contain "base" jackpots. An entity may be able to avoid the payment of a base jackpot, for example, by removing the machine from play. Accordingly, no liability associated with the base jackpot is recognized in such cases until the entity has the obligation to pay the base jackpot. This is the case even if the entity has no plan or intention of removing the machine from play and fully expects the base jackpot to be won.

    Some slot machines include "progressive" jackpots. Those are machines in which the value of the jackpot increases with every game played. Entities in many gaming jurisdictions cannot avoid payment of the portion of the progressive jackpot that is incremental to the base jackpot. That's because the gaming regulators consider such incremental portions of prizes to be funded by customers, and therefore are required to be paid out. In these cases, the incremental portion of the jackpot should be accrued as a liability at the time of funding (that is, play) by its customers.

    These rules will be operative with respect to fiscal years (and interim periods within such fiscal years) beginning on or after December 15, 2010. Moreover, an entity shall apply this guidance with a "cumulative effect" adjustment recorded in retained earnings in the period of adoption of such guidance.

    Tax Accounting for Jackpots When does the jackpot liability accrue for tax purposes? This issue was addressed by the Supreme Court in United States v. Hughes Properties, Inc., 476 US 593 (1986). There, the taxpayer owned and operated slot machines at its casinos, including a number of progressive machines. A progressive machine pays a fixed amount when certain symbol combinations appear on its reels. But a progressive machine has an additional progressive jackpot which is won only when a different combination of symbols appears. The casino initially sets these jackpots at a minimal amount. The figure increases, progressively, as money is gambled on the machine. The amount of the jackpot at any given time is registered on a "payoff indicator" on the face of the machine.

    At the conclusion of each fiscal year, the taxpayer entered the total of the progressive-jackpot amounts shown on the payoff indicators as an accrued liability. From that total, it subtracted the corresponding figure for the preceding year to produce the current year's increase in accrued liability. On its tax return, the taxpayer asserted this net figure as a deduction. The Internal Revenue Service disallowed the deduction. In its view, the taxpayer's obligation to pay a progressive jackpot "matures" only upon a winning patron's "pull of the handle" in the future. From the perspective of the IRS, until that event occurs, the taxpayer's liability is merely contingent. However, both the Claims Court and the Court of Appeals for the Federal Circuit ruled in favor of the taxpayer. The Supreme Court sided with the taxpayer as well.

    The All-Events Test
    The high court noted that an accrual-method taxpayer is entitled to deduct an expense in the year in which it is incurred. The standard for determining when an expense is incurred is the so-called all-events test: all the events must have occurred that establish the fact of the liability, and the amount must be capable of being determined with "reasonable accuracy." So to satisfy the all-events test, a liability must be "final and definite" in amount, "fixed and absolute," and "unconditional."1

    The IRS argued that the taxpayer's liability for the progressive jackpots was not "fixed and certain" and was not "unconditional or absolute" by the end of the fiscal year, for there existed no person who could assert any claim over those funds. It took the position that the indispensable event is the winning of the jackpot by a gambler.2

    The effect of the Nevada Gaming Commission's regulations3 was to fix the taxpayer's liability. The regulations forbade reducing the indicated payoff without paying the jackpot. The taxpayer's liability — that is, its obligation to pay the indicated amount — was not contingent. That an extremely remote and speculative possibility existed that the jackpot might never be won does not change the fact that, as a matter of state law, the taxpayer had a fixed liability for the jackpot that it could not escape.

    The IRS, the court concluded, misstates the need for identification of a winning player. That is a matter "of no relevance" for the casino operator. The obligation is there, and whether it turns out that the winner is one patron or another makes no conceivable difference as to basic liability. In fact, the court acknowledged that there is always the possibility that a casino may go out of business with the result that the amount shown on the jackpot indicators would never be won. However, this potential nonpayment of an incurred liability exists for every business that uses an accrual method, and it does not prevent accrual. "The existence of an absolute liability is necessary; absolute certainty that it will be discharged by payment is not...." 4

    The Economic Performance Test
    However, under the law that exists today, a liability is not incurred until the historical all-events test is satisfied and "economic performance" occurs with respect to the liability. As a result, the all-events test cannot be met with respect to an item any earlier than the time that economic performance occurs with respect to the item.5

    Continued in article

     


    "Biased Expectations:  Can Accounting Tools Lead To, Rather Than Prevent, Executive Mistakes," Knowledge@Wharton,  March 19, 2008
    http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=9a30c173f4042b274364?articleid=1922 

    Accounting techniques like budgeting, sales projections and financial reporting are supposed to help prevent business failures by giving managers realistic plans to guide their actions and feedback on their progress. In other words, they are supposed to leaven entrepreneurial optimism with green-eye-shaded realism.

    At least that's the theory. But when Gavin Cassar, a Wharton accounting professor, tested this idea, he found something troubling: Some accounting tools not only fail to help businesspeople, but may actually lead them astray. In one of his recent studies, forthcoming in Contemporary Accounting Research, Cassar showed that budgeting didn't help a group of Australian firms accurately forecast their revenues. In a second paper,he found that the preparation of financial projections added to aspiring entrepreneurs' optimism, leading them to overestimate their subsequent levels of sales and employment.

    "It's been shown in many studies that people are overly optimistic," Cassar says. "What's interesting here is that, when you use the accounting tools, the optimism is even more extreme. This suggests that using the tools, which a lot of academics and government agencies say is good practice, can lead to even bigger mistakes."

    He is not suggesting that anyone ignore accounting activities and techniques. Investors and regulators expect firms to implement robust accounting systems. And they should, he says, because financial reports provide a detailed map of a business and its performance. But Cassar believes that businesspeople -- especially entrepreneurs, who bet both their reputations and personal wealth on their ventures -- should understand the limitations of accounting estimates as well as how common human tendencies, like optimism, can lead to their misinterpretation.

    Cassar's first study, titled "Budgets, Financial Reports and Manager Forecast Accuracy," set out to the test the usefulness of some basic tools in the accounting kit. It sprang from his work experience before he attended graduate school, when, as an accountant for a builder in his native Australia, he watched the company's gradual decline into bankruptcy. "My first job was as a financial and managerial accountant for a civil construction firm," he says. "My second, 18 months later, was working for the [bankruptcy] receiver of that same company."

    On review, the firm's accountants had seemed to do everything right. They had prepared budgets and put systems in place to get timely performance reports that could then be factored into the company's future budgets and plans. As two big highway jobs foundered, the losses showed up promptly in the monthly reports. Even so, company executives failed to take remedial action. "The project managers said that the losses would turn around, but they didn't," Cassar says. "On both those jobs, they went over budgeted costs by 50%. Those two jobs resulted in the demise of that company."

    But it wasn't the accounting systems that were the problem. It was the users. "No one would take responsibility because the cost of doing that was losing your job," Cassar says. "The irony is that, in the end, everyone lost their jobs."

    Cassar's study enabled him to assess whether budgeting and internal reporting have helped other firms more than they did his former employer. He examined a group of about 4,000 companies, all with less than 200 employees, surveyed by the Australian Bureau of Statistics. Managers of these firms were asked whether they prepared budgets and internal reports and also were asked to provide revenue forecasts and in future years were asked to provide subsequent performance. The agency followed the firms over four years. Thus its data showed how close they came to meeting their forecasts.

    Cassar suspected that doing either budgets or internal reports -- or, better yet, both -- might improve a company's forecasts. "The presence in a firm of a budget preparation activity should result in improved forecast accuracy because the systematic collection of a broad range of information should allow for a more accurate assessment of future performance," write Cassar and his co-author, Brian Gibson, an accounting professor at Australia's University of New England. "However, budgeting in itself may not improve forecasting accuracy, because budgeting without internal reporting is a meaningless formal control system."

    When Cassar and Gibson crunched the numbers, their prediction was borne out: The impact of budgeting alone was trivial, improving forecast accuracy by less than 2%. But internal reporting made a real difference, improving accuracy by about 8.5%. And used together, the two techniques improved forecast accuracy even more, by about 12%. "Collectively these results suggest that internal accounting report preparation improves forecast accuracy. In addition, although the accuracy benefits from budget preparation appear limited, the improvement is greater when both budget preparation and internal account reporting are used," Cassar and Gibson write.

    What's more, the firms that saw the most improvement in their forecasts were ones that operated in the most uncertain environments, as measured by the variability of revenue. Arguably, these firms most needed the guidance.

    Cassar's second study, titled "Are Individuals Entering Self-Employment Overly-Optimistic? An Empirical Test of Plans and Projections on Nascent Entrepreneur Expectations," built on the findings of his first one. Here, he wasn't interested in whether accounting tools merely helped entrepreneurs; he wanted to know whether they could distort their thinking.

    His curiosity grew partly from his knowledge of the field of behavioral economics, which marries the insights and methods of psychology and economics. Behavioralists have documented a number of mental shortcuts and biases that can lead people to depart from the logic that traditional economic orthodoxy would suggest. One of the concepts, for example, introduced by Nobel Laureate Daniel Kahneman and co-author Dan Lovallo, is that "an inside view" can distort decision making. A person who adopts an inside view becomes so focused on formulating his particular plan that he neglects to consider critical outside information, like other people's experiences in pursuing the same goal.

    "Individuals form an inside view forecast by focusing on the specifics of the case, the details of the plan that exists and obstacles to its completion, and by constructing scenarios of future progress," Cassar summarizes. "In contrast, an outside view is statistical and comparative in nature and does not involve any attempt to divine the future at any level of detail."

    Doing financial projections for an entrepreneurial venture, Cassar realized, entails the creation of an inside view. The entrepreneur builds a storyline of success in her head and then plays it out in her spreadsheet, showing rising sales year after year. "Humans are good at storytelling and building causal links," Cassar notes. "They think, 'I'll go to college, I'll write a business plan, I'll raise some capital and then I'll go public or sell out to a big competitor.' There's a probability attached to each of these steps, but they don't think about that. They put all the links together and evaluate the likelihood of success at a much higher probability than is realistic."

    Consider the approximately 400 aspiring U.S. entrepreneurs whom Cassar studied. On average, they believed that their ideas had about an 80% likelihood of becoming viable ventures, though only half actually ended up becoming businesses. Of the entrepreneurs who realized their plans, about 62% overestimated their first-year sales, and about 46% overestimated what their employment would be at the end of year one. Employment, unlike sales, implies both costs and benefits, perhaps explaining the lower jobs figure, Cassar notes. As a company grows it needs more employees, but it also has to pay them.

    So far, none of this seems radical. Yes, entrepreneurs are optimistic. They have to be if they are undertaking the risks of starting a business. But when Cassar started to sort through the entrepreneurs' use of common accounting and planning techniques, he uncovered surprises.

    People who did financial projections were the most likely to overestimate the future sales of their ventures. In other words, "the same management activities that entrepreneurs rely on to cope with uncertainty appear to be causing individuals to hold optimistic expectations," he writes. Interestingly, writing a business plan also led to optimism about the likelihood of success, but it didn't lead to overly optimistic expectations because it's also "positively associated with the likelihood that the nascent activity will become an operating venture," he adds. Put another way, people who write plans are more likely to start companies, thereby justifying their optimism.

    One group turned out to be more realistic than the others -- entrepreneurs who had received money from real sales. "This demonstrates the benefit of actually making sales in improving the rationality of financial sales expectations," Cassar notes.

    Despite his findings, Cassar doesn't believe that aspiring entrepreneurs should abandon financial projections. For one thing, investors, particularly venture capitalists, wouldn't allow that; they expect firms in which they invest to do projections, if only because it demonstrates a command of the basics of budgets and accounting. For another, Cassar believes that preparing projections helps entrepreneurs understand the drivers of profitability in their businesses and the dynamics of their industries.

    But he says that entrepreneurs need to understand the ways in which accounting tools may subvert their thinking. "Acknowledging how management practices bias expectations may allow decision makers to use organizational or decision making controls to reduce this influence," he writes. "For example, generating reasons why the planned outcome may not be achieved or consciously relating past experiences to the forecasting task at hand are approaches individuals can take to reduce overly optimistic or overconfident forecasts."

    Cassar hasn't studied them, but he suspects that venture capitalists might be better than entrepreneurs at viewing financial projections with the appropriate skepticism. Because they see hundreds, even thousands, of business plans a year, they tend to take an outside view.

    "Very good VCs are good at picking winners because they know what the risks are," he says. "A lot of VCs, when they go through business plans, think, 'What are the drivers of value creation and what's the scope of their upsides? And what are the fundamental threats that the entrepreneur isn't focusing on because it's not in his interest to do so?'"

    Based on his own experience, Cassar sees "many benefits from managers and entrepreneurs using accounting techniques." However, he adds, "it is important to recognize that financial projections of success are merely projections based on beliefs, which are sometimes based on overconfident or optimistic assumptions. Using these accounting tools may actually exacerbate, rather than dampen, these tendencies."


    FAS 163 "Accounting for Financial Guarantee Insurance Contracts"--- http://www.fasb.org/pdf/fas163.pdf

    From the AccountingWeb on May 27, 2008 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=105224

    Last week The Financial Accounting Standards Board (FASB) issued FASB Statement No. 163, Accounting for Financial Guarantee Insurance Contracts. The new standard clarifies how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. It also requires expanded disclosures about financial guarantee insurance contracts. The Statement is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise's risk-management activities. Disclosures about the insurance enterprise's risk-management activities are effective the first period beginning after issuance of the Statement. "By issuing Statement 163, the FASB has taken a major step toward ending inconsistencies in practice that have made it difficult for investors to receive comparable information about an insurance enterprise's claim liabilities," stated FASB Project Manager Mark Trench. "Its issuance is particularly timely in light of recent concerns about the financial health of financial guarantee insurers, and will help bring about much needed transparency and comparability to financial statements."

    The accounting and disclosure requirements of Statement 163 are intended to improve the comparability and quality of information provided to users of financial statements by creating consistency, for example, in the measurement and recognition of claim liabilities. Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. It also requires disclosure about (a) the risk-management activities used by an insurance enterprise to evaluate credit deterioration in its insured financial obligations and (b) the insurance enterprise's surveillance or watch list.


    Questions
    Is there a problem with how GAAP covers one's Fannie?
    Would fair value accounting help in this situation?

    "Fannie Execs Defend Accounting Change Friday," by Marcy Gordon, Yahoo News, November 16, 2007 --- http://biz.yahoo.com/ap/071116/fannie_mae_accounting.html 

    Fannie Mae executives on Friday defended a change in the way the mortgage lender discloses losses on home loans amid concern from analysts that it could mask the true impact of the credit crisis on its bottom line.

    The chief financial officer and other executives of the government-sponsored company, which reported a $1.4 billion third-quarter loss last week, held a conference call with Wall Street analysts to explain the recent change.

    Analysts peppered the executives with questions in a skeptical tone. The way Fannie discloses its mortgage losses, addressed in an article published online by Fortune, raises extra concern among analysts given that Fannie Mae was racked by a $6.3 billion accounting scandal in 2004 that tarnished its reputation and brought government sanctions against it.

    Moreover, the skepticism from Wall Street comes as Fannie seeks approval from the government to raise the cap of its investment portfolio.

    The chief financial officer, Stephen Swad, said in the call that some of the $670 million in provisions for credit losses on soured home loans that Fannie Mae wrote off in the third quarter likely would be recovered.

    "We book what we book under (generally accepted accounting principles) and we provide this disclosure to help you understand it," Swad said.

    Shares of Fannie Mae fell $4.30, or 10 percent, to $38.74 on Friday, following a 10 percent drop the day before.

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's threads on Fannie Mae's enormous problem (the largest in history that led to the firing of KPMG from the audit and a multiple-year effort to restate financial statemetns) with applying FAS 133 --- http://faculty.trinity.edu/rjensen/caseans/000index.htm#FannieMae

     


     



    Honda Says Fuel-Cell Cars Face Hurdles
    by Yoshio Takahashi
    The Wall Street Journal

    Jun 17, 2008
    Page: B4
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB121364017994578203.html?mod=djem_jiewr_AC
     

    TOPICS: Cost Management, Managerial Accounting, Product strategy

    SUMMARY: Honda Motor. Co. "...obtained the world's first certification for fuel-cell cars in the U.S. in 2002." Its president, Takeo Fukui, "...said prices have to fall further for fuel-cell cars to reach the mass market, even as the Japanese car maker unveiled the latest generation of fuel-cell vehicle."

    CLASSROOM APPLICATION: Management accounting and MBA course instructors may use this article to discuss the impact of fixed costs on pricing and product development. Most interestingly, this article identifies interrelationships between lines of two industries--automobile manufacturing and fueling stations--that can be used to discuss strategic investments.

    QUESTIONS: 
    1. (Introductory) What is the difference between a fuel-cell automobile and hybrid automobiles?

    2. (Introductory) Why is Honda developing these fuel-cell vehicles if it can't yet mass-market them? What factors are limiting the ability to mass market the vehicles?

    3. (Advanced) Why are fixed production costs higher if a car maker cannot mass produce the vehicle? In your answer, define the terms "fixed costs" and "barriers to entry".

    4. (Introductory) What variable production costs, identified in the article, are at issue in this case? What strategies can be undertaken to reduce those costs?

    5. (Advanced) Suppose you are Honda's president. What strategic choices in investment would you make to advance this line of Honda's business?

    6. (Advanced) Refer to your answer to question 4. What types of investments might you make? How might a financing entity be used to help make those strategic investments?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Honda Says Fuel-Cell Cars Face Hurdles Prices Have to Fall For Autos to Reach The Mass Market," by Yoshio Takahashi, The Wall Street Journal, June 17, 2008; Page B4 --- http://online.wsj.com/article/SB121364017994578203.html?mod=djem_jiewr_AC

    TOCHIGI, Japan -- Honda Motor Co. President Takeo Fukui said prices have to fall further for fuel-cell cars to reach the mass market, even as the Japanese car maker unveiled the latest generation of fuel-cell vehicle.

    Fuel-cell cars are considered the most promising pollution-free vehicles, as they are powered through a chemical reaction between hydrogen and oxygen, and emit only water as a byproduct.

    But low-emission cars such as gasoline-electric hybrids and diesel vehicles are more popular now. A lack of hydrogen service stations, among other factors, is limiting demand for the cars, and therefore car makers can't mass produce them, keeping production costs high.

    Honda said Monday that it will begin leasing the third generation of a fuel-cell model called FCX Clarity in the U.S. in July. The company plans to lease the new zero-emission car in Japan this autumn.

    Mr. Fukui said the new fuel-cell car costs tens of millions of yen, significantly less than the several hundred million yen it cost to make previous models. The price would need to fall to below 10 million yen, or about $92,000, for fuel-cell cars to be a mass-market product, he said.

    "I think it wouldn't take 10 years" for his company to slash the price of its fuel-cell car to this level, he said.

    To cut the price, the company especially needs to reduce the use of expensive precious metals and address the costliness of the hydrogen fuel tank, he said.

    Honda, Japan's second-biggest car maker by sales volume, aims for combined lease sales of 200 vehicles of the latest fuel-cell model for the U.S. and Japan within three years. The lease fee is $600 a month in the U.S. The company hasn't disclosed the fee in Japan.

    Honda, which obtained the world's first certification for fuel-cell cars in the U.S. in 2002, is a leading maker of such vehicles and has been competing in the development of the advanced car with rivals such as Toyota Motor Corp. and General Motors Corp.

     


    Question
    When should warranty expenses be deducted all at once in a big bath rather than deferred like bad debt expenses in an Allowance for Future Warranty Expenses contra account?

    First Consider Some Problems of Estimation

    Speech by SEC Staff: Critical Accounting and Critical Disclosures
    by Robert K. Herdman
    Chief Accountant U.S. Securities and Exchange Commission
    Speech Presented to the Financial Executives International —
    San Diego Chapter, Annual SEC Update
    San Diego, California January 24, 2002
    http://www.sec.gov/news/speech/spch537.htm

    Product Warranty Example For balance, let me go through an example of a manufacturer's warranty reserve. Consider a company that manufactures and sells or leases equipment through a network of dealerships. The equipment carries a warranty against manufacturer defects for a specified period and amount of use. Provisions for estimated product warranty expenses are made at the time of sale.

    Significant estimates and assumptions are required in determining the amount of warranty losses to initially accrue, and how that amount should be subsequently adjusted. The manufacturer may have a great deal of actual historical experience upon which to rely for existing products, and that experience can provide a basis to build its estimate of potential warranty claims for new models or products.

    Necessarily, management must make certain assumptions to adjust the historical experience to reflect the specific uncertainties associated with the new model or product. These assumptions about the expected warranty costs can have a significant impact on current and future operating results and financial position.

    In this example, investors may benefit from a clear description of such items as the nature of the costs that are included in or excluded from the liability measurement, how the estimation process differs for new models/product lines versus existing or established models and products, and the company's policies for continuously monitoring the warranty liability to determine its adequacy.

    In terms of sensitivity, investors would benefit from understanding what types of historical events led to differences between estimated and actual warranty claims or that resulted in a significant revisions to the accrual. For example, an investor could benefit from understanding if a new material or technique had recently been introduced into the manufacturing of the equipment and historically such changes have resulted in deviations of actual results from those previously expected. Similarly, if warranty claims tend to exceed estimates, say, if actual temperatures are higher or lower than assumed, that fact may also be relevant to investors.

    Obviously these examples don't address all of the possible scenarios. While each company will have differing critical accounting policies, the key points for everyone are to identify for investors the 1) types of assumptions that underlie the most significant and subjective estimates; 2) sensitivity of those estimates to deviations of actual results from management's assumptions; and 3) circumstances that have resulted in revised assumptions in the past. There is a great deal of flexibility in providing this information and some may choose to disclose ranges of possible outcomes.

    Continued in article

    Now Roll Ahead to Microsoft's Big Problem With Warranties in Year 2007

    Microsoft's Billion Dollar Attempted Fix
    Why isn't the need for this surprising from a company that almost always releases products in need of fixing before they're out of the box?

    In the face of staggering customer returns of the Xbox 360 console, the software maker announces a charge of at least $1.05 billion to address the problem In the quest for supremacy in next-generation gaming consoles, Microsoft (MSFT) had a big advantage by releasing the Xbox 360 a full year ahead of competing devices from Sony (SNE) and Nintendo (NTDOY). But hardware failures on the device are forcing Microsoft to cede some of its hard-won ground.
    Cliff Edwards, "Microsoft's Billion-Dollar Fix," Business Week, July 6, 2007 --- Click Here
    Also see http://www.technologyreview.com/Wire/19021/

    From The Wall Street Journal Accounting Weekly Review on July 13, 2007

    "Microsoft's Videogame Efforts Take a Costly Hit" by Nick Wingfield, The Wall Street Journal, July 6, 2007, Page: A3
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Financial Accounting, Financial Analysis, Reserves

    SUMMARY: Microsoft Corp. said it will take a $1.05 billion to $1.15 billion pretax charge to cover defects related to its Xbox 360 game console. Microsoft executives declined to discuss the technical problems in detail, but a person familiar with the matter said the problem related to too much heat being generated by the components inside the Xbox 360s. An analyst in the consumer-electronics industry, Richard Doherty, says the magnitude of the charge Microsoft is taking, which represents nearly $100 for every Xbox 360 shipped to retailers so far indicates Microsoft is concerned about widespread failures or that the company is being extremely conservative in taking this estimated charge. The charge will be taken in the quarter ended June 30, Microsoft's fiscal year end.

    QUESTIONS:
    1.) Describe the accounting for warranty expenses. In general, why must companies report warranty expenses ahead of the time in which defective units are submitted for repair?

    2.) Why must Microsoft record this charge of over $1 billion entirely in one quarter, the last quarter of the company's fiscal year ended June 30, 2007? Support your answer with references to authoritative literature.

    3.) How are analysts using the disclosures about the warranty charge to assess Microsoft's expectations for the repairs that will be required and for the general success of this line of business at Microsoft?

    4.) Consider the analyst Richard Doherty's statement that either a high number of Xbox 360s will fail or the company is being overly conservative in its warranty estimate. What will happen in the accounting for warranty expense if the estimate of future repairs is overly conservative?

    Reviewed By: Judy Beckman, University of Rhode Island


    Misleading Financial Statements:  Bankers Refusing to Recognize and Shed "Zombie Loans"
    One worrying lesson for bankers and regulators everywhere to bear in mind is post-bubble Japan. In the 1990s its leading bankers not only hung onto their jobs; they also refused to recognise and shed bad debts, in effect keeping “zombie” loans on their books. That is one reason why the country's economy stagnated for so long. The quicker bankers are to recognise their losses, to sell assets that they are hoarding in the vain hope that prices will recover, and to make markets in such assets for their clients, the quicker the banking system will get back on its feet.
    The Economist, as quoted in Jim Mahar's blog on November 10, 2007 --- http://financeprofessorblog.blogspot.com/

    After the Collapse of Loan Markets Banks are Belatedly Taking Enormous Write Downs
    BTW one of the important stories that are coming out is the fact that this is affecting all tranches of the debt as even AAA rated debt is being marked down (which is why the rating agencies are concerned). The San Antonio Express News reminds us that conflicts of interest exist here too.
    Jime Mahar, November 10, 2007 --- http://financeprofessorblog.blogspot.com/

    Jensen Comment
    The FASB and the IASB are moving ever closer to fair value accounting for financial instruments. FAS 159 made it an option in FAS 159. One of the main reasons it's not required is the tremendous lobbying effort of the banking industry. Although many excuses are given resisting fair value accounting for financial instruments, I suspect that the main underlying reasons are those "Zombie" loans that are overvalued at historical costs on current financial statements.

    Daniel Covitz and Paul Harrison of the Federal Reserve Board found no evidence of credit agency conflicts of interest problems of credit agencies, but thier study is dated in 2003 and may not apply to the recent credit bubble and burst --- http://www.federalreserve.gov/Pubs/feds/2003/200368/200368pap.pdf

    In September 2007 some U.S. Senators accused the rating agencies of conflicts of interest
    "Senators accuse rating agencies of conflicts of interest in market turmoil," Bloomberg News, September 26, 2007 --- http://www.iht.com/articles/2007/09/26/business/credit.php
    Also see http://www.nakedcapitalism.com/2007/05/rating-agencies-weak-link.html

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's Rotten to the Core threads are at http://faculty.trinity.edu/rjensen/FraudRotten.htm


    From The Wall Street Journal Accounting Educators' Review on July 9, 2004

    TITLE: Accrual Accounting Can Be Costly 
    REPORTER: Gene Colter 
    DATE: Jul 02, 2004 
    PAGE: C3 
    LINK: http://online.wsj.com/article/0,,SB108871005216853178,00.html  
    TOPICS: Earnings Management, Earnings Quality, Financial Accounting, Financial Analysis, Financial Statement Analysis, Restatement, Revenue Recognition

    SUMMARY: The article discusses a research study relating the extent of accrual accounting estimates to subsequent firm performance and incidence of shareholder litigation. The study was conducted by Criterion Research Group, LLC, and the article notes that the research is of interest to insurers that offer directors and officers policies.

    QUESTIONS: 
    1.) Summarize the research study described in the article. Who performed the research? What can you understand about the relationships examined in the project? What was the motivation for the research?

    2.) Define the term accrual accounting. Is it accurately compared to cash basis accounting by the description given in the article? Why must accrual accounting always involve estimates?

    3.) What is the overall impression of accrual accounting that is created in the article? In your answer, comment on the statement, "Accrual accounting is common and kosher."

    4.) Describe weaknesses of cash basis accounting as compared to the issues with accrual basis accounting that are presented in the article. Which basis do you think better presents information that is useful to financial statement readers? Support your answer; you may cite relevant accounting literature to do so.

    5.) What basis of accounting is being described using the computer network example in the article? What accounting standards prescribe this treatment? Name at least one other industry besides computer software sales in which this accounting treatment is required.

    6.) Refer again to question #5 and your answer. What alternative method must be used in this area if accrual accounting were to be avoided entirely? What are the disadvantages of this approach?

    7.) Why do you think some companies must record more extensive accruals and estimates than other companies must? Do these factors themselves lead to greater likelihood of shareholder litigation as is found in the article?

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

    "Accrual Accounting Can Be Costly," by Gene Colter, The Wall Street Journal, July 2, 2004, Page C1 --- http://online.wsj.com/article/0,,SB108871005216853178,00.html 

    Firms Booking Aggressively Are More Likely to Be Sued By Shareholders, Study Says

    Book now. Pay later.

    Pay the lawyers, maybe. A study to be released today suggests that companies that are most aggressive when booking noncash earnings are four times as likely to be sued by shareholders as less-aggressive peers.

    At issue is so-called accrual accounting, in which companies book revenue when they earn it and expenses when they incur them rather than when they actually receive the cash or pay out the expenses. Accrual accounting is common and kosher. Problems arise, however, when companies miscalculate how much revenue they've really earned in a given period or how much in related expenses it cost to get that money.

    For example, say Company A agrees to build a computer network for Company B over four years for $4 million, a job that Company A estimates it'll have to spend $1 million to complete. Company A works hard and estimates it ended up building half the computer network in the first year on the job, so it books $2 million of revenue that year. By accounting rules, it must accrue related costs in the same proportion as revenues, so it also books $500,000 of expenses in the same first year. But say it then turns out that Company A's costs to finish the network actually run to $2 million. Company A has to address that by booking $1.5 million of expenses in future years. In other words, Company A would end up increasing earnings in the first year, but at a cost to future earnings.

    Getting the numbers wrong isn't a violation of generally accepted accounting principles (though intentionally misestimating is). But companies have a lot of leeway, and those that make the most aggressive assumptions when booking what the green-visor guys call accruals can end up creating a misleading picture of their financial health in any given year. When skeptics refer to a company's "revenue recognition problems," this is often what they're talking about.

    The new study, based on six years of data, was conducted by Criterion Research Group LLC, an independent research firm in New York that caters primarily to institutional investors. It shows that companies that fall into what Criterion calls the highest accrual category are more likely to end up getting sued by shareholders.

    The study builds on earlier research by Criterion that showed companies that use more accruals underperform companies with fewer accruals. In that report, Criterion screened 3,500 nonfinancial companies over 40 years and found that those using the most accruals had poorer forward earnings and stock returns and also had more earnings restatements and Securities and Exchange Commission enforcement actions.

    None of this is to say that companies that end up in shareholder litigation set out to mislead shareholders. Rather, says Criterion Chairman Neil Baron, these companies simply run a higher risk of making mistakes with their books.

    "Accruals are estimates," Mr. Baron says. "If you're a company and a much higher percentage of your earnings come from accruals or estimates, it's much more likely that you're going to be wrong more often."

    Criterion screened companies involved in class-action suits from 1996 to 2003 for its new study. In each case it looked at a company's earnings for the year of the class start date, which is the year in which the alleged misbehavior began. Criterion then assigned these companies into one of 10 ranks, with those in the 10th group using the most accruals and those in 1st using the fewest. There were four times as many shareholder class-action suits among 10th group companies as there were among 1st group firms.

    A number of companies in the two highest accrual categories recently settled shareholder class actions related to accounting issues, including Rite Aid Corp., Waste Management Inc., MicroStrategy Inc. and Gateway Inc. Other companies still involved in ongoing shareholder class actions involving accounting issues also turned up in the aggressive-accruals group.

    Companies currently in Criterion's highest-accrual category include Chiron Corp., eBay Inc., General Motors Corp., Halliburton Co. and Yahoo Inc. -- none of which now face shareholder suits related to accounting -- among others.

    EBay spokesman Hani Durzy says he doesn't think his company belongs in the high-accruals gang, noting that the company's profit-and-loss statement "closely mirrors our cash flow." He adds: "We are essentially a cash business."

    A GM spokesman says, "All of GM's accounting policies and procedures are in full compliance with U.S. GAAP and are reviewed by our outside auditor and the audit committee, and we have, to the best of our knowledge, never had to restate earnings because of an accounting issue."

    An e-mail from Halliburton's public-relations office notes that Halliburton follows GAAP and adds that accruals "are universally required by GAAP."

    Representatives from Chiron and Yahoo said the companies had no comment.

    A Criterion analyst pointed out that accruals don't necessarily relate to everyday operations. For example, a company estimating and booking tax benefits from employee stock options is also using accruals. Estimates related to pension accounting are also accruals.

    Mr. Baron stresses that the vast majority of companies that book a lot of accruals are unlikely to face shareholder suits, restatements or SEC actions. Many may even outperform low-accrual companies. But he says investors should be "more scrutinizing" of financial statements from companies that make liberal use of accruals, because, statistically, they are most likely to run into these problems.

    Sophisticated investors, such as fund managers, might reckon they can spot bookkeeping alarms before the broad investing public and get out of a stock before the lawyers start filing briefs. But it's possible that companies with a lot of accruals can suffer even without litigation: Mr. Baron says his firm has been contacted by insurers that offer directors and officers policies, which large companies buy to protect executives and directors against lawsuits. The insurers are asking about Criterion's research as they weigh whether to charge D&O customers higher premiums, he says.

    Bob Jensen's threads on revenue accounting are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 


    From The Wall Street Journal Accounting Weekly Review on January 28, 2005

    TITLE: Quirk Could Hurt Mortgage Insurers  (Quirk = FAS 60)
    REPORTER: Karen Richardson 
    DATE: Jan 21, 2005 
    PAGE: C3 
    LINK: http://online.wsj.com/article/0,,SB110626962297132172,00.html  
    TOPICS: Financial Accounting, Financial Accounting Standards Board, Insurance Industry, Loan Loss Allowance, loan guarantees, Contingent Liabilities

    SUMMARY: "Millions of people who can't afford to put down 10% or 20% of a home's price are required by their mortgage lenders to buy policies from mortgage insurers, which, by agreeing to shoulder some risk of missed loan payments, can lower the buyer's down payment to as little as 3%." However, as a result of a "quirk" in establishing Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" in 1982, the FASB allowed an exclusion for mortgage insurers from requirements to reserve for future losses. This exclusion may lead to to delayed reporting of costs associated with the mortgage lending and of exacerbation of losses if default rates increase due to the type of borrowers taking advantage of this insurance in the hot real estate market.

    QUESTIONS: 
    1.) What is the purpose of mortgage insurance for a home buyer?

    2.) How do mortgage insurance providers, and insurance providers in general, earn profits on their activities? How are insurance rates determined? In general what costs are deducted against revenues determined from those insurance rates?

    3.) Access Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises," via the FASB's web site, located at http://www.fasb.org/pdf/fas60.pdf From the discussion in the summary of the standard, state the general accounting requirements contained in this statement.

    4.) Based on the discussion in the article, what is the exemption allowed for mortgage insurers from Statement No. 60's requirements? What is the reasoning for that exemption? What is your opinion about this reason?

    5.) Refer again to the FASB Statement No. 60 on the FASB's web site. Locate the exemption described in question 4 and give its citation.

    6.) Given this accounting requirement exemption, what are the concerns with measuring profit in the mortgage insurance industry in general (regardless of the issues with the current real estate market)? What is the technique used to handle that issue in financial reports? In your answer, specifically refer to, and define, the matching concept in accounting.

    7.) How does the potential caliber of the real estate buyers using mortgage insurance exacerbate the concerns raised in question 6?

    Reviewed By: Judy Beckman, University of Rhode Island


    August 7, 2006 message from Ganesh M. Pandit, DBA, CPA, CMA [profgmp@hotmail.com]

    Hi Bob,

    How would you answer this question from a student: "I wonder if a company's Web site is considered a long-lived asset!"

    Ganesh M. Pandit
    Adelphi University

    August 9, 2006 reply from Bob Jensen

    Hi Ganesh,

    Accounting for Website investment is a classic example of the issue of "matching" versus "value" accounting. From an income statement perspective, matching requires the matching of current revenues with the expenses of generating that revenue, including the "using up" of fixed asset investments. But we don't depreciate investment in the site value of land because land site value, unlike a building, is not used up due to usage in generating revenue. Like land site value, a Website's "value" probably increases in value over time. One might argue that a Website should not be expensed since a successful Website, like land, is not used up when generating revenue. However, Websites do require maintenance fees and improvement outlays over time which makes it somewhat different than the site investment in land that requires no such added outlays other than property taxes that are expensed each year.

    I don't think current accounting rules for Websites are appropriate in theory --- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Issue08

    It seems to me that you can partition your Website development and improvement outlays into various types of assets and expenses. For example, computers used in development and maintenance of the Website are accounted for like other computers. Software is accounted for under software amortization accounting rules. Purchased goodwill is accounted for like purchased goodwill under new impairment test rules. Labor costs for Website maintenance versus improvements are more problematic.

    Leased Website items are treated like leases, although there are some complications if a Website is leased entirely. For example, such a leased Website is not "used up" like airplanes that are typically contracted as operating leases. Leased Website space may be appropriately accounted for as an operating lease. But leasing an entire Website is more like the capital lease of a land in that the asset does not get "used up." My hunch is that most firms ignore this controversy and treat Website leases as operating leases. It is pretty easy to bury custom development costs into the "rental fee" for leased Website server space, thereby burying the development costs and deferring them over the contracted server space rental period. It would seem to me that rental fees for Websites that are strictly used for advertising are written off as advertising expenses. Of course many Websites are used for much more than advertising.

    Firms are taking rather rapid write-offs of purchased Websites such as write-offs over three years. I'm not certain I agree with this, but firms are "depreciating" these for tax purposes and you can see them in filed SEC financial statements such as the one at Briton International (under the Depreciation heading) ---
    http://sec.edgar-online.com/2006/01/27/0001127855-06-000047/Section27.asp

    It is more common in annual reports to see the term Website Amortization instead of Website Depreciation. A few sites amortize on the basis of Website traffic --- http://www.nexusenergy.com/presentation6.aspx
    This makes no sense to me since traffic does not use up a Website over time.

    Bob Jensen

    Bob Jensen's threads on e-Commerce and e-Business revenue accounting controversies are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm


    "Assessing the Allowance for Doubtful Accounts:  Using historical data to evaluate the estimation process," by Mark E. Riley and William R. Pasewark, The Journal of Accountancy, September 2009 --- http://www.journalofaccountancy.com/Issues/2009/Sep/20091539.htm
     Jensen Comment
     The biggest problem with estimating from historical data is identification of shocks to the system that create non-stationarities that make extrapolation from the past hazardous.

    Messaging Between Malcom McLelland and Bob Jensen About Bad Debt Estimation

    -----Original Message-----
    From: AECM, Accounting Education using Computers and Multimedia [mailto:AECM@LISTSERV.LOYOLA.EDU] On Behalf Of Mc Lelland, Malcolm J
    Sent: Sunday, August 23, 2009 11:35 PM
    To: AECM@LISTSERV.LOYOLA.EDU
    Subject: Re: Insurers Biggest Write downs May Be Yet to Come

     

    Hi again Bob,

    It is interesting to note that, once we begin to get into any real depth (when discussing things like FAS 5), it seems to become necessary to start talking about accountics.  One gets the idea accountics is useful in both understanding accounting and applying the understanding in the real world.

    Let's begin with bad debt estimation in large companies like Sears or JC Penney that have their own charge cards. In most instances your concern over >whether mean, median, or mode is used is irrelevant because each risk pool assumes a uniform probability distribution where mean, median, and mode >are identical numbers. The typical first step in bad debt estimation is to partition outstanding accounts into overdue classes of time. Then these are >sub-partitioned as to overdue account balances. It is possible to further subdivide on the basis of information in each customer's credit application form >(residence location, age, income, marital status, credit score, etc.) but I don't think this is common across all companies. A lot of that information is >subject to change such as change in marital status.

    Ok, but what does it mean to say "each risk pool assumes a uniform probability distribution where mean, median, and mode are identical numbers"?  Also who does the assuming, and how do they know the assumption is correct if we *know* such distributions are non-stationary?

    Let me try to make this concrete using accountics.  I'll represent receivables as A = A1 + A2 + ... + An, and estimated uncollectibles as U = U1 + U2 + ... + Un, for n different customer receivable accounts (so, total net AR = A - U).  For each account i, Ui = Li*Ai where Li is the proportion of the receivable account estimated to be uncollectible.  Now, Li is an accounting random variable with an unknown probability distribution.

    Is it appropriate to assume that Li (for any i = 1, 2, ..., n) is uniformly distributed?  Assume with loss of further generality that Li has only five potential outcomes; 0, .25, .5, .75, 1.  Representing probabilities with p(.), the mean of the Li can be written as ...

    mean(Li) = p(Li=0)*0 + p(Li=.25)*.25 + p(Li=.5)*.5 + p(Li=.75)*.75 + p(Li=1)*1

    If Li is uniformly distributed, then p(Li=0) = ... = p(Li=1) = .2 and ...

    mean(Li) = .2*0 + .2*.25 + .2*.5 + .2*.75 + .2*1 = .50

    Notice: If one thinks about it, any loss proportion between 0 and 1 is possible, so *if Li is uniformly distributed, then the mean loss proportion is (always) .50*.  This suggests, at least to me, that the accounting random variable "(allowance for) uncollectible accounts receivable" cannot be uniformly distributed.

    If not uniformly distributed, how is this accounting random variable distributed and how would an accountant know?

    I'll spare the argument for the time being, but I can similarly show in a clear way that uncollectible receivables are *positively*-skewed random variables.  I can think of economic conditions (like those we're in at present) where uncollectible receivables are fairly highly positively-skewed, in which case mean, median, and mode are all different; perhaps substantially different.

    So ... I ask again: Under FAS 5, what is the accountant's estimation objective; mean, median, mode, or some other quantile?  Should such an accounting standard specify the estimation objective, or simply leave it to accountants' (ad hoc) judgments?

    Cheers,

    Malcomb J. McLelland

    mjmclell@indiana.edu

    Hi Malcomb,

    "Assessing the Allowance for Doubtful Accounts:  Using historical data to evaluate the estimation process," by Mark E. Riley and William R. Pasewark, The Journal of Accountancy, September 2009 --- http://www.journalofaccountancy.com/Issues/2009/Sep/20091539.htm
     Jensen Comment
     The biggest problem with estimating from historical data is identification of shocks to the system that create non-stationarities that make extrapolation from the past hazardous.

    Now consider receivables Pool D for accounts outstanding 31-60 days overdue and balances due between $501-$1000. We assume that the bad debt probability distribution in Pool D is a uniform probability distribution. We then look at the recent history of Pool D and conclude that on average 10% of the total outstanding balance in Pool D is ultimately written off as bad debt. For next month, September 2009, the total balance due in Pool D is $64 million. We then estimate that $6.4 million of Pool D accounts will ultimately be declared bad debts.

    In Pool D with n outstanding accounts, we assume that each account has a 1/n probability of going bad in a uniform distribution. We've assumed each account is a random variable with D dollars outstanding. There is error in assuming that each account has D dollars, but Kurtosis error decreases if we more finely partition Pool D into finer partitions than $501-$1000, such as Pools D1, D2, D3, etc. We've also assumed each customer's probability of becoming a bad debt is independent of every other customer, which is probably a source of minor error in large pools. But David Li's formula controversy hangs over our heads --- http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html

    Now if you really want to take out more of the error in this bad debt estimation process of over a million companies, then be my guest. I suggest that you persuade a large company to examine an actual pool of aged accounts over a several years. Then you devise whatever means you like (look at some of the previous Bayesian models for bad debt estimation and the body of literature for alternative models of bad debt estimation). I don't really think I can greatly improve upon what companies use in practice.

    "An Intuitive Explanation of Bayes':  Theorem:  Bayes' Theorem for the curious and bewildered; an excruciatingly gentle introduction," by Eliezer S., Yudkowsky, August 2009 --- http://yudkowsky.net/rational/bayes

     

    See “Constructing Bayesian Networks to Predict Uncollectible Telecommunications Accounts” --- http://doi.ieeecs.org/portal/web/csdl/doi/10.1109/64.539016

    Below is a fantastic book (a true classic) for you to study, Malcomb
    A classic older book in my library  that I still really, really treasure on the topic of bad debt estimation is
    Selecting A Portfolio of Credit Risks by Markov Chains, by R. M. Cyert and G. L. Thompson © 1968
    The University of Chicago Press.
    I was disturbed by the unrealistic assumptions of the Markov chains in their models, but this does not detract from the creative contributions of these great CMU scholars.

    The reason companies are advised to know their customers either personally (if possible) or in general (if there are many, many customers) is that the more they know about their customers the more they can adapt their bad debt estimation systems to non-stationarities caused by such things as economic downturn (my WT Grant illustration I gave you previously), regional problems (Hurricane Katrina), pending legislation (Cap and Prayed carbon emissions), etc.

    I don't think I have much more to add to this thread other than if you feel strongly about your contentions then this provides a great opportunity for you to conduct research and write up your own findings. I eagerly look forward to the benefits and costs of what you discover.

    Once again, I cannot stress enough that you start with all the basic theory monographs of Yuji Ijiri that are listed at http://aaahq.org/market/display.cfm?catID=5
    Especially note Studies 10 and 18. Unfortunately Study 10 is no longer listed because it is out of print. It is available, however, in hundreds of libraries. The title is "Theories of Accounting Measurement" as published by the American Accounting Association as SAR #10 in 1975. This is the book Yuji dedicated to his lovely wife Tomo.

    Although I admire the creative thinking of my old mentor, Yuji left much room for more research. My fantasy would be to come back to Yuji’s research base, but I fear my concerns for engineering practicality of accountancy corrupted the purity of my creative thinking.

    At the same time I fear that we no longer have accounting theorists of Yuji's caliber, albeit impractical as they might be. Tom Selling is trying to become one, and I encourage him to truly live out his fantasies. Seriously Tom Selling --- forget cynics like me and go for it!

    Thanks Malcomb
    I enjoyed this thread, but I fear I’ve reached the limit to what I can contribute.

     Bob Jensen

     


    Management and Accounting Web (MAAW) --- http://maaw.info/

    Institute of Managerial Accountants (IMA) --- http://en.wikipedia.org/wiki/Institute_of_Management_Accountants
    Home Page --- http://www.imanet.org/

    From the IMA
    Conceptual Framework for Managerial Costing

    February 2015
    http://www.imanet.org/resources-publications/research-studies-and-resources/transforming-the-finance-function/mccf

    Full Report --- http://www.imanet.org/PDFs/Public/Thought_Leadership/Transforming_the_Finance_Function/MCCF.pdf


    Lean Accounting --- https://en.wikipedia.org/wiki/Cost_accounting#Lean_accounting

    Conceptual Issues in Lean Accounting: A Review

    The IUP Journal of Accounting Research & Audit Practices, Vol. XVI, No. 3, July 2017, pp. 54-63

    SSRN
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3214401
    Posted: 4 Aug 2018
     

    Vineeta Arora

    Independent

    G. Soral

    Mohanlal Sukhadia University

    Date Written: July 16, 2018

    Abstract

    In today’s business world, accounting is defined as not only a tool for measuring financial figures, but also a foolproof system that can measure and manage the value. This has forced the companies to re-think on their internal processes so that the process also meets the value definition of the customer. Lean accounting can be the answer to all the expectations raised. It is a principle-based operating system which can be expressed in terms of customer value, value stream, flow and pull with minimum interruption, pursuit of perfection, and empowered people. It is a systematic approach to eliminate waste like overproduction, waiting, transportation, inventory, over-processing, etc. through continuous improvement. The current cost accounting system earns profit by full utilization of resources, and is associated with large inventory, long lead time and poor delivery, while lean system earns profit through ‘maximized flow’ on pull from customers and elimination of waste, resulting in superior customer value, good quality, good delivery and shorter lead time. This paper tries to explore the conceptual issues of lean accounting, i.e., its meaning, definition, evolution, need, and also presents a comparison between lean accounting and traditional accounting which helps the readers to understand the term lean accounting clearly.

     


    The Journal of Management Accounting Research: A Citation Analysis of the First 25 Years
    SSRN, May 27, 2016
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2785755

    Authors

    Daryl M. Guffey Clemson University

    Nancy L. Harp Clemson University

    Abstract

    This article provides a citation analysis for the Journal of Management Accounting Research (JMAR) between 1989 and 2013. During this study, citations to articles in JMAR were collected and used to rank articles and authors. Citations collected were used to identify individuals, articles, and methodologies that contributed the most towards establishing JMAR as a premier accounting journal. Rankings were based on (scaled and unscaled) citation count and citation rate. This article also provides information on methodological trends in JMAR and highlights both encouraging and cautionary insights for the future of JMAR.


    Defense Contractors to Face New Cost Accounting Oversight with Creation of Defense Cost Accounting Standards Board ---
    http://www.natlawreview.com/article/defense-contractors-to-face-new-cost-accounting-oversight-creation-defense-cost

    Jensen Comment
    Since fraud is also monumental in Medicaid and Medicare spending, I would also like to see the formation of a M&M Accounting Standards Board that investigates, among other things, both fraudulent billings by providers and fraudulent benefits by patients such as when half the people on Medicaid in Illinois were not even eligible for Medicaid. I also think there's way too much fraud in the pilfering of estates by heirs so that that grandma or grandpa can get free nursing home care paid for by Medicaid.


    Square Root Costing: The only costing methodology based on an accurate understanding of complexity costs, say the co-founders of Wilson Perumal ---
    http://ww2.cfo.com/budgeting/2018/04/square-root-costing-a-better-method/


    Teaching Case:  Costs for Decision Making: An Instructional Case of Relevant Costs and Differential Analysis of Cost Reduction Alternatives
    by Scott McGregor, Fairleigh Dickinson University
    IMA Educational Case Journal, Volume 0, Issue 3, 2016
    http://www.imanet.org/educators/ima-educational-case-journal/iecj-index/2016/copy-of-volume-9-issue-3

    TEXTBOOK QUESTIONS AND CASES OFTEN ASK STUDENTS to use differential analysis to evaluate one independent cost reduction action. But businesses often have multiple cost reduction alternatives to evaluate simultaneously. Furthermore, companies may consider these options independently or through combinations of alternatives. The case is based on an actual project to evaluate alternative cost reduction actions at a large insurance company. For educational purposes, the scope of the project has been significantly reduced to one function, the accounting department, to provide students with a realistic situation in a manageable format. Students are presented with three alternative cost reduction approaches and must identify the relevant costs and calculate the estimated potential impacts of each alternative. The cost reduction actions evaluated are outsourcing (“offshoring”), greater automation, and an office relocation. Additionally, the students must identify the risks and other nonfinancial considerations associated with the potential cost reduction actions and make a recommendation. Keywords: relevant costs, differential analysis, cost reductions, outsourcing, relocation, automation.


    Teaching Case:  Lack of Internal Controls: Beaumont Independent School District
    by Russell Tietz, University of Mount Union;  Wendy Tietz, Kent State University; and  Linda Zucca, Kent State University
    MA Educational Case Journal, Volume 7, Issue 4, 2016
    http://www.imanet.org/educators/ima-educational-case-journal/iecj-index/2016/volume-9-issue-4

    THIS CASE, BASED ON A TRUE STORY, examines the misappropriation of funds by an administrator in the Beaumont Independent School District (BISD) in Beaumont, Texas. Patricia Adams Lambert diverted more than $500,000 of funds while she was a BISD employee. Students are asked to apply the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 Internal Control–Integrated Framework to evaluate internal controls; students will also evaluate an ethical dilemma. The case is particularly unique because it is designed to be used in introductory financial and managerial accounting classes as an example of internal controls. The case can also be used in upper-level accounting classes as appropriate.


    Teaching Case:  The Student Housing Decision
    by
    Kathy Otero, Debra Kerby, and Keith Harrison --- all from Truman State University
    IMA Educational Case Journal, Volume 0, Issue 3, 2016
    http://www.imanet.org/educators/ima-educational-case-journal/iecj-index/2016/copy-of-volume-9-issue-3

    THIS CASE PROVIDES A REALISTIC APPLICATION OF inflation-adjusted capital budgeting in a university setting. The case is designed for use in an upper-division cost accounting course or a graduate level cost/managerial accounting class. Students are required to analyze the costs of building and operating a student apartment complex, to determine a reasonable rental rate for three types of apartments, and to make a recommendation about the feasibility of the project. Critical thinking is emphasized in the development and interpretation of the present value (PV) model, identification and discussion of qualitative issues, and recognition and inclusion of uncertainty

     


    Jensen Comment
    I'm still looking for an operational concept of the most important measurement in all of accountancy (net earnings) from the IASB, FASB, or IMA. No luck.

    Net earnings and EBITDA cannot be defined since the FASB and IASB elected to give the balance sheet priority over the income statement in financial reporting ---
    "The Asset-Liability Approach: Primacy does not mean Priority," by Robert Bloomfield, FASRI Financial Accounting Standards Research Initiative, October 6, 2009 ---
    http://www.fasri.net/index.php/2009/10/the-asset-liability-approach-primacy-does-not-mean-priority/

    "Whither the Concept of Income?" by Shizuki Saito University of Tokyo and Yoshitaka Fukui Aoyama Gakuin University, SSRN, May 17, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607234

    Abstract:
    Since the 1970s, the decision-usefulness has taken center stage and our attention has been concentrated on valuation of assets and liabilities instead of income measurement. The concept of income, once considered the gravitational center of accounting has lost its primacy and become a byproduct of the balance sheet derived from the measurement of assets and liabilities.

    However, we have not been equipped with robust conceptual foundation supporting theoretically reasoned accounting measurement. It is not only theoretically but also practically important to renew our seemingly waned interest in the concept of income because ongoing reforms of accounting standards cannot be successfully implemented without a sound understanding of the concept of income.

    IMA to Endorse Universities Preparing Students for Careers in Management Accounting:  Pennsylvania State University and Washington State University Vancouver Endorsed in Pilot Program ---
    http://www.businesswire.com/news/home/20130807005147/en

    Jensen Criteria
    I was disappointed that the criteria focused mostly on curriculum rather than placement. I would recommend the addition of the proportion of corporate accounting recruiters who visit a campus and the numbers of entry-level job offers to newly-minted accounting graduates in the four-year and five-year programs.

    The IMA struggles to keep managerial accounting from dying in accounting programs. But without more entry-level job offers in corporate accounting it;s an uphill battle.

    Sue Haka, former AAA President, commenced a thread on the AAA Commons entitled
    "Saving Management Accounting in the Academy,"
    --- http://commons.aaahq.org/posts/98949b972d
    A succession of comments followed.

    The latest comment (from James Gong) may be of special interest to some of you.
    Ken Merchant is a former faculty member from Harvard University who form many years now has been on the faculty at the University of Southern California.

    Here are my two cents. First, on the teaching side, the management accounting textbooks fail to cover new topics or issues. For instance, few textbooks cover real options based capital budgeting, product life cycle management, risk management, and revenue driver analysis. While other disciplines invade management accounting, we need to invade their domains too. About five or six years ago, Ken Merchant had written a few critical comments on Garrison/Noreen textbook for its lack of breadth. Ken's comments are still valid. Second, on the research and publication side, management accounting researchers have disadvantage in getting data and publishing papers compared with financial peers. Again, Ken Merchant has an excellent discussion on this topic at an AAA annual conference.


    Amazon Is Now Worth More Than Walmart ---
    http://time.com/3970321/amazon-walmart-worth/?xid=newsletter-brief

    Jensen Comment
    Worth and value can be defined in various ways depending a lot upon how intangibles are valued relative to tangible assets and whether the valuation is based upon aggregation of values of net assets versus stock market valuation of equity shares. Certainly Walmart is worth a lot more than Amazon in terms of tangible assets like stores, warehouses, and delivery trucks. Amazon is now worth slightly more in terms of stock market valuation of equity shares that are based on a whole lot of technology intangibles in the case of Amazon.

    Walmart employs many more workers, and this carries with it a lot of unbooked financial obligations for such things as future payroll and employee benefit costs, especially medical insurance costs.  Add to this the constant costs of labor disputes and costs of fending off unions. Walmart also has much higher inventory costs since Amazon tends to pass many inventory  costs upstream to suppliers. Amazon has more robotics and is positioned for replacement of labor with even more robotics and other technologies.

    Amazon is more vulnerable to risks of outsourcing such as the risks supplier pricing disputes and labor disputes in UPS/USPS and price gouging by UPS or the USPS.  My point is that a whole lot of important risks in Amazon's operations are outside the control of Amazon due to outsourcing.

    Our current managerial accounting courses and textbooks do a poor job of analyzing financial risks when comparing companies like Amazon versus Walmart.


    Teaching Case from Issues in Accounting Education, Volume 31, Issue 4 (November 2016)
    http://aaajournals.org/doi/full/10.2308/iace-51189
    In general, American Accounting Association journal articles are not free, but they can be distributed for free in accounting education courses via controlled distributions
    There's a separate link to Teaching Notes for this case

    Arizona Microbrewery, Inc.: An Instructional Case on Management Decision Making

    Authors

    Janet A. Samuels --- Arizona State University

    Kimberly M. Sawers --- Seattle Pacific University

    Abstract

    This case provides students with an opportunity to utilize cost volume profit (CVP) analysis tools in a contextually rich environment of a microbrewery. The case explores basic CVP concepts as well as decision making for constrained resources, make versus buy, and new product development. Further, the case requires quantitative analysis, understanding, and exploration of contextual issues as well as assessment of qualitative factors. While directed at graduate students (M.B.A. and E.M.B.A.) in a managerial accounting course, this case may also be suitable for undergraduate students with some minor modifications.

    Bob Jensen's threads on CVP analysis are at
    http://faculty.trinity.edu/rjensen/theory02.htm#ManagementAccounting

     


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on August 7, 2015

    UPS Earnings Surge, Gives Optimistic Guidance
    by: Laura Stevens
    Jul 29, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Financial Reporting, Managerial Accounting

    SUMMARY: United Parcel Service Inc. reported strong earnings, delivered optimistic rest-of-the-year guidance and outlined its plans for controlling costs during 2015's peak holiday season. The delivery company said all three of its major business segments contributed to a near tripling in profit to $1.23 billion. The rise also reflected an after-tax charge of $665 million in last year's second quarter that was related to employee health care. The latest results led UPS executives to raise their full-year outlook to the high range of their previous guidance of between 6% and 12% growth in earnings per share.

    CLASSROOM APPLICATION: This article offers a good, small case study of how UPS is reining in costs and approaching its next holiday busy season.

    QUESTIONS: 
    1. (Introductory) What financial results did UPS recently report? Were these results favorable or unfavorable?

    2. (Advanced) What challenges has UPS faced in the past two holiday seasons? What is UPS doing to manage those issues for future busy seasons?

    3. (Advanced) What managerial accounting tools could UPS use to manage the holiday volume more successfully? How could the company adjust pricing to manage volume surges and maintain or increase profitability?

    4. (Advanced) What changes has UPS made? Which of these changes involve variable costs? Which involve fixed costs? How flexible are the company's plans? Does the company need flexibility or are volumes steady?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    UPS, FedEx Got Back On Time This Holiday
    by Laura Stevens
    Dec 29, 2014
    Online Exclusive

    UPS, FedEx Cap Holiday Deliveries Amid Late Surge
    by Laura Stevens and Suzanne Kapner
    Dec 23, 2014
    Online Exclusive

    "UPS Earnings Surge, Gives Optimistic Guidance," by Laura Stevens, The Wall Street Journal, July 29, 2015 ---
    http://www.wsj.com/articles/ups-earnings-surge-led-by-growth-in-international-segment-1438085242?mod=djem_jiewr_AC_domainid

    Chief executive says shipping company looking at reining in costs during holiday season.

    United Parcel Service Inc. on Tuesday reported strong earnings, delivered optimistic rest-of-the-year guidance and outlined its plans for controlling costs during this year’s peak holiday season.

    Despite a slight dip in second-quarter revenue, the news sent UPS shares up 5.1% to $99.94 in 4 p.m. composite trading on the New York Stock Exchange.

    The delivery company said all three of its major business segments contributed to a near tripling in profit to $1.23 billion.

    The rise also reflected an after-tax charge of $665 million in last year’s second quarter that was related to employee health care.

    The latest results led UPS executives to raise their full-year outlook to the high range of their previous guidance of between 6% and 12% growth in earnings per share.

    Executives said the stronger dollar has driven more import traffic to the U.S., boosting the company’s international segment and its bottom line.

    Continued in article


    New Idea for a Managerial Accounting Case or Other Type of Assignment

    Harvesting Sunshine More Lucrative Than Crops at Some U.S. Farms ---
    http://www.bloomberg.com/news/articles/2016-03-29/harvesting-sunshine-more-lucrative-than-crops-at-some-u-s-farms?cmpid=BBD033016

    . . .

    The rise in solar comes as the value of crops in the Southeast -- with the exception of tobacco -- has dropped. Cotton prices have fallen 71 percent in the last five years. Soybeans are down 33 percent and peanuts have slipped 16 percent.

    Solar companies, meanwhile, are paying top dollar, offering annual rents of $300 to $700 an acre, according to the NC Sustainable Energy Association. That’s more than triple the average rent for crop and pasture land in the state, which ranges from $27 to $102 an acre, according to the U.S. Agriculture Department.

    The economic incentives spurring solar will be discussed at a Bloomberg New Energy Finance conference in New York starting April 4.

    “Solar developers want to find the cheapest land near substations where they can connect,” said Brion Fitzpatrick, director of project development for Inman Solar Inc. of Atlanta. “That’s often farmland.”

     

    Developers have installed solar panels on about 7,000 acres of North Carolina pasture and cropland since 2013, adding almost a gigawatt of generating capacity, according to the NC Sustainable Energy Association. Georgia has added 200 megawatts on fields and cleared forests over the same period, much of it farmland, according to the Southface Energy Institute of Atlanta.

     

    The number of megawatts developers can generate per acre of farmland varies, based on weather patterns, size of the panels and contours of the land. On Singletary’s farm, Strata Solar installed 21,600 panels, each about 6 feet by 3 feet (1.8 meters by 914 centimeters). Combined, they can power as many as 5,000 local homes. 

     

    Long-Term Contracts

    Farmers typically lease a portion of their land, signing 15- to 20-year contracts with developers who install the panels and sell the power to local utilities. In rare cases, farmers have leased their entire property to solar companies.

     

    Singletary signed a 15-year lease in 2013, with two 10-year extension options, and Chapel Hill, North Carolina-based Strata sells the power to Duke Energy Corp. He declined to disclose financial terms.

     

    Government incentives have played a key role in the spread of solar farms built on real farms. North Carolina granted developers tax credits equal to 35 percent of their projects’ costs though a program that expired at the end of 2015, helping make the state the third-biggest U.S. solar market. In Georgia, the Public Service Commission passed a bill in 2013 requiring the state’s largest utility, Southern Co.’s Georgia Power, to buy 525 megawatts of solar by 2016. Both policies sent companies scouring for open space to build.

    Solar panels have buoyed tax bases in impoverished rural counties, said Tim Echols, a member of the Georgia Public Service Commission. They also let farmers diversify their income with revenue that’s not subject to markets or unpredictable weather patterns.

    ‘Stable Income’

     

    “Solar and wind farms have become a new stable income stream for farmers -- and they don’t fluctuate with commodity prices,” said Andy Olsen, who promotes clean energy projects in rural areas for the Chicago-based Environmental Law & Policy Center.

    Not everyone is happy to see solar panels or wind turbines becoming more common on farmland. In the U.K. lawmakers have pushed to limit large clean energy projects on farms, saying they blight the landscape and squeeze out local food production. Similar criticisms have surfaced in the U.S., where local officials have pushed for zoning changes to restrict solar developments to industrial properties. 

     

    Neighbor Complaints

    “I get a lot of complaints from neighbors” said Tim Sheppard, who don’t like the looks of the 1-megawatt solar system that takes up about 5 acres of his 135-acre cattle farm in Brasstown, North Carolina.

    Continued in article


    Question for Cost Accounting Students
    Every cost accounting student can explain why toilet seats purchased by the Navy cost over $1 million each?
    Times are changing with technology.
    Are cost accounting courses and textbooks  and professors keeping up with changing times in defense contracting?

    Hint:
    Pictures of Midshipman Bob Jensen on a battleship ---
    http://faculty.trinity.edu/rjensen/Tidbits/Ocean/Set01/OceanSet01.htm
    When I was on a battleship  salt water splashed underneath toilet seats over a trough --- with salt water flowing under ten toilet seats in each row. Privacy in the bathroom is was reserved only for officers' quarters above deck. Salt water is corrosive such that ship builders had to guarantee that toilet seats would not corrode from salt water splash in the trough.

    But a guarantee against corrosion is only part of the cost of each toilet seat. Every cost accounting student knows that the bulk of the cost of a $1 million toilet seat is overhead cost allocation for costs having nothing remotely related to toilet seat manufacturing.

    "Pentagon Purchasing Is Overdue for an Overhaul," by Charles Josef Duch, The Wall Street Journal, July 22, 2015 ---
    http://www.wsj.com/articles/pentagon-purchasing-is-overdue-for-an-overhaul-1437608461?mod=djemBestOfTheWeb

    Here’s an anecdote that illustrates the problems with U.S. defense acquisition: The Navy, concerned about corrosion of equipment that spends its operating life surrounded by salt water, began requiring paperwork to certify that new systems would be corrosion free. But the rule applies without exception, meaning Navy staff go through the motions to certify the corrosion resistance of, say, new software programs they acquire.

    Rep. Mac Thornberry cited this example when rolling out legislation in March that would overhaul Pentagon procurement. Mr. Thornberry, who leads the House Armed Services Committee, wants to give program managers more responsibility and eliminate dozens of reports required by Congress or the Pentagon. “The system has just grown these barnacles around it that’s made it so sluggish it’s a wonder anything comes out the other end,” he told the Washington Post.

    This is a worthwhile endeavor: For foes of excessive bureaucracy and paperwork, the Pentagon is what one would call a target-rich environment.

    Continued in article

    Jensen Comment
    It seems like it's time to rewrite some of those badly out-of-date cost accounting textbooks.


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on July 17, 2015

    Google Takes Stricter Approach to Costs
    by: Alistair Barr
    Jul 14, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Managerial Accounting

    SUMMARY: With revenue growth ebbing, profit margins shrinking and shares flat, Google is curbing hiring and seeking ways to run its sprawling empire more efficiently. Google is a long way from cutting jobs and the company is still growing. But the scrutiny on expenses is a significant change for a company that long favored expansion and experimentation over bottom-line concerns. Some employees cite examples of increased frugality, albeit at a workplace that is luxurious compared with most others. Travel, supplies and events all require more justification or approvals than in the past.

    CLASSROOM APPLICATION: This article offers a good example of a company using managerial accounting tools to manage costs in an attempt to maintain/increase profitability.

    QUESTIONS: 
    1. (Introductory) What is Google's current financial condition? How has the situation changed in recent years?

    2. (Advanced) What is a company's most recent profit margin? How has Google's profit margin changed? What is the reason for this? How should Google management approach this issue?

    3. (Advanced) How has Google's approach to hiring employees changed in recent times? What other expense categories are being examined and changed?

    4. (Advanced) What is a fixed cost and what is a variable cost? How do they differ? What different approaches should managers take when a particular expense is in one of those categories or the other?

    5. (Advanced) In general, is the expense of employing employees a fixed expense or a variable expense? What information would you need to decide accurately? Which type of expense would Google employees likely be? Why? How would this affect how Google manages hiring and employee totals?

    6. (Advanced) In what areas is Google slowing or restricting hiring, and in what areas is hiring continuing? Why? Show how Google could use managerial accounting tools - segmenting and others - to effectively analyze hiring and employment priorities.

    7. (Advanced) The article states travel, supplies and events all require more justification or approvals than in the past. What managerial accounting tools could help the company analyze these expenses, manage the spending levels, and help to keep track of spending throughout the year and in total?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Google Takes Stricter Approach to Costs," by Alistair Barr, The Wall Street Journal, July 14, 2015 ---
    http://www.wsj.com/articles/google-takes-stricter-approach-to-costs-1436827885?mod=djem_jiewr_AC_domainid

    With revenue growth ebbing, profit margins shrinking and shares flat, Google is curbing hiring and seeking ways to run its sprawling empire more efficiently, according to recruiters, venture capitalists and others familiar with the matter.

    New Chief Financial Officer Ruth Porat, who joined the company in late May, is active in the effort. Ms. Porat, who reduced expenses and reallocated capital while CFO of Morgan Stanley, is involved in an internal audit examining costs, revenue and accounting systems, according to one of the people. She is looking to make her mark on what has become a more stable but more complex company, another person said.

    Google will offer an update on its expenses on Thursday, when it reports second-quarter financial results after regular trading hours and Ms. Porat is expected to speak during a conference call with Google analysts for the first time. The company declined to comment for this article.

    The clearest sign of the new attitude: Google added 1,819 employees in the first quarter, bringing its total to 55,419. That was the smallest increase since the final quarter of 2013; last year, Google added an average of 2,435 employees per quarter.

    For many years, Google teams assumed they could add staff each year. Now, Google executives are selecting which groups can hire, based on the company’s strategic priorities. Since late last year, many Google teams have had to submit plans describing how additional employees will produce specific business objectives, such as increased revenue or more users.

    Continued in article

     


    "The Hidden Side of Traditional Management Accounting," Vladimir Kuryakov Los Angeles International University, SSRN. April 23, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2604572

    Proceedings of the Research and Academic Conference "Research and Technology – Step into the Future". Transport and Telecommunication Institute, Riga, Latvia (2015)

    Abstract: Research by Flanholtz and Randle (1998) demonstrated striking results that successful companies from start-ups to Fortune 100 could experience extreme difficulties (and even failure) after sufficient growth including:

    • People Express, which reached $1.8 billion in revenue and then entered bankruptcy;

    • MaxiCare, which reached $1.6 billion in revenue and the entered bankruptcy;

    • Compaq Computers which reached $40 billion in revenue before it had to be sold to Hewlett-Packard to survive;

    • Osborne Computer which reached $100 million in revenue in two years, and went bankrupt in year 3;

    • Eastman-Kodak which once dominated the field of photography and now fights for survival;

    • Sears which was once “where America Shops” and now is fighting for survival.

    Many of these companies are regarded as leaders and even some of them were considered as “too big to fail”. In recent studies by Flamholtz and Randle (2007) pointed out that the common reason for failure was non-uniform development of organization, mainly delay in operation, strategic management systems and corporate culture. This is caused as management (especially of entrepreneurial type) of growing companies are not focusing on the fact that “All organizations are perfectly designed to get the result they get” and to get new higher results organizations need to be carefully re-designed, including environmental analysis and selection the proper configuration that corresponds strategy type of organization. In some cases management would like to control everything and insisting on functional configuration that suits for environment with limited scope of predictable changes and feel uncomfortable for necessity to delegate authority for matrix configuration that comply with highly unpredictable environment. Organizations with functional configuration are profitable as following effect of volume, but permitting very limited scope of changes compared to matrix and could not be successful in high unpredictable environment. Fact of inconvenience for changes is the reason that some factors limiting organizational capacities to drive growing revenues into profit were invisible for management as the hidden side of the Moon.

    We know it from the nature that it is really difficult to deal with something invisible. That is the reason for medical diagnostics for humans. The same is for organizations. Traditional management accounting excessively concentrated on revenue/profit oriented marketing metrics has limited opportunities to discover organizational risks experienced by businesses.

    The organizational risks could have been detected and eliminated early on if senior leaders had paid attention to the early warning signs.

    Flamholtz and Randle (2007) developed and validated general set of “growing pain” symptoms that could evaluate organizational risks for an organization as a result of “Growing pains Survey©”. In case of high value assessment research should be “drilled” through the organizational building blocks that helps to define specific problems as a result of “Organizational Effectiveness Survey©” that are grounds for organizational risks.

    Comparative analysis for local organizations with the similar is USA and other countries demonstrate differences in management habits and corporate culture. And such differences helps companies to become “best-in-the class” in high competitive markets and obtain sustainable competitive advantage.

    Keywords: Management science, organizational failure, organizational configuration, growing pains survey, organizational effectiveness survey, sustainable competitive advantage


    From the Global CPA Newsletter on September 24, 2014

    Begin preparing for the CGMA exam with an online practice test
    http://r.smartbrief.com/resp/geasBYbWhBCJtWdgCidKtxCicNnKyJ
    To help CGMA designation candidates prepare for the upcoming CGMA exam, a practice exam is now available. The practice exam illustrates the case study exam's key features, demonstrates the questions' format and allows candidates to gain familiarity of the exam's functionality. Visit CGMA.org to learn more, and download both pre-seen materials and exam answers.


    "Audi Drives Innovation on the Shop Floor:  A carmaker’s automated body shop illustrates how German manufacturing is moving forward," by Russ Juskalian, MIT's Technology Review, September 16, 2014 ---
    http://www.technologyreview.com/news/530691/audi-drives-innovation-on-the-shop-floor/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20140922

    Jensen Comment
    This and related robotics articles have important implications for cost accounting. Have cost accounting innovations kept pace with robotics manufacturing innovations? I have my doubts.


    "Discussing (Revenue) Variance Analysis with the Performance of a Basketball Team," by William R. Strawser and Jeffrey W. Strawser, Issues in Accounting Education, August 2014 ---
    http://aaajournals.org/doi/full/10.2308/iace-50671
    This article is not a free download, but I think, like most AAA journal articles, I think it can be distributed free to current students in accounting courses.

    ABSTRACT:

    While current cost and managerial accounting texts devote extensive coverage to comparisons of actual and expected costs, relatively scant attention is devoted to analyzing comparable differences in revenues. Methods commonly used to identify differences between actual and expected revenues include the calculation of variances such as the sales price (SPV), sales quantity (SQV), and the sales mix (SMV) variances. We decided to approach the discussion of these variances in an innovative setting by presenting the SQV and SMV in the context of analyzing the performance of a basketball team, providing a setting that is both appropriate and interesting for illustrating revenue variances. Also, there are trade-offs in the choice between two of these “revenue” sources, for example, should the shooter attempt a two- or a three-point shot? Other relevant questions propel the decomposition of the SQV into the market size (MSV) and market share (MShV) variances. Was the game an offensive showdown, tallying numerous shots, or a defensive lock-down with relatively few shots? How effective was the team in controlling the ball and scoring a dominant proportion of shots? Feedback from students indicates that this illustration provides an interesting and comprehensive discussion of revenue variances. Using this and similar settings, a better understanding of quantity and mix variances, and the impact of these variances on improving performance, may be obtained.

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

    PS
    Except for the Strawser and Strawser article, the teaching cases in IAE for August 14, 2014 are devoted to famous recent frauds ---
    http://aaajournals.org/toc/iace/current

  • Satyam Fraud: A Case Study of India's Enron by Veena L. Brown, Brian E. Daugherty and Julie S. Persellin

    Grand Teton Candy Company: Connecting the Dots in a Fraud Investigation by Carol Callaway Dee, Cindy Durtschi and Mary P. Mindak

    Blurred Vision, Perilous Future: Management Fraud at Olympus by Saurav K. Dutta, Dennis H. Caplan and David J. Marcinko

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


  • Teaching Case
    From The Wall Street Journal Weekly Accounting Review on August 1, 2014

    Moving to the Cloud? Engage Internal Audit Upfront to Manage Risks
    by: Deloitte Risk Journal Editor
    Jul 24, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Auditing, Cloud Computing, Internal Auditing

    SUMMARY: Cloud computing can yield significant benefits, from increasing speed to market and achieving better economies of scale to improving organizational flexibility and trimming spending on technology infrastructure and software licensing. As organizations increasingly migrate to cloud computing, however, they could be putting their data at significant risk. Positioning the internal audit (IA) function at the forefront of cloud implementation and engaging IA in discussions with the business and IT early on can help address potential risks.

    CLASSROOM APPLICATION: This article offers an example how the internal audit function of a business operates, in this case specifically with cloud computing.

    QUESTIONS: 
    1. (Introductory) What is the internal audit (IA) function of a business? Why would a business use IA?

    2. (Advanced) What is cloud computing? What is it value to a business? What new issues might it bring to the business?

    3. (Advanced) What value can the IA function bring to an organization's adoption of cloud computing? What problems could occur if the organization does not engage internal auditors in the process?

    4. (Advanced) What are the various stages of the process in which IA can help? In which stage do you see the greatest value added by IA? Why?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Moving to the Cloud? Engage Internal Audit Upfront to Manage Risks," by Deloitte Risk Journal Editor, The Wall Sttreet Journal, July 24, 2014 ---
    http://deloitte.wsj.com/riskandcompliance/2014/07/24/moving-to-the-cloud-engage-internal-audit-upfront-to-manage-risks/?mod=djem_jiewr_AC_domainid

    Cloud computing can yield significant benefits, from increasing speed to market and achieving better economies of scale to improving organizational flexibility and trimming spending on technology infrastructure and software licensing. As organizations increasingly migrate to cloud computing, however, they could be putting their data at significant risk. Those risks include reduced levels of control as information technology (IT) departments are bypassed, as some business owners opt to obtain services more quickly and cheaply by creating their own “rogue” technology environments via the cloud.

    Positioning the internal audit (IA) function at the forefront of cloud implementation and engaging IA in discussions with the business and IT early on can help address potential risks. “Internal auditors view the business through a risk lens,” says Michael Juergens, a principal at Deloitte & Touche LLP. “With their deep understanding of risk mitigation, internal auditors can work with the business and the IT function to build a framework for assessing and mitigating the risks associated with cloud computing.”

    Broadly defined, cloud computing is a model for enabling ubiquitous on-demand network access to a shared pool of configurable computing resources and services, which can be rapidly provisioned and released with minimal management effort or service provider interaction. The IA function can provide assurance on the effectiveness of risk mitigation efforts tied to cloud utilization, explains Mr. Juergens. “Before entering into agreements with cloud vendors or potential customers, a thorough assessment of the current vendor procurement process should be conducted by IA to determine how to mitigate cloud risks the company may be taking on,” he says. “And while an organization’s information security group can build cloud monitoring capabilities, IA can assist and assess the effectiveness of the control environment and prevent the IT department being left out of the loop.”

    A Steady Migration to the Cloud

    Companies are migrating to the cloud in such numbers because of significant advantages it can provide. Once the migration to cloud functionality is complete, organizations no longer face the task of creating and maintaining large data centers and developing proprietary complex systems. The expense of software upgrades or application patches is carried by the provider, which can allocate these costs across a wide customer base. Freed from large up-front capital investments, time-consuming installation and hefty maintenance costs, IT departments can focus on value-added activities that promote the business. While not every organization today has fully embraced cloud computing, chances are cloud services will be the norm within the next decade.

    The growing consumer use of social media and mobile technologies has also added to the demand for cloud services, as businesses seek better and faster ways to reach out to existing and potential customers. Some companies go beyond using the cloud to provide customer services. For instance, in an effort to focus its IT operations on business services, an online video rental and streaming company moved its internal applications to a cloud service provider and began using software as a service (SaaS) applications. Even governments are getting in on the game: A large metropolitan city equipped all its employees with an application for both email and cloud-based collaboration.

    The shift to cloud computing has essentially extended the boundaries of the traditional computer processing environment to include multiple service providers,” says Khalid Wasti, a director at Deloitte & Touche LLP. “This brings a complex set of risks to an organization’s data as it travels through the cloud.” When a company opts for the speed and convenience of moving to the cloud, it must often relinquish control not only of its own data, but that of its customers. Confidentiality, security and service continuity become critical considerations—as does regulatory compliance, which remains the responsibility of the business,” Mr. Wasti adds.

    How IA Can Help Assess Risks

    As an initial step, an organization should work with IA to create a Cloud Risk Framework Tool. “The tool can help the organization get to the heart of risks by providing a view on the pervasive, evolving and interconnected nature of risks associated with cloud computing,” adds Mr. Wasti. These include governance, risk management and compliance; delivery strategy and architecture; infrastructure security; identity and access management; data management; business resiliency and availability; and IT operations.  Such a tool can also improve efficiency in compliance and risk management efforts and be used to develop risk event scenarios that require integrated responses.

    To be more effective, the tool should be customized to include regulatory, geographic, industry and other specific issues that impact the organization. As IA modifies its organizational risk framework and guides the risk conversation with IT and the business, the following issues pertaining to infrastructure security, identity and access management and data management should be taken into account.

     1. Infrastructure Security—Companies should verify that cloud providers have acceptable procedures in areas such as key generation, exchange, storage and safeguarding, as flawed security could result in the exposure of infrastructure or data.

    2.  Identity and Access Management—Organizations should consider how their authorization and access models will integrate with new cloud services and assess whether they are using appropriate identity and authorization schemes.

    3.  Data Management—Because organizations may have to relinquish control over their data to cloud providers, it is crucial that they fully understand how data will be handled in the cloud environment.

    Moving Forward

    Implementing a cloud strategy changes the risk landscape in profound ways. As some risks are minimized, others spring up in their place. “Recognizing and responding to this shifting organizational risk profile is IA’s purview,” says Charlie Willis, a senior manager at Deloitte & Touche LLP. “Because internal auditors understand the interplay between business processes and risk, they can help business leaders to articulate their appetite for risk and help develop strategies for mitigating it,” he adds. As the organization adopts technology initiatives that involve cloud computing, IA should consider taking proactive steps to:

    Related Resources

    Social Media Risks Create an Expanded Role for Internal Audit

    Audit Committees: The Risks and Rewards of Emerging Technologies

    Creating a Cloud Risk Framework with Internal Audit Support

    Can Internal Audit Be a Command Center for Risk?

    The SEC’s Social Media Guidance: Issues and Risks to Consider


    Are the stock shares you own really yours?
    http://www.nytimes.com/2015/07/22/business/dealbook/funds-find-they-dont-really-own-dell-shares.html?_r=0


    How to Mislead With Statistics
    "How the Government Exaggerates the Cost of College," by David Lennhardt, The New York Times, July 29, 2014 ---
    http://www.nytimes.com/2014/07/29/upshot/how-the-government-exaggerates-the-cost-of-college.html?rref=upshot&_r=2

    The government’s official statistic for college-tuition inflation has become somewhat infamous. It appears frequently in the news media, and policy makers lament what it shows.

    No wonder: College tuition and fees have risen an astounding 107 percent since 1992, even after adjusting for economywide inflation, according to the measure. No other major household budget item has increased in price nearly as much.

    But it turns out the government’s measure is deeply misleading.

    For years, that measure was based on the list prices that colleges published in their brochures, rather than the actual amount students and their families paid. The government ignored financial-aid grants. Effectively, the measure tracked the price of college for rich families, many of whom were not eligible for scholarships, but exaggerated the price – and price increases – for everyone from the upper middle class to the poor.

    Here’s an animation that explains the difference succintly. It shows the government’s estimate of how college costs have changed since 1992 — and, for comparison, toggles between the changes in the colleges' published prices and actual prices, according to the College Board, the group that conducts the SAT.

    Continued in article

    Bob Jensen's threads on higher education controversies ---
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm


    Video
    "Seven Trends in Management Accounting," by Jim Martin, MAAW's Blog, February 18, 2014 ---
    http://maaw.blogspot.com/2014/02/seven-trends-in-management-accounting.html

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Question
    In the realm electric power, what is a "levelized cost?"

    Hint
    The Economist:  Wind and solar power are even more expensive than is commonly thought ---
    http://www.businessinsider.com/free-exchange-sun-wind-and-drain-2014-7#ixzz38bOmPFSx

    . . .

    But whereas the cost of a solar panel is easy to calculate, the cost of electricity is harder to assess. It depends not only on the fuel used, but also on the cost of capital (power plants take years to build and last for decades), how much of the time a plant operates, and whether it generates power at times of peak demand. 

    To take account of all this, economists use "levelised costs"--the net present value of all costs (capital and operating) of a generating unit over its life cycle, divided by the number of megawatt-hours of electricity it is expected to supply.

    The trouble, as Paul Joskow of the Massachusetts Institute of Technology has pointed out, is that levelised costs do not take account of the costs of intermittency. Wind power is not generated on a calm day, nor solar power at night, so conventional power plants must be kept on standby--but are not included in the levelised cost of renewables.

    Electricity demand also varies during the day in ways that the supply from wind and solar generation may not match, so even if renewable forms of energy have the same levelised cost as conventional ones, the value of the power they produce may be lower. In short, levelised costs are poor at comparing different forms of power generation.

    To get around that problem Charles Frank of the Brookings Institution, a think-tank, uses a cost-benefit analysis to rank various forms of energy. The costs include those of building and running power plants, and those associated with particular technologies, such as balancing the electricity system when wind or solar plants go offline or disposing of spent nuclear-fuel rods.

    The benefits of renewable energy include the value of the fuel that would have been used if coal- or gas-fired plants had produced the same amount of electricity and the amount of carbon-dioxide emissions that they avoid. 

    Mr Frank took four sorts of zero-carbon energy (solar, wind, hydroelectric and nuclear), plus a low-carbon sort (an especially efficient type of gas-burning plant), and compared them with various sorts of conventional power. Obviously, low- and no-carbon power plants do not avoid emissions when they are not working, though they do incur some costs.

    So nuclear-power plants, which run at about 90% of capacity, avoid almost four times as much CO{-2} per unit of capacity as do wind turbines, which run at about 25%; they avoid six times as much as solar arrays do. If you assume a carbon price of $50 a tonne--way over most actual prices--nuclear energy avoids over $400,000-worth of carbon emissions per megawatt (MW) of capacity, compared with only $69,500 for solar and $107,000 for wind.

    Nuclear power plants, however, are vastly expensive. A new plant at Hinkley Point, in south-west England, for example, is likely to cost at least $27 billion. They are also uninsurable commercially. Yet the fact that they run around the clock makes them only 75% more expensive to build and run per MW of capacity than a solar-power plant, Mr Frank reckons.

    To determine the overall cost or benefit, though, the cost of the fossil-fuel plants that have to be kept hanging around for the times when solar and wind plants stand idle must also be factored in. Mr Frank calls these "avoided capacity costs"--costs that would not have been incurred had the green-energy plants not been built.

    Thus a 1MW wind farm running at about 25% of capacity can replace only about 0.23MW of a coal plant running at 90% of capacity. Solar farms run at only about 15% of capacity, so they can replace even less. Seven solar plants or four wind farms would thus be needed to produce the same amount of electricity over time as a similar-sized coal-fired plant. And all that extra solar and wind capacity is expensive.

    A levelised playing field

    If all the costs and benefits are totted up using Mr Frank's calculation, solar power is by far the most expensive way of reducing carbon emissions. It costs $189,000 to replace 1MW per year of power from coal. Wind is the next most expensive. Hydropower provides a modest net benefit.

    But the most cost-effective zero-emission technology is nuclear power. The pattern is similar if 1MW of gas-fired capacity is displaced instead of coal. And all this assumes a carbon price of $50 a tonne. Using actual carbon prices (below $10 in Europe) makes solar and wind look even worse. The carbon price would have to rise to $185 a tonne before solar power shows a net benefit.

    There are, of course, all sorts of reasons to choose one form of energy over another, including emissions of pollutants other than CO{-2} and fear of nuclear accidents. Mr Frank does not look at these. Still, his findings have profound policy implications. At the moment, most rich countries and China subsidise solar and wind power to help stem climate change.

    Yet this is the most expensive way of reducing greenhouse-gas emissions. Meanwhile Germany and Japan, among others, are mothballing nuclear plants, which (in terms of carbon abatement) are cheaper. The implication of Mr Frank's research is clear: governments should target emissions reductions from any source rather than focus on boosting certain kinds of renewable energy.


    Responsibility Accounting --- http://www.businessdictionary.com/definition/responsibility-accounting.html
    For details see http://www2.gsu.edu/~accvjg/12_Responsibility_Acct.PDF

    "Problems with Traditional Responsibility Accounting," by Jim Martin, MAAW's Blog, July 22, 2014 ---
    http://maaw.blogspot.com/2014/07/problems-with-traditional.html

    To continue with the theme of the previous post on Elliott's Third wave breaks on the shores of accounting, see the following for some background on the problems with traditional responsibility accounting and recommended changes.

    McNair, C. J. 1990. Interdependence and control: Traditional vs. activity-based responsibility accounting. Journal of Cost Management (Summer): 15-23.
    http://maaw.info/ArticleSummaries/ArtsumMcNair90.htm

    McNair, C. J. and L. P. Carr, 1994. Responsibility redefined: Changing concepts of accounting-based control. Advances in Management Accounting: 85-117. http://maaw.info/ArticleSummaries/ArtSumMcnairCarr94.htm

    Dolk, D. R. and K. J. Euske. 1994. Model integration: Overcoming the stovepipe organization. Advances in Management Accounting (3): 197-212. http://maaw.info/ArticleSummaries/ArtSumDolkEuske94.htm

    Jensen Comment
    The big problems are the usual suspects in evaluation of managers, including long-term versus short-term evaluations and activities where managers have partial but not total control along with circumstantial events over which managers have no control, e.g., weather and the economy. There are also externalities that should be taken into account where decisions of a manager have direct and indirect impacts upon external realms such as how opening or closing of a plant affects the greater community outside the firm.

    "The Pay-for-Performance Myth,"  By Eric Chemi and Ariana Giorgi, Bloomberg Businessweek, July 22, 2014 ---
    http://www.businessweek.com/articles/2014-07-22/for-ceos-correlation-between-pay-and-stock-performance-is-pretty-random?campaign_id=DN072214

    Aside from outrageous compensation levels of top executives, my biggest gripe is how executives are paid outrageous salaries and golden parachutes even when they fail ---
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation

    Bob Jensen's threads on managerial accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     


    Jensen Comment
    We generally teach good things about the cost advantages of economies of scale. Perhaps we should had illustrations of some of the downers of economies of scale.

    "Why the Promise of Cheap Fuel from Super Bugs Fell Short:  The sell-off of synthetic biology pioneer LS9 goes to show that making biofuels from genetically engineered microbes is harder than though has yet to deliver economically, by Martin LaMonica, MIT's Technology Review, February 5, 2014 ---
    http://www.technologyreview.com/news/524011/why-the-promise-of-cheap-fuel-from-super-bugs-fell-short/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20140205

    . . .

    “Many of the claims being made in connection with biofuels in 2006 and 2007 were way too optimistic,” says MIT biotechnology and chemical engineering professor Gregory Stephanopoulos.

    The trouble, says James Collins, professor of biomedical engineering at Boston University, is that while the science behind these companies was promising, “in most cases, they were university lab demonstrations that weren’t ready for industrialization.”

    In addition to the challenge of designing effective organisms, synthetic-biofuel companies struggle with the high capital cost of getting into business. Because fuels are low-margin commodities, biofuel companies need to produce at large volumes to make a profit. Commercial plants can cost on the order of hundreds of millions of dollars. Some advanced biofuel companies have been able to secure the money for large-scale plants by going public, but now many investors have soured on biofuels. “People want to see things validated a little further along and take more technology risk off the table early. There’s little willingness for investors to pay for proofs of concept,” Berry says.

    Jay Keasling, cofounder of LS9 and the CEO of the Department of Energy’s Joint BioEnergy Institute acknowledges that synthetic-biology companies have moved more slowly than many investors had hoped. He also cautions against expecting bioenergy to undercut petroleum fuels on price any time soon. Making cost-competitive fuels with genetically engineered microbes will require advances in both science and engineering, he says. “We’re never going to have biofuels compete with $20-a-barrel oil—period,” he says. “I’m hoping we have biofuels that compete with $100-a-barrel oil.”

    In theory, hydrocarbons that can power planes and diesel engines are more valuable than ethanol, which has to be blended. But the yield of converting sugars to hydrocarbons is lower than the yield for ethanol because of the basic chemistry, Keasling says, so the economics depend more heavily on the price of sugar. “[Getting] the yields up to make them economically viable is very hard to do,” he says.

    Keasling says new techniques are needed to speed up the process of engineering fuel-producing organisms. If engineers could isolate desired genetic traits quickly and predict how a combination of metabolic pathway changes would affect a microörganism, then designing cells would be much faster, he says. “We need to be as good at engineering biology as we are at engineering microelectronics,” he says. Optimizing crops for energy production and new techniques for making cheaper sugars could also help bring down the cost.

    After cofounding LS9, Berry cofounded another biotech company called Joule that seeks to decouple fuel production from the price of sugar. It has engineered strains of photosynthetic microörganisms to produce fuels using sunlight, carbon dioxide, and nutrients, rather than from sugar (seeAudi Backs a Biofuel Startup” and “Demo Plant Targets Ultra-High Ethanol Production”).

    Given the challenges that have beset synthetic biology companies so far, some new companies are deciding from the outset not to make biofuels. Indeed, the first company to be spun out of Keasling’s Joint BioEnergy Institute—Lygos, based in Albany, California—has decided to make a few high-value chemicals, rather than fuel.


    "Factory Jobs Are Gone. Get Over It," by Charles Kenny, Bloomberg Businessweek, January 23, 2014 ---
    http://www.businessweek.com/articles/2014-01-23/manufacturing-jobs-may-not-be-cure-for-unemployment-inequality

    In the runup to this year’s State of the Union address, President Obama has been busy trying to fulfill pledges from last year’s. He went to Raleigh, N.C., to announce it would become a high-tech manufacturing hub to ensure that the U.S. attracts “the good, high-tech manufacturing jobs that a growing middle class requires.”

    The president is one of many politicians of both parties as well as pundits who think manufacturing deserves special treatment. But this factory obsession is based on flawed economics. As the Brookings Institute economist Justin Wolfers asked recently, “What’s with the political fetish for manufacturing? Are factories really so awesome?”

    Not really—at least not for the U.S. in 2014. Any attempt to draw lessons from the 1950s, when many a high school-educated (white, male) person got a job in a factory and joined the middle class, doesn’t account for the changes in the U.S. and global economy since the middle of the last century. While it’s smart to focus on creating more stable, remunerative jobs, few of them are likely to come from manufacturing.

    In 1953 manufacturing accounted for 28 percent of U.S. gross domestic product, according to the U.S. Bureau of Economic Analysis. By 1980 that had dropped to 20 percent, and it reached 12 percent in 2012. Over that time, U.S. GDP increased from $2.6 trillion to $15.5 trillion, which means that absolute manufacturing output more than tripled in 60 years. Those goods were produced by fewer people. According to the Bureau of Labor Statistics, the number of employees in manufacturing was 16 million in 1953 (about a third of total nonfarm employment), 19 million in 1980 (about a fifth of nonfarm employment), and 12 million in 2012 (about a tenth of nonfarm employment).

    Service industries—hotels, hospitals, media, and accounting—have taken up the slack. Even much of the value generated by U.S. manufacturing involves service work—about a third of the total. More than half of all people still employed in the U.S. manufacturing sector work in such services as management, technical support, and sales.

    Over the past 30 years, manufacturers have spent more on labor-saving machinery and hired fewer but more skilled workers to run it. From 1980 to 2012 across the whole economy, output per hour worked increased 85 percent. In manufacturing output per hour climbed 189 percent. The proportion of manufacturing workers with some college education has increased from one-fifth to one-half since 1969.

    Across richer countries, growth has been accompanied by a decline in the number of manufacturing jobs and the rise of service jobs. Some of the richer countries, such as France, that have seen the slowest decline in manufacturing’s share of employment have actually suffered some of the most sluggish growth. In the U.S., Eric Fisher of the Federal Reserve Bank of Cleveland suggests that those states where the shift from manufacturing employment has been the most rapid are those where wages have climbed the fastest.

    Developing countries have taken over much of the low-skilled, low-capital production once done in the U.S.: Consider the garment industry or tire manufacturing. Such low-tech work is even more mind-numbing and poorly paid than it was when the work was done in the U.S. through the 1970s. Many of the workers killed in the recent Rana Plaza garment factory collapse in Bangladesh earned just $3 a day. Some politicians have regretted the loss of similar jobs in the U.S. The question is: Do we want such jobs here now?

    Shutting the borders to low-cost imports in the hope of reviving low-skilled manufacturing employment at home would likely kill jobs, not save them. When Obama in 2009 slapped tariffs on Chinese tire imports that had flooded the U.S. market, he temporarily preserved 1,200 jobs in the tire industry as supplies tightened and U.S. tiremakers helped make up the difference. But the impact on the U.S. labor force as a whole was negative. Gary Hufbauer of the Peterson Institute estimates that the cost to U.S. consumers was more than $1 billion. As tires got more expensive, tire buyers had less money to spend on other goods. The effect of that drop in demand on retail employment was a loss of 3,731 jobs, three times the number preserved in the tire industry.

    Champions of reindustrialization often cite the cluster effect as a reason to back manufacturing. If a company builds a factory, then other factories will pop up in the same place to benefit from the industry knowledge and experienced workforce found there. If that theory were strongly supported by the facts, that might be a reason for governments to subsidize early investors in building the first plant somewhere. But work by economists Glenn Ellison of Massachusetts Institute of Technology and Ed Glaeser of Harvard suggests that while “slight concentration is widespread” among industries, “extreme concentration” is the exception. High levels of concentration aren’t a particularly common or unique feature of high-tech manufacturers (although high-tech service industries cluster in Silicon Valley). In manufacturing, the two economists suggest clustering is most evident in fur, wines, hosiery, oil and gas, carpets and rugs, sawmills, and costume jewelry.

    Continued in article

    Jensen Comment
    In the meantime cost and managerial courses and textbooks should be making the shift to accompany changing labor patters such as accounting for complicated indirect costs and services such as medical services, food services, and online selling.

    Management and Accounting Web (MAAW) --- http://maaw.info/


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on June 20, 2014

    GM Repair Costs Jump to $2 Billion
    by: Jeff Bennett
    Jun 17, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Contingent Liabilities, Product Recall

    SUMMARY: General Motors pushed its repair-cost estimate for auto recalls this year to $2 billion as it disclosed plans to replace potentially faulty ignition keys on 3.37 million older model cars in North America. The filing is located on the web at http://www.sec.gov/Archives/edgar/data/1467858/000146785814000184/ex-99106162014.htm In it, the company states, "GM expects to take a charge of up to approximately $700 million in the second quarter for the cost of recall-related repairs announced in the quarter. This amount includes a previously disclosed $400 million charge for recalls announced May 15 and May 20." These statements imply a $1.3 billion charge in the first quarter of 2014. In the 10-Q for the quarter ended March 31, 2014, under Notes Tables, Product Warranty and Related Liabilities, $1,386 million is disclosed as "Warranties issued and assumed in period - recall campaigns and courtesy transportation." Students are asked to find this amount.

    CLASSROOM APPLICATION: The article can be used to cover accounting for estimated warranty liability with this current issue facing General Motors.

    QUESTIONS: 
    1. (Introductory) In the article, the author writes that GM's repair cost estimate for auto recalls this year now totals $2 billion. Summarize the accounting for this estimate.

    2. (Advanced) Access the SEC filing describing this estimate in a press release located at http://www.sec.gov/Archives/edgar/data/1467858/000146785814000184/ex-99106162014.htm Scroll down to read until you find the actual amounts recorded by GM. In what time periods has this estimate been recorded?

    3. (Advanced) Explain the difference between the $2 billion highlighted in the title to this article and the amount disclosed in the press release. How much warranty costs do you think were estimated and recorded in the first quarter of 2014?

    4. (Advanced) Access the General Motors first quarter 2014 financial statements filed with the SEC and available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=1467858&accession_number=0001467858-14-000125&xbrl_type=v# Confirm the amount you determined in the question above. Where do you find this information?

    5. (Advanced) Compare this estimate to the one made for these 3 months in the preceding year.

    6. (Advanced) What other warranty provisions also are made in the first quarter of 2014? How do those compare to the preceding year?

    7. (Introductory) Has this warranty/product recall work actually been executed and paid for in this quarter? Explain.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    General Motors Recalls 1.7 Million More Vehicles
    by Jeff Bennett
    Mar 18, 2014
    Page: A

    "GM Repair Costs Jump to $2 Billion," by Jeff Bennett, The Wall Street Journal, June 20, 2014 ---
    http://online.wsj.com/articles/gm-recalls-more-vehicles-because-of-ignition-switch-1402949521?mod=djem_jiewr_AC_domainid

    General Motors Co. GM -0.21% on Monday pushed its repair-cost estimate for auto recalls this year to $2 billion as it disclosed plans to replace potentially faulty ignition keys on 3.37 million older model cars in North America.

    The move comes two days before Chief Executive Mary Barra is set to testify before a House committee on the auto maker's mishandling of an ignition switch recall involving Chevrolet Cobalts and other older models.

    The nation's largest auto maker is attempting to "clear the decks" of any potential recall problems ahead of Ms. Barra's testimony in a show of good faith to lawmakers currently investigating its safety operations, according to people familiar with the matter.

    Detroit-based GM said it would expand a second quarter charge to earnings by $300 million, to $700 million, to cover the costs for recalling older Buicks, Chevrolets and Cadillacs covered by the latest recall. The charge is in addition to a $1.3 billion spent in the first quarter.

    It was the second major ignition switch-related recall in less than a week. The auto maker on Friday recalled 500,000 newer-model Chevrolet Camaros with an ignition-switch that could turn off when jarred. It plans to change the key in those cars.

    In the latest action, GM would rework or replace the keys on about 3.37 million 2000 to 2014 model year cars in the U.S. because of a similar shift if the key is carrying extra weight and is jarred or bumped. Regulators continue to probe car parts suppliers about switches and air bag shut offs.

    GM intends to turn the slot on the end of the key head—used to hold a key ring—to a hole, alleviating the weight issue. The auto maker cited eight crashes and six injuries related to the latest recall.

    Continued in article


    Teaching Case:  Managerial Accounting Courses Should Focus on Long-Term and Short-Term Impacts of Poor Quality on Costs and Revenues
    From The Wall Street Journal Accounting Weekly Review on December 20, 2013

    Lululemon Woes Persist
    by: Ben Fox Rubin and Andrew Dowell
    Dec 13, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management, Managerial Accounting, Quality Costs

    SUMMARY: "Lululemon Athletica Inc. said hits to its reputation and continuing quality problems hurt sales of its yoga gear in November, contributing to a weak outlook that sent the company's stock sliding on Thursday."

    CLASSROOM APPLICATION: The article introduces the managerial topic of cost of quality issues with a product likely of interest to at least the female students in the class.

    QUESTIONS: 
    1. (Introductory) What events have led to Lululemon facing declining foot traffic in its stores? For further background, you may refer also to the related article.

    2. (Advanced) Define cost of quality and name four types of quality costs.

    3. (Advanced) Which types of cost of quality is Lululemon now experiencing? Name all that you can find from the article and support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Lululemon Pants Back in Stores After Recall
    by Suzanne Kapner
    Jun 03, 2013
    Page: B2

    "Lululemon Woes Persist," by Ben Fox Rubin and Andrew Dowell, The Wall Street Journal, December 13, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702303293604579253882031794794?mod=djem_jiewr_AC_domainid

    Lululemon Athletica Inc. LULU -0.56% said hits to its reputation and continuing quality problems hurt sales of its yoga gear in November, contributing to a weak outlook that sent the company's stock sliding on Thursday.

    The company has long enjoyed a loyal following that enabled it to command premium prices for its clothing.

    But it suffered a string of self-inflicted wounds this year, including the recall of popular yoga pants in March, the surprise resignation of its CEO in June and comments in November by its chairman, who appeared to say new quality problems were the fault of overweight customers.

    Lululemon Chief Financial Officer John Currie said on a conference call with analysts that all of those issues likely contributed to an unexpected drop in store traffic in November.

    "Any time there's negative PR for a company, there's an impact on the business," Mr. Currie said.

    That slowdown, along with quality-control problems that led monitors at the company's distribution centers to reject some product and left stores with inadequate supplies of some gear, prompted the company to lower its outlook for the rest of the year. Shares closed down 12% at $60.39 on Thursday.

    The weak outlook overshadowed growth in the company's third quarter.

    For the quarter ended Nov. 3, the Vancouver-based company reported a profit of $66.1 million, up from $57.3 million. Revenue grew 20% to $379.9 million.

    The company's gross margin slipped to 53.9% from 55.4% as product costs jumped 24%.

    Investors focused on the company's outlook for the holiday quarter.

    Continued in article

    See the topic Quality Cost and Models in MAAW at
    http://maaw.info/QualityRelatedMain.htm

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Teaching Case:  Contingent Liability for Paint Companies Who Obey the EPA Laws and Rules
    From The Wall Street Journal Accounting Weekly Review on December 20, 2013

    Lead-Paint Cleanup Ordered by Judge
    by: James R. Hagerty
    Dec 17, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Contingent Liabilities, Litigation

    SUMMARY: A California Superior Court judge in San Jose ordered Sherwin Williams Co., NL Industries Inc., and Con Agra Grocery Products Co. to fund $1.1 billion "to be used to clean up hazards from lead paint in hundreds of thousands of homes in the state." Past litigation in the states of Rhode Island, Missouri, Illinois, New Jersey and Wisconsin have failed to produce such results. "The defendants argued that they couldn't have known 50 or more years ago the full risks of lead and that the use of lead paint began declining after the 1920s as the knowledge of the hazards grew." Du Pont Co. and Atlantic-Richfield Co. (owned by BP PLC) were dismissed from the case.

    CLASSROOM APPLICATION: The article is an excellent resource to introduce accounting for contingent liabilities. Questions specifically direct students to the Sherwin Williams Co. SEC filings since that is the company most likely to be familiar to them.

    QUESTIONS: 
    1. (Advanced) Define the term contingent liability.

    2. (Introductory) Summarize the circumstances surrounding the legal case described in this article. Explain how these circumstances fit the definition of contingent liabilities to Sherwin Williams Co., NL Industries Inc., and Con Agra Grocery Products Co.

    3. (Advanced) Access the Sherwin Williams Co. filing of Form 10-Q for the 9 months ended September 30, 2013, available on the SEC web site at http://www.sec.gov/cgi-bin/viewer?action=view&cik=89800&accession_number=0000089800-13-000094&xbrl_type=v# Click on Notes to Financial Statements, then Litigation. Has the company accrued a liability for this lead pigment and lead-based paint litigation? What are its reasons for the accounting that has been done regarding these matters? State your answer in terms of the accounting requirements for contingent liabilities.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Lead-Paint Cleanup Ordered by Judge," by James R. Hagerty, The Wall Street Journal, December 17, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304173704579262851705350832?mod=djem_jiewr_AC_domainid

    A California Superior Court judge in San Jose ordered three current or former paint companies to pay $1.1 billion into a fund to be used to clean up hazards from lead paint in hundreds of thousands of homes in the state.

    The decision of Judge James Kleinberg, handed down Monday afternoon, requires payments by three defendants in the 13-year-old case: Sherwin-Williams Co. SHW +0.13% , NL Industries Inc. NL -1.93% and ConAgra Grocery Products Co. The judge dismissed two other defendants— DuPont Co. DD +0.84% and Atlantic-Richfield Co., owned by BP BP.LN +0.60% PLC—from the case. Under California law, the remaining defendants have 15 days to file objections to the decision, described as "proposed."

    Bonnie J. Campbell, a spokeswoman for the three remaining defendants, said they would appeal the decision unless the judge agrees to hold a new trial or declare a mistrial. Ms. Campbell said the ruling "violates the federal and state constitutions by penalizing manufacturers for the truthful advertising of lawful products, done at a time when government officials routinely specified those products for use in residential buildings." She added: "The risks to children alleged today were unknown and unknowable decades ago."

    The lawsuit, filed by 10 city and county governments in California, sought a court order requiring the defendants—current or former makers or distributors of paint and pigments—to pay to remove lead-paint hazards from homes in Los Angeles County, San Franciso and other places whose local governments joined the legal action. The judge ordered the creation of a fund to achieve those aims. It is to be administered by California's existing state Childhood Lead Poisoning Prevention Branch program.

    Nancy Fineman, an attorney representing local government bodies who filed the suit, said the decision would have a "tremendous impact on the health and welfare of the children of California." She said Sherwin-Williams, NL and ConAgra would have to decide among themselves how to divide the $1.1 billion cost of the program.

    The use of lead in residential paint has been banned in the U.S. since 1978 but it lies below layers of other paint and wall coverings in millions of homes. The cleanup plan doesn't require removal of all lead paint from homes. It does, however, require work to remove lead inside homes from such areas as window frames and doors where friction may release lead dust.

    Makers of cigarettes and products containing asbestos have paid billions of dollars in damages to people hurt by those items. Until this decision, however, paint companies managed to defeat lawsuits blaming them for the health problems of people exposed to lead since 1978. Such suits had failed in Rhode Island, Missouri, Illinois, New Jersey and Wisconsin.

    As a "bench trial," the California case didn't involve a jury. Motley Rice, a law firm that has reaped large fees in asbestos and tobacco litigation, advised the California plaintiffs on a contingency-fee basis.

    The suit said lead paint can "severely and permanently" damage children's mental and physical development and alleges that the defendants promoted the use of lead paint despite knowing about the risks. The continuing presence of lead paint in and around houses has created a "public nuisance" under California's civil code, the suit argues.

    The defendants argued that they couldn't have known 50 or more years ago the full risks of lead and that the use of lead paint began declining after the 1920s as knowledge of the hazards grew. In addition, they noted, old paint isn't the only source of lead risk to children; for example, gasoline containing lead, also now banned, left residues in soil.

    Christopher Connor, chief executive officer of Sherwin-Williams, in July told analysts he was confident of defeating the California suit. He added that Sherwin-Williams hadn't created a reserve to pay for a possible court-ordered cleanup.

    Jensen Comment
    This case will hinge upon just how much the paint manufacturers knew about the risks of lead in paint. There are not as many smoking guns as in the case of the tobacco industries phony denials of health risks of smoking. There is also the issue of adding tens of billions to clean up costs in the other 49 states, This case could easily destroy the age-old paint companies.

    See the topic Environmental Cost and Green Accounting
    http://maaw.info/EnvironmentalCostMain.htm

    Intangibles and Contingencies: Theory Disputes Focus Mainly on the Tip of the Iceberg ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    Teaching Case on Cost Accounting in a Medical Revolution and Those 500% Mark Ups
    From The Wall Street Journal Accounting Weekly Review on November 21, 2013

    What Care Costs. Really.
    by: Melinda Beck
    Nov 18, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management, Cost-Basis Reporting, Health Care, Managerial Accounting

    SUMMARY: Brent C. James is "...Chief Quality Officer for Intermountain Healthcare, a...network of 22 hospitals and 185 clinics in Utah and Idaho. Dr. James has been using electronic records to improve care and cut costs since the 1980s." In this interview-format article, he discusses the medical field push to a cost-based system, away from a current system of charging for services performed regardless of necessity of the procedure. The article gives classic examples of establishing standard costs for materials and labor such as management engineers "who go around and stopwatch how much time it takes a technician to set up a lab test. They measure how much glassware and reagent the test consumes to process...."

    CLASSROOM APPLICATION: The article may be used in a management accounting class to introduce standard costs, particularly the process of establishing standard costs.

    QUESTIONS: 
    1. (Introductory) Who is Brent C. James? What "medical revolution" may he be starting?

    2. (Advanced) Define the term "standard cost." What measurement techniques are described I the article to establish standard costs for hospital products and services?

    3. (Introductory) What does Dr. James say is the reason has it taken until now for hospitals to establish cost management systems?

    4. (Advanced) What is "transparency"? How has Dr. James's hospital network's management pledged to provide transparency?

    5. (Advanced) Are patients at Dr. James's hospital network going to seeing the cost data his team is compiling? Explain your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "What Care Costs. Really," by Melinda Beck, The Wall Street Journal, November 18, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304561004579135434122969634?mod=djem_jiewr_AC_domainid

    Brent C. James may be starting another medical revolution.

    As chief quality officer for Intermountain Healthcare, a Salt Lake City-based network of 22 hospitals and 185 clinics in Utah and Idaho, Dr. James has been using electronic records to improve care and cut costs since the 1980s.

    His data-driven clinical-management systems have been emulated around the world. He estimates that they save at least $250 million and 1,000 lives a year at Intermountain alone.

    Now, Intermountain is building an ambitious new data system that will also be able to track the actual cost of every procedure and piece of equipment used in its hospitals and clinics, a function that is standard in many industries but not in health care.

    Dr. James shared his vision and the challenges ahead with The Wall Street Journal. Cost Clarity

    WSJ: You've described your new data system as a "cost master," in contrast to the "charge master" that many hospitals use to set prices. What's the difference?

    DR. JAMES: In a charge master, what you're seeing is the old phenomenon called "mark it up to mark it down." Hospitals will make an initial estimate of what something costs, and then they'll mark it up—sometimes 400% to 500%. Insurance brokers measure success in the size of the discount they get. That's how you end up with $17 pieces of gauze. It loses all connection to reality.

    In a cost-master system, you have empirical, fact-based costs. We have eight management engineers, for example, who go around and stopwatch how much time it takes a technician to set up a lab test. They measure how much glassware and reagent the test consumes to process, and how much time it takes on the analyzing machine. The engineers load all that information into the cost master and they get the true cost of running that lab test. They do similar cost measurements on every item contained in our cost master.

    We figure we have about 5,000 clinical terms and upward of 25,000 total items in our cost master. Once I get those costs, I can manage them the way I would if I were building an automobile or a washing machine.

    These are not new systems. They've been around for a long time in other industries. All we're doing is shifting them over to health care. Truth is, Intermountain has run this sort of activity-based costing since 1983. It just wasn't integrated into clinical documentation through an electronic medical record [EMR]. With a link to the EMR, maybe we'll be able to move health care out of the dark ages.

     

    WSJ: How will knowing what everything costs change the way you deliver care?

    DR. JAMES: If you know the true cost of providing care, you can ask yourself whether doing one thing is really more important than doing something else.

    Our mission statement is: the best medical result at the lowest necessary cost. We think there is enough waste in health care that we can dramatically improve our costs. But to do that, I've got to be able to measure and manage those costs.

    A Money Loser?

    WSJ: In fee-for-service medicine, hospitals lose money when they cut costs and unnecessary care. How do you get around that?

    DR. JAMES: That's why Intermountain made the decision several years ago to shift our business, over time, to capitated care.

    In the past, the way to make money was to do more. Figure out how to do more surgeries, even if they're unnecessary. Add that famous physician to try to attract more patients. It creates a medical arms race. Imagine instead that I get a per-member, per-month payment for a population of patients. I no longer have a strong financial incentive for doing more. If I find a way to save money by taking out waste, all the savings come back to me and my patients. At the same time, I make measures of quality outcomes transparent. That way patients can know they are getting good care, and know what it will cost them.

     

    WSJ: What impact do you expect this to have on the health-care industry?

    DR. JAMES: The whole health-care world is shifting to having the care provider take over the financial risk. In that world, your survival depends on being able to manage your costs. We happened, by luck and circumstance, to get going on it early on. Suddenly this is becoming a race, with some very capable groups entering the fray—but it's a race toward excellence.

    Total Transparency

    WSJ: Will patients be able to see your actual costs?

    DR. JAMES: We made a commitment from senior management that we will be completely transparent.

    We have already started to post prices for things that many patients buy directly, such as lab tests and imaging exams [such as X-rays]. We will soon add things like routine office visits and simple procedures, like screening colonoscopy. Later we will add major treatments like delivering a newborn, or surgery to implant an artificial knee joint.

    While we will post prices on our website, probably the most effective sharing of cost information will happen through our insurance partners' websites. We believe that patients will mostly want to know what their own out-of-pocket costs will be, given that they've already paid for their health insurance. That's true even if your "insurance plan" is the care delivery group.

    Finally, remember that some care delivery is impossible to price as a package deal in advance. For example, treatment of major automobile trauma is so unique that it's impossible to predetermine a standard price.

     

    WSJ: How much will the new system cost?

    DR. JAMES: Several hundred million dollars. But I could pay for it in one year, if I can use it to get significantly more waste out.

    Continued in article

    Bob Jensen's universal health care messaging --- http://faculty.trinity.edu/rjensen/Health.htm

     


    Teaching Case on Forecasting the Free Cash Flow Breakeven Point

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

    Tesla Stock Skids on Outlook
    by: Mike Ramsey
    Nov 06, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cash Flow, Lease Accounting, Revenue Forecast, Stock Options, Stock Price Effects

    SUMMARY: This article describes many financial accounting issues related to Tesla Motors' quarterly filing for the three months ended September 30, 2013. As of this writing only the Form 8-K filing for the press release of these results has been made. Topics addressed include overall description of financial performance, stock based compensation, leasing revenues versus outright sales, and free cash flow. Managerial topics of production constraints and investment in property, plant, and equipment also are touched upon.

    CLASSROOM APPLICATION: The article may be used in a financial accounting class to cover the wide array of topics listed above and below.

    QUESTIONS: 
    1. (Introductory) Summarize the Tesla Motors financial performance reported in the article for the three months ended September 30, 2013

    2. (Introductory) How did the stock market react to the company's performance? What was the reason for this reaction?

    3. (Advanced) The company has said it had "adjusted income" of $15 million after excluding the accounting for certain items. What are these items? List the items and briefly explain the accounting for them.

    4. (Advanced) What do you think is the rationale for excluding "stock-based compensation costs" in describing the company as profitable rather than losing money?

    5. (Advanced) "Tesla began a leasing program this year...." How many of Tesla's customers lease their vehicles rather than buy them? Do you think that having a customer take a lease of a vehicle is as good as making an outright sale? Explain your answer.

    6. (Advanced) Why must some revenue be deferred when a customer leases rather than buys a vehicle? Hint: To understand the leasing and other programs offered to its customers, you may access the most recent Tesla Motors filing on Form 10-Q with the SEC click on Notes to Financial Statements, then Summary of Significant Accounting Policies, and scroll down to Revenue Recognition.

    7. (Advanced) Is it helpful to understand the company's operations when Tesla Motors says that it would have had revenues of $602 million rather than the $431 million reported in this quarter's income statement if it had counted all revenue from auto leases as sales? Explain your answer.

    8. (Advanced) What is free cash flow? What does it mean for the company to forecast "break-even free cash flow"?

    9. (Advanced) What is a production constraint? What constraint is Tesla Motors currently facing?

    10. (Advanced) What purchase of property, plant and equipment is Tesla Motors' leader, Elon Musk, proposing? If this plan is undertaken, will it impact the company's free cash flow? Explain your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Tesla Stock Skids on Outlook," by Mike Ramsey, The Wall Street Journal, November 6, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304391204579179953951299592?mod=djem_jiewr_AC_domainid

    Tesla Motors Inc. TSLA -7.53% reported a narrower third quarter net loss on higher production but its shares fell sharply in after-hours trading as investors worried the luxury electric car maker's outlook for revenue and profit fell short.

    The Palo Alto, Calif., company said it delivered 5,500 of its $70,000 and up Model S electric cars in the three months ended Sept. 30, including 1,000 vehicles shipped to Europe. That was more than the company had projected earlier but below the whisper number of as many as 7,000 cars.

    Tesla's shares fell 12% in after hours trading on Tuesday after the company told investors to expect fourth quarter adjusted profit would be similar to the third quarter. Excluding stock-based compensation costs and accounting for Model S leases and "noncash interest expense," the company said it had adjusted income of $16 million, or 12 cents a share, in the quarter.

    Shares gained $1.61 to $176.81 in 4 p.m. trading on the Nasdaq Stock Market NDAQ -1.07% before the release of quarterly results.

    Chief Executive Officer Elon Musk said the company would continue to increase production over the next several quarters from its current rate of about 550 cars a week. Tesla forecast production of about 6,000 Model S sedans in the current quarter.

    Mr. Musk said the company is production constrained primarily because of a lack of battery cells for its battery-powered Model S. He said he expects the company's battery supply to improve next year as a result of a new agreement with Panasonic Corp. 6752.TO -2.55%

    Tesla Motors Inc. reported a narrower third quarter net loss on higher production but its shares fell sharply in after-hours trading as investors worried the outlook for revenue and profit fell short. Mike Ramsey reports. Photo: Jason Henry for The Wall Street Journal.

    Mr. Musk said that when Tesla begins building in late 2016 or 2017 its mass-market electric vehicle, current production capacity for the lithium-ion batteries won't be adequate. The company is exploring building a battery plant with partners, most likely in North America, he said on a conference call.

    "There will need to be incremental production capacity that doesn't exist in the world today," Mr. Musk said. "There will need to be some kind of giga factory build."

    Mr. Musk described the proposed battery factory as one that could take raw materials in at one end, and ship finished battery packs from the other end, evoking a lithium-ion battery equivalent of Ford Motor Co. F -2.13% 's Rouge complex that early in the 20th century took in iron ore and rolled out finished Model Ts.

    The company posted a net loss of $38 million, or 32 cents a share, down from a loss of $110 million, or $1.05 a share, a year earlier. Revenue rose eightfold to $431 million from $50 million a year ago when the Model S was just starting to be delivered. Compared with the second quarter, Tesla's revenue was up 6%.

    On an operating basis, Tesla lost $30.6 million. Now Reporting

    Track the performances of 150 companies as they report and compare their results with analysts' estimates. Sort by date and industry.

    More photos and interactive graphics

    Tesla's gross margin, the profit after product costs, was 24%. The company aims to get to a 25% gross margin by year-end.

    Tesla began a leasing program this year under which some revenue is deferred. Tesla said that if it took credit for the total revenue expected from each lease transaction, it would have had revenues of $602 million in the last quarter. Customers leased about half of the Model S sedans delivered in the period, the company said.

    Continued in article


    "How not to cut ethical corners as economic growth slows in emerging markets," by Sabine Vollmer, CGMA Magazine, October 10, 2013 ---
    http://www.cgma.org/magazine/news/pages/20138871.aspx

    Challenging economic conditions are increasing the risk of unethical practices in markets around the world, according to EY surveys in Asia-Pacific, Europe, Africa and the Middle East.

    After years of rapid growth, economies in Brazil, Russia, India, China and South Africa, known collectively as the BRICS, have slowed considerably, International Monetary Fund data show. The economic environment has also gotten more difficult in central and eastern Europe, the Middle East and North Africa.

    EY surveys found that many companies in these countries are under increased pressure to meet targets of their investors and owners. In countries where enforcement of anti-bribery and anti-corruption laws is less rigorous, survey respondents perceived a rise in unethical practices. The surveys involved 681 executives, senior managers and other employees at companies in eight Asia-Pacific countries and more than 3,000 board members, managers and their team members in 36 European, African and Middle Eastern countries.

    While regulatory efforts to tackle fraud and corruption seem to be improving in China, where only 9% of respondents said using bribery to win contracts is common practice in their industry, 79% of respondents in Indonesia reported widespread bribery and corruption.

    In South Korea, where investigations into alleged bribery are underway at state-owned enterprises, 86% of respondents said their companies have policies that are good in principle but do not work well in practice.

    In India, 74% of respondents reported increased pressure to deliver good financial performance in the next 12 months, and 54% of respondents said their companies often make their financial performance look better than reality.

    Respondents in Spain and Russia reported the highest incidence of misleading financial statements (61%).

    About half of all respondents in Malaysia (54%) said their companies are likely to take ethical short cuts to meet targets when economic times are tough, or double the Asia-Pacific average (27%).

    Local application is key

    “The majority of businesses surveyed have created or are in the process of creating policies and procedures to deal with fraud, bribery and corruption,” Chris Fordham, an EY managing partner for Asia-Pacific, observed in the introduction of one of the survey reports. “However, too often we see a disconnect in the local application of these policies and tools.”

    The Asia-Pacific findings echo results of the survey involving European, Middle Eastern, Indian and African companies, Fordham said.

    Big data technology. Seventy-eight per cent of the Asia-Pacific respondents agreed that tapping the large volumes of data companies generate and collect routinely to examine all company transactions would result in better fraud detection and more effective prevention of corruption, but only 53% do it. In several Asia-Pacific countries, including Malaysia and Indonesia, IT investments are still seen more as a burden than a tool.

    Whistleblower programmes. Eighty-one per cent of the Asia-Pacific respondents considered them useful, mainly because whistleblower programmes are easy to access and employees are willing to use them, but only 32% set them up. Concerns about potential retribution and lack of legal protection and confidentiality prevent implementation of whistleblower programmes. Thirty-four per cent of respondents in Europe, Africa and the Middle East said their companies had whistleblower programmes.

    Codes of conduct. About half of the respondents in Europe, Africa and the Middle East said their companies had anti-bribery codes of conducts with clear penalties for breaking them and that senior management was strongly committed to the codes of conduct. Forty-eight per cent said certain unethical practices, such as offering gifts or cash to win business or falsifying financial statements, are justified to help a business survive an economic downturn. In Asia-Pacific, 40% of respondents said their companies have anti-bribery codes of conduct, but only 34% include clear penalties and senior management at only 35% of companies were seen as strongly committed to compliance.

    How to better manage the risks

    Continued in article

    Bob Jensen's threads on professionalism and ethics ---
    http://faculty.trinity.edu/rjensen/Fraud001c.htm

     


    Jensen Questions
    Why build that new GM plant in Arlington, Texas and not the historic Motor City, Detroit?
    Isn't Detroit centrally located for both the USA and Canadian vehicle markets?
    Aren't there enough good auto workers left in Detroit? I hope so in Detroit and other parts of Michigan!
    Won't the UAW make concessions to save Detroit? I hope so for the sake of Detroit and Michigan!
    (Note that the UAW did make concessions on wages, pensions, and robotics when both GM and Chrysler were in Bankruptcy courts.)
    What's the continuing comparative advantage of Texas?

    Teaching Case for Managerial Accounting
    From The Wall Street Journal Accounting Weekly Review on October 17, 2013

    GM Cuts Costs for the Long Haul
    by: Jeff Bennett
    Oct 14, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management, Managerial Accounting, Manufacturing, Supply Chains

    SUMMARY: General Motors Co. is opening a $200 million metal-stamping plant next to its Arlington, TX, site. Hoods, fenders, and doors going into Tahoe and Yukon sport-utility vehicles for years were made in Ohio and Michigan, then shipped to Texas. The new plant reduces the travel for these parts "...to about 20 feet from machine to welder. Estimated savings: about $40 million a year in shipping costs." GM's CEO Dan Akerson is focusing on reducing logistics costs "to close the company's profit margin gap with rival Ford Motor Co."

    CLASSROOM APPLICATION: The article may be used in a managerial accounting class to introduce logistics and supply chain management. It also includes managerial accounting uses of four financial accounting measures: gross profit, operating margin, operating profit, and pre-tax profit.General Motors

    QUESTIONS: 
    1. (Advanced) Define the terms logistics and supply chain management.

    2. (Introductory) Summarize how GM is trying to improve profitability by reducing costs of logistics.

    3. (Advanced) Why do you think that consultant John Henke says "auto makers who are just trying to cut costs and not working with the parts makers will lose"?

    4. (Introductory) GM's overriding reasons for making moves to cut logistics costs have to do with comparisons to rival Ford Motor Co. What was the average profitability per vehicle shipped for Ford in the quarter ended June 30, 2013? For GM?

    5. (Advanced) How do you think that Ford and GM determine average profitability per vehicle?

    6. (Advanced) What are the differences among operating margin, operating profit, and pretax profit? In your answer, define each of these terms.

    7. (Introductory) How do GM and Ford compare on each of the metrics discussed in question 6?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "GM Cuts Costs for the Long Haul," by Jeff Bennett, The Wall Street Journal, October 14, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304500404579127860223275366?mod=djem_jiewr_AC_domainid

    For years, General Motors Co. GM +1.51% pounded out hoods, fenders and doors for its Tahoe and Yukon sport-utility vehicles at plants in Ohio and Michigan and shipped them to its assembly plant in Arlington, Texas.

    On Monday, the auto maker officially opens a $200 million metal-stamping plant adjacent to the Arlington factory that reduces that travel to about 20 feet from machine to welder. Estimated savings: about $40 million a year in shipping costs.

    The new plant, is part of a broader rethinking of logistics by GM Chief Executive Dan Akerson, who is anxious to close the company's profit margin gap with rival Ford Motor Co. F +0.98%

    His aim is to lift GM's North American margins to 10% from about 8% now, a feat that would generate hundreds of million of dollars in new profit.

    "We spend billions a year on logistics," Mr. Akerson said. "Think about that, billions. Any savings I can get by cutting my logistics bill goes right to my bottom line and makes us more competitive. I've told our teams that we need to make this a priority to look across the organization and take the steps to cut the costs."

    Having cut labor costs and closed unprofitable plants during the 2008/2009 recession, GM now sees logistics as representing the biggest potential opportunity to squeeze new profit from operations.

    For its second quarter ended June 30, crosstown rival Ford earned $2,830 for each car it shipped in North America—$387 more per vehicle than GM did during the same period. Ford's 10.4% operating margin and $2.3 billion operating profit overshadowed GM's 8.4% operating margin and $1.98 billion pretax profit in the region.

    Co-locating parts-making and auto assembly promise higher quality and greater profit. GM and other auto makers say they can no longer put up with parts that arrive scratched or dented and have to be repaired. Workers at the Arlington plant had to waste time trying to buff out imperfections caused by travel, GM said.

    "We as an industry chased labor costs for years because that was the only thing we thought we could control," said Tim Leuliette, CEO of parts maker Visteon Corp. VC +1.30% "Now, with the reset of labor costs, especially in the U.S., more efficiency in the plants and the importance of quality, we can finally evolve."

    Mr. Leuliette points to his own company's plans, which include building more production facilities in Russia to supply car makers there. Last month the company's Halla Visteon Climate Control unit opened its first plant in Togliatti, Russia, to build cooling, heating and air conditioning units for local producers such as OAO AvtoVAZ.

    "They have finally all wised up," said John Henke, chief executive of consultants Planning Perspective Inc., which conducts an annual survey of auto maker and supplier relationships. "But unless all of them stick with it, the savings won't amount to peanuts. I can't tell you how many times we see new people on the executive level come in and change things."

    Mr. Henke said the drive to co-locate factories intensifies the cost pressures on the parts suppliers. "Those auto makers who are just trying to cut costs and not working with the parts makers will lose," Mr. Henke said. "They will lose out on the latest advancements and financial savings. Then all the logistic changes in the world won't mean much."

    Continued in article


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review
    on August 9, 2013

    CBS-Time Warner Cable Dispute Shows an Industry Unaware of Reality
    by: Martin Peers
    Aug 07, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management, Revenue Recognition

    SUMMARY: The article describes a current dispute "..that has become commonplace in pay TV, centering on how much more money Time Warner Cable should pay to carry CBS on its cable lineup....[A]t the core of it, the companies are squabbling over their share of pay-TV's spoils-money that, if the newspaper and music industries are any guide, could disappear much faster than anyone expects." The related video clearly describes the fees being disputed by Jason Bellini in #TheShortAnswer.

    CLASSROOM APPLICATION: The article may be used to discuss revenue-related contracts and cost control with a focus on change, including decline, and innovation.

    QUESTIONS: 
    1. (Introductory) For what service does Time Warner Cable pay CBS?

    2. (Introductory) What is the nature of the current dispute between the two companies? (Hint: The related article and video both help in answering this question.)

    3. (Introductory) How have these contracts in dispute impacted costs at cable operators?

    4. (Introductory) Access the related video "The Short Answer: Why Time Warner Cable and CBS are at War." List all alternatives available to viewers for watching their favorite television shows.

    5. (Advanced) How have changes in this sector of the entertainment industry impacted the way each party views the value of this contract between the cable operator and network television stations? How are these changes comparable to the newspaper and music industries?

    6. (Advanced) What do you think might happen to the primary sources of revenue to television network stations given the changes describe in this and the related article?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Future of Cable Might Not Include TV
    by Shalini Ramachandran and Martin Peers
    Aug 05, 2013
    Page: B1

     

    "CBS-Time Warner Cable Dispute Shows an Industry Unaware of Reality," by Martin Peers, The Wall Street Journal, August 7, 2013 ---
    http://online.wsj.com/article/SB10001424127887323420604578652271175622986.html?mod=djem_jiewr_AC_domainid

    If anyone in the media world should pay attention to the Washington Post's WPO -0.64% sale, it's Time Warner Cable Inc. TWC +0.78% CEO Glenn Britt and CBS Corp. CBS -0.13% chief Les Moonves.

    It was a mere coincidence that news of the Post sale broke right after Mr. Britt had sent his latest missive to Mr. Moonves in a months-long squabble over money. But the timing highlighted the essence of what another cable executive, Jim Dolan of Cablevision Systems Corp., CVC +0.10% was quoted saying Monday: The pay-TV industry is in a bubble. And it remains perilously out of touch.

    The dispute is one that has become commonplace in pay TV, centering on how much more money Time Warner Cable should pay to carry CBS on its cable lineup. CBS says it wants to be "paid fairly" for its programming, while Time Warner Cable says it is trying to protect its customers. But at the core of it, the companies are squabbling over their share of pay-TV's spoils—money that, if the newspaper and music industries are any guide, could disappear much faster than anyone expects.

    As Dish Network Corp. Chairman Charlie Ergen said on Tuesday, "all the content revenue in the industry is probably at risk," adding that "I don't think the industry quite understands how the Internet works."

    The Washington Post's $250 million sale perfectly captures how digital technology has sucked most of the value out of newspapers as advertisers defect to the Web.

    Newspaper print ads fell 55% between 2007 and 2012, according to the Newspaper Association of America.

    It isn't only the Post suffering. The Boston Globe was sold for $70 million Saturday, a fire sale for New York Times Co., which paid $1.1 billion for it 20 years ago. That's what is called value destruction.

    Other sectors of media haven't fared much better. In music, thanks to both piracy and the digital dismantling of the album system, album sales fell 54% between 2000 and 2012, according to Nielsen SoundScan. There are now just three major music companies, when six existed in the mid-1990s.

    Newsweek has its third owner in three years.

    Some other companies are responding to the digital transition. On Madison Avenue, Publicis Groupe SA's proposed merger with Omnicom Group Inc. is an attempt to get ahead of the curve, joining forces to better compete with Silicon Valley ad giants.

    In television though, it isn't about the future. It's about protecting the past. The players are seeking to squeeze more money from the existing ecosystem—an ecosystem in which U.S. households pay an average of $84 a month, according to SNL Kagan, for hundreds of channels they don't watch.

    Cable networks' share of those fees is expected to amount to $44 billion this year, SNL Kagan says. That is separate to the $24 billion in advertising that flowed to cable networks last year, estimates Kantar Media.

    These huge flows of cash have fueled profits of big entertainment companies in recent years. Time Warner Inc., 21st Century Fox (the now-separate former entertainment side of News Corp, which owns The Wall Street Journal), Walt Disney Co. and Viacom Inc. each derive the majority of their profits from cable networks. Broadcasters, long out of that loop, are making up for lost time by seeking bigger cash fees, which explains CBS's current battle with Time Warner Cable.

    But as Messrs. Dolan and Ergen have acknowledged, these arrangements aren't sustainable. Younger people watch what they want online, making the idea of cable TV less appealing. The percentage of people age 13 to 33 subscribing to pay TV fell to 76% this June from 85% in June 2010, a new study by research firm GfK found.

    "Cord cutting used to be an urban myth. It isn't any more," said cable analyst Craig Moffett in a report Tuesday.

    Yet the entertainment companies seem blissfully unaware. Yes, most make their cable programming available online, but only to TV subscribers who remember passwords, itself a turnoff. Some shows are separately licensed to online outlets, like Amazon.com Inc., Hulu or Netflix Inc., but not every outlet has all seasons.

    Continued in article


    "The Cost-Effectiveness of Armored Tactical Wheeled Vehicles for Overseas U.S. Army Operations," by Chris Rohlfs and Ryan Sullivan, SSRN, June 11, 2013 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916818

    Abstract:     
    This study uses For Official Use Only data on U.S. military operations to evaluate the large-scale Army policies to replace relatively light Type 1 Tactical Wheeled Vehicles (TWVs) with more heavily protected Type 2 variants and later to replace Type 2s with more heavily protected Type 3s. We find that Type 2 TWVs reduced fatalities at $1.1 million to $24.6 million per life saved, with our preferred cost estimates falling below the $7.5 million cost-effectiveness threshold, and did not reduce fatalities for administrative and support units. We find that replacing Type 2 with Type 3 TWVs did not appreciably reduce fatalities and was not cost-effective.

    Harvard Business Review Blog, September 10, 2013

    In substituting heavily armored combat vehicles at a cost of $170,000 each for lighter, $50,000 vehicles during the 2000s, the U.S. Army reduced infantry deaths by 0.04-0.43 per month at an estimated cost per life saved that is below the $7.5 million commonly accepted "value of a statistical life," say Chris Rohlfs of Syracuse University and Ryan Sullivan of the U.S. Naval Postgraduate School. However, the Army's subsequent replacement of about 9,000 of those new vehicles with even more heavily armored vehicles, costing $600,000 each, did not appreciably reduce fatalities and was not cost-effective for less-active infantry units, according to the researchers' analysis of Army data.

    Jensen Comment
    I'm not quite sure about how or why "$7.5 million (is) a commonly accepted 'value of a statistical life.'"

    In courts of law other factors are used in valuing human life, including age where younger people are valued more highly. The value of us old has beens declines rapidly. Most infantry soldiers are relatively young (certainly compared to me).

    Of course in courts of law settlements must be doubled or tripled for the so-called value of the lawyers.

     


    From the CFO Journal's Morning Ledger on June 6, 2013

    Companies turn to 3-D printing to cut costs
    Thanks to cheaper equipment and better technology, 3-D printing is moving into the mainstream of business faster than many people realize,
    CIO Journal’s Clint Boulton reports. GE‘s Aviation unit prints fuel injectors and other components within the combustion system of a jet engine. GE is also experimenting with 3-D printing to produce a medical device, the ultrasound probe. Researchers at GE say that 3-D printing could help cut the costs of manufacturing certain parts of the probe by 30%.

    Jensen Comment

    This technology seems to be betting for an accounting research case study in cost accounting.

    Bob Jensen's Helpers for Case Writers ---
    http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Cases


    There is a different legislative framework in the EU and the US regarding internal controls in companies. In the US, regulation on an audit of internal control on financial reporting is contained in the Sarbanes-Oxley Act, and subsequently embodied in the PCAOB standards. In the EU, internal control regulations are contained in Company Law of the member states. As a consequence, legislative differences have a pervasive effect on our analysis ---
     http://ec.europa.eu/internal_market/auditing/docs/ias/evalstudy2009/report_en.pdf


    From the CFO Journal's Morning Ledger on January 7, 2015

    New COSO Internal Control Framework Takes Effect
    http://deloitte.wsj.com/cfo/2015/01/07/new-coso-internal-control-framework-takes-effect/

    As of December 15, 2014, the new 2013 COSO framework superseded the 1992 version for companies applying and referencing COSO's internal control framework for purposes of complying with Section 404 of the Sarbanes-Oxley Act of 2002. For banks and capital markets firms, which operate under a complex regulatory environment, the transition to the new framework involves careful considerations.

    Continue Reading Today's Article »

    Read more Deloitte Insights »

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     

    Committee of Sponsoring Organizations of the Treadway Commission (COSO) ---
    http://en.wikipedia.org/wiki/Committee_of_Sponsoring_Organizations_of_the_Treadway_Commission

    "COSO’s ERM framework to undergo update," by Ken Tysiac, Journal of Accountancy, October 21, 2014 ---
    http://www.journalofaccountancy.com/News/201411173.htm

    A well-known framework for risk management is scheduled for another update.

    The Committee of Sponsoring Organizations of the Treadway Commission (COSO) announced Tuesday that it is undertaking a project to update its Enterprise Risk Management—Integrated Framework, which debuted in 2004.

    Organizations use the framework to help them manage uncertainty, consider how much risk to accept, and improve understanding of their opportunities to increase and preserve value.

    The update is being undertaken to improve the framework’s content and relevance in the context of an increasingly complex business environment. The update is intended to:

    • Reflect the evolution of risk management thinking and practices, as well as stakeholder expectations.
    • Develop tools to help management report risk information, and review and assess the application of enterprise risk management.


    PwC has been engaged to update the framework under the direction of COSO’s board. PwC will seek input and feedback on the project, and will conduct a survey seeking opinions on the current framework and suggestions for improvements.

    More information is available at coso.org.

    COSO is a committee of five sponsoring organizations, including the AICPA, that come together periodically to provide thought leadership on enterprise risk management, internal control, and fraud deterrence.

    In 2013, COSO completed an update of its internal control framework to reflect changes in technology and the business environment that have taken place since that framework’s origination in 1992.

     

    What's New with COSO?

    From the CFO Journal's Morning Ledger on September 24, 2014

    Implementing COSO's Internal Control-Integrated Framework ---
    http://deloitte.wsj.com/cfo/2014/09/26/implementing-cosos-internal-control-integrated-framework/

    To unlock the value that can be achieved by adopting COSO's 2013 Internal Control-Integrated Framework, management should take a step back and evaluate how it is addressing the risks to its organization in light of its size, complexity, global reach and risk profile. Learn about leading internal control practices that may help address common challenges related to implementing the 2013 Framework, as well as perspectives on applying the framework for operational and regulatory compliance purposes.

    Continue Reading Today's Article --- http://deloitte.wsj.com/cfo/2014/09/26/implementing-cosos-internal-control-integrated-framework/

    Read More --- Deloitte Insights »http://deloitte.wsj.com/cfo/

     

    May 14, 2013

    2013 Internal Control-Integrated Framework Released

    COSO has issued the 2013 Internal Control–Integrated Framework (Framework). The Framework published in 1992 is recognized as the leading guidance for designing, implementing and conducting internal control and assessing its effectiveness. The 2013 Framework is expected to help organizations design and implement internal control in light of many changes in business and operating environments since the issuance of the original Framework, broaden the application of internal control in addressing operations and reporting objectives, and clarify the requirements for determining what constitutes effective internal control.

    COSO has also issued Illustrative Tools for Assessing Effectiveness of a System of Internal Control and the Internal Control over External Financial Reporting (ICEFR): A Compendium of Approaches and Examples. The Illustrative Tools are expected to assist users when assessing whether a system of internal control meets the requirements set forth in the updated Framework. The ICEFR Compendium is particularly relevant to those who prepare financial statements for external purposes based upon requirements set forth in the updated Framework.

    Read Press Release
    Download Executive Summary
    Read FAQs
    Download PowerPoint Slides
    Purchase Framework and Tools

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Internal Control --- https://en.wikipedia.org/wiki/Internal_control

    "In the NSF's Priciest Grant-Fraud Settlement, Northeastern U. Will Pay $2.7 Million," by Paul Baskin, Chronicle of Higher Education, August 21, 2015 ---
    http://chronicle.com/article/In-the-NSFs-Priciest/232511/?cid=at&utm_source=at&utm_medium=en

    Northeastern University has agreed to pay $2.7 million to cover nine years of mishandling federal research funds, in the largest-ever civil settlement with the National Science Foundation.

    The case stems from the management of NSF grant money awarded to Northeastern for work at CERN, the European Organization for Nuclear Research, from 2001 to 2010. The work was led by a professor of physics, Stephen ­Reucroft.

    Both the NSF and Northeastern declined to discuss the matter in detail. But the university issued a written statement that put the blame largely on Mr. Reucroft, who retired from Northeastern in 2010.

    "The conduct in question related to accounting and grant oversight," Northeastern said in a written statement. "The university self-reported the discrepancies to the funding agency, the National Science Foundation, as soon as they were discovered and fully cooperated with the agency’s review."

    But the terms of the $2.7-million settlement suggested that Northeastern bore substantial responsibility. According to the agreement, the university failed to provide necessary oversight, failed to pay interest due, paid salaries without required documentation, and paid expense money based on inadequate or fraudulent documentation submitted by Mr. Reucroft.

    Northeastern "continued to engage in these practices when it knew or should have known in 2006, if not before, that Professor Reucroft had violated NSF requirements when he submitted fraudulent claims for personal expenses," said the settlement, which was signed by lawyers for Northeastern and by Anita Johnson, an assistant U.S. attorney in Boston.

    Continued in article

    One of the problems is that the first trait may make the organization complacent about the other two traits. Exhibit A is Brigham Young University that certainly gets an A+ on the "encouraging an ethical culture" trait. But this made BYU complacent about skepticism and engaging employees in internal controls. Who would have guessed that a financial officer at BYU would pilfer hundreds of thousands of dollars (2002)?
    http://www.deseretnews.com/article/948838/Ex-BYU-official-is-charged-with-stealing-fees.html?pg=all

    PROVO — Prosecutors say that a former BYU finance officer and his wife used a defunct corporation as a shell to steal hundreds of thousands of dollars in collection fees from the university over several years.

    In a preliminary hearing Friday in 4th District Court, deputy Utah County Attorney David Wayment charged that John Davis and his wife, Carol, used an expired corporate name as a front to skim thousands in inflated student fees that were supposed to go to collection agencies.

    By the end of the four-hour hearing, Judge James Taylor found probable cause to bind John Davis over on seven counts of theft and one count of racketeering, all second-degree felonies. Taylor, however, found the state lacked enough evidence to prove that Carol Davis knew that potential criminal activity was going on, despite having her name on several bank accounts related to the crime.

    Taylor ordered that four counts of theft and one count of racketeering be dropped against Carol Davis.

    During the hearing, finance officials with Brigham Young University testified finding strange financial activity involving John Davis, who worked as BYU's supervisor of collections.

    Mark Madsen, assistant treasurer over student financial services at BYU, testified of finding several checks requested by John Davis made payable to a company called RCM (Regional Credit Management). Madsen assumed that the company was a collection agency contracted with BYU to collect on outstanding debts from students who had failed to pay their tuition, library fees or parking tickets.

    Continued in article

    Jensen Comment
    Universities are notorious for relying upon trust without adequate internal controls. Much of the problem lies in tight budgets and unwillingness to allocate funds for better internal control systems.

    Bob Jensen's Fraud Updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    Teaching Case for Managerial Accounting
    From The Wall Street Journal Accounting Weekly Review on October 17, 2013

    LVMH Needs to Mix and Match
    by: John Jannarone
    Oct 16, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting For Investments, business combinations, Interim Financial Statements

    SUMMARY: The article begins with a review of the LVMH report for the third quarter of 2013. Sales of leather goods and fashion are falling; the Louis Vuitton brand accounts for half the company's overall operating profit. The discussion then covers acquisition strategies for new designers which includes initial steps of support for young designers and small investments which could be discussed as equity investments.

    CLASSROOM APPLICATION: The article discusses a company whose brands are likely of interest to many students. The first questions on quarterly performance may be used in any financial reporting class. The later questions may be used to introduce business investment strategies before covering either accounting for investments or business combinations.

    QUESTIONS: 
    1. (Introductory) Summarize the main problems, according to the author, with the financial report just issued by LVMH Moet Hennessy Louis Vuitton.

    2. (Advanced) Where is the stock for this company traded? (Hint: click on the live link in the article in the first mention of the company's name.)

    3. (Introductory) What brand is the primary source of the company's profits? What other brands and products does the company sell?

    4. (Introductory) Until recently, what was the company's brand focus for making sales grow?

    5. (Introductory) What is the concept of diversification? According to the article, how does this concept apply to LVMH's strategy in acquiring designer brands?

    6. (Advanced) Refer to the related article. Describe the newest strategy the company is undertaking to spur growth.

    7. (Advanced) How does LVMH support younger designers? How does this strategy help spur growth at LVMH?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    LVMH Looks to Buy, Cultivate Young Designers
    by Christina Passariello and Nadya Masidlover
    Oct 16, 2013
    Online Exclusive

    "LVMH Needs to Mix and Match," by John Jannarone, The Wall Street Journal, October 16, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304384104579139700180331742?mod=djem_jiewr_AC_domainid

    These days, investors in LVMH Moët Hennessy Louis Vuitton MC.FR +1.52% could do with a little variety.

    Shares of the French fashion house fell 4.3% Wednesday after the company issued disappointing third-quarter revenue. The culprit: a mere 3% rise in currency-adjusted sales from the key fashion and leather-goods division, which makes almost all of its profit from the Louis Vuitton brand. While LVMH has some other red-hot brands such as Celine, they were unable to make up for a soft performance from Louis Vuitton, which accounts for about half of operating profit overall.

    Unfortunately, heavy reliance on Louis Vuitton could be an issue for some time to come.

    In China, for instance, the luxury market has become considerably more challenging in recent years. In the past, luxury consumers mainly shopped for a few brands such as Louis Vuitton, Gucci and Hermès. These days, malls in major cities are loaded with options for increasingly sophisticated shoppers, says Frank Yao of SmithStreetSolutions, a consultancy.

    Another problem: LVMH has been slow to win online sales, which have surged at rival luxury labels such as Burberry. It is understandable that LVMH wants to have close control over the in-store luxury-shopping experience. But the Internet will increase the knowledge of wealthy shoppers quickly and probably encourage them to expand beyond their old favorites.

    What can Louis Vuitton do in response? Its current strategy seems to be protecting itself from competitors by becoming even more exclusive. In recent quarters, the company has begun focusing more on ultraexpensive soft leather to reduce its reliance on canvas bags emblazoned with the "LV" logo.

    Such a shift makes sense—in the long run. But those canvas bags probably help Louis Vuitton maintain very high margins that it would have to sacrifice. Indeed, Thomas Chauvet of Citigroup estimates the brand has an operating margin of 42%, well above the industry average.

    Ultimately, the real solution is for LVMH to actually make its conglomerate model work by nurturing the various brands it has acquired into big moneymakers.

     

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    CGMA Portfolio of Tools for Accountants and Analysts ---
    http://www.cgma.org/Resources/Tools/Pages/tools-list.aspx
    Includes ethics tools and learning cases.


    Question From Freakonomics:
    Must there be a disconnect between introductory microeconomics and the business world?

    "Putting Microeconomics to Work," by Steven D. Levitt, Freakonomics, November 27, 2012 ---
    http://www.freakonomics.com/2012/11/27/putting-microeconomics-to-work/

    I’ve long been puzzled by the almost complete disconnect between real-world businesses and academic economics.  After I graduated from college, I went to work as a management consultantAlmost nothing I learned as an economics major proved helpful to me in that job.  Then, when I went back to get a Ph.D., I thought what I had learned in consulting would help me in economics.  I was wrong about that as well!

    Ever since, I’ve felt that both business and economics would benefit from a greater connection.  Why don’t businesses set prices the way economics textbooks say they should?  Why are randomized experiments so rare in business?  Why do economists write down models of how businesses behave without spending time watching how decisions are actually made at businesses? The list goes on and on.

    It’s taken a while, but the business/economics connections are finally starting to happen with greater regularity.  John List and I wrote an academic piece about field experiments in businesses a few years back that focused on how partnering with businesses could help academics with their research.

    The benefits are also going the other way.  The Economist has a nice article about how microeconomists are adding value to businesses.  (I’m sure the economists mentioned in the article are delighted to be included; I’m almost as sure they will hate the cartoon likenesses that accompany it!)

    For what it’s worth, I’m trying to do my part to improve philanthropy and business through a little firm called The Greatest GoodBut, damn, it turns out to be a lot harder to make things happen in the real world than it is in the ivory tower!

    Jensen Comment
    We could use more of this in managerial accounting, especially in such areas as CVP Analysis and ABC Costing.


    CGMA Videos --- http://www.cgma.org/Resources/Videos/Pages/videos-list.aspx


     

    Activity Based (ABC) Costing --- http://en.wikipedia.org/wiki/Activity-based_costing

    Jensen Comment
    Even though ABC Costing did not live up to its hype in terms of ongoing usage by business firms, it is not yet dead!

    Activity Based (ABC) Costing --- http://en.wikipedia.org/wiki/Activity-based_costing


    Research Review on Activity-Based Costing System (ABC): ABC's Development, Applications, Challenges, and Benefits

    SSRN
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3347713
    21 Pages Posted: 29 Mar 2019

    Merlita Durana

    First Asia Institute of Technology and Humanities

    Date Written: February 14, 2019

    Abstract

    Management accounting continues to be useful for business, and one of its tools is Activity-Based Costing (ABC). This paper is a thematic research review on the ABC System, its development, applications, challenges, and benefits. Several researchers claim that ABC is efficient in product pricing, cost-cutting strategy, and customer and profitability analysis. Meanwhile, Time-Driven ABC was introduced with the advantages of firm-wide application and lower costs. Several academicians argue that TDABC can be useful in the simulation of the optimal resource allocation, benchmarking, Balanced Scorecard and Total Quality Management. For both American and British companies, researchers attributed a highly significant correlation between overall ABC success and the purpose ‘Activity Performance Measurement and Improvement.’ According to practitioners, ABC adoption has an important consequence, i.e. it reinstated the relevance of management accounting. However, based on adoption rates in the U.K. and the U.S.A., few companies adopt ABC. Challenges faced by companies in the implementation are the possible reasons. Researchers cited the huge costs and technical complexity as the system’s predominant challenges. This paper synthesized the researchers’ conclusions into two unifying hypotheses on factors correlated to ABC adoption and success.

    Keywords: Activity-Based Costing, Time-Driven ABC, Management Accounting, ABC adoption, success

     


    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2482345

  • Abstract:
    In a competitive environment, accurate costing information is crucial for every business including manufacturing and service firms, fishing and farming enterprises, and educational institutions. The Activity-Based Costing (ABC) system, argued to be superior to the traditional volume-based costing system, has increasingly attracted the attention of practitioners and researchers alike as one of the strategic tools to aid managers in better decision making. The benefits of the ABC system and its impact on corporate performance have motivated numerous empirical studies on ABC; it is considered to be one of the most-researched management accounting areas in developed countries. China, an emerging market with a growing rate of manufacturing industries, is no exception, as ABC entered China as a choice for an innovative accounting system. Previous research on ABC conducted in China examined pertinent issues related to ABC implementation, such as the levels of ABC adoption in various countries, the reasons for implementing ABC, the problems related to ABC and the critical success factors influencing ABC. In their case studies, several authors declared ABC implementation to be successful, but many have been reluctant to support this seemingly novel system for many reasons. This paper reviews 48 research studies on ABC carried out within the past decade in China, both case studies and questionnaire-based research, from 2000 to 2013. We found that ABC has been adopted in most manufacturing firms, many of which claim success in cost reduction and performance improvement since its implementation; in some service corporations, especially in logistics and hospitals; and in only a few firms in the construction sector. In our study, it should be noted that large firms with more than 1,000 employees were the dominant group (65.58 per cent) applying ABC. Even though many firms in China supported ABC’s use, many factors hindered its implementation: 1) difficulty in establishing activities and linkages to existing systems for gathering information to enter into an ABC system; 2) lack of adequate IT resources; 3) insufficient knowledge of ABC among employees, which leads to the fourth reason; 4) lack of management support. Despite these obstacles, our research review leads us to believe that the rate of ABC implementation in an emerging market like China will continue to rise.

    Jensen Comment
    I'm not certain that "accurate costing information" is the main goal of ABC costing. Perhaps a better phrase is "comprehensive costing information." For example, ABC costing declined in popularity in product costing in the USA due to derivation costs and limitations of ABC costing for product costing ---
    http://en.wikipedia.org/wiki/Activity-based_costing#Tracing_Costs

     The value of ABC costing may come more from the process of investigating activity costs than from the dubious inaccurate product costs using ABC models. One problem is that the benefits from a quality ABC costing effort often do not exceed the costs of the effort. The above Terdpaopong et al. paper suggests this may also be the case in China.

    Academics love ABC costing because it is relatively easy to teach and is one of the great 20th Century innovations (developed initially by practitioners) in cost accounting. But academics may pass over the decline in popularity in real-world implementations in practice.

    "Better Accounting Transforms Health Care Delivery. Accounting Horizons," by Robert S. Kaplan and Mary L. Witkowski, Accounting Horizons, June 2014, Vol. 28, No. 2, pp. 365-383 ---
    http://aaajournals.org/doi/full/10.2308/acch-50658 (Not Free)

    SYNOPSIS:

    The paper describes the theory and preliminary results for an action research program that explores the implications from better measurements of health care outcomes and costs. After summarizing Porter's outcome taxonomy (Porter 2010), we illustrate how to use process mapping and time-driven activity-based costing to measure the costs of treating patients over a complete cycle of care for a specific medical condition. With valid outcome and cost information, managers and clinicians can standardize clinical and administrative processes, eliminate non-value added and redundant steps, improve resource utilization, and redesign care so that appropriate medical resources perform each process step. These actions enable costs to be reduced while maintaining or improving medical outcomes. Better measurements also allow payers to offer bundled payments, based on the costs of using efficient processes and contingent on achieving superior outcomes. The end result will be a more effective and more productive health care sector. The paper concludes with suggestions for accounting research opportunities in the sector.

    Keywords:  cost management, health care, measurement, activity-based costing

    Received: October 2013; Accepted: October 2013 ;Published Online: June 2014

    Robert S. Kaplan is Senior Fellow and Professor Emeritus at Harvard University; Mary L. Witkowski is a Fellow and an MD candidate at Harvard University. Corresponding author: Robert S. Kaplan. Email: rkaplan@hbs.edu

    This research has been motivated and greatly enriched by collaborative work with our Harvard Business School colleague, Professor Michael E. Porter. His health care value framework provided the context for understanding how improved accounting can contribute to better delivery of health care.

    INTRODUCTION

    Health care spending in the U.S. has increased from 7.2 percent of Gross Domestic Product in 1970, to 9.2 percent in 1980, 13.8 percent in 2000, and 17.9 percent in 2011 (Centers for Medicare & Medicaid Services [CMS] 2013). At the same time, U.S. citizens have higher morbidity and mortality rates than citizens in countries that spend much less on their health care system (Nolte and McKee 2012). Much of the higher U.S. spending is caused by a fee-for-service reimbursement system that compensates providers for the volume of procedures they perform and not for the outcomes they deliver. Another cause is the extensive fragmentation of health care delivery and reimbursement (Reinhardt, Hussey, and Anderson 2004) in which patients are treated in diverse organizational units including independent physician practices, primary care clinics, hospitals, and rehabilitation and chronic care centers. These clinical organizational units are structured by medical and surgical specialty, not by a patient's medical conditions. As a result, patient treatment and its reimbursement are dispersed across multiple functional units, with each unit doing only one component of a patient's total care for a specific medical condition.

    Few incentives currently exist for treating a patient's complete medical situation, or for performing a more active role in preventive behavior and wellness. The 2011 Affordable Care Act improves residents' access to the U.S. health care system, but it includes only modest attempts to reform the system itself (Wilensky 2012). Increasing access to a poorly organized and inefficient system will likely eventually lead to government-imposed spending and price cuts, followed by lower quality of care, longer waits for patients, and the financial distress and exit of providers.

    Other countries, while spending a smaller percentage of their GDP on health care, are also experiencing cost increases comparable to those in the U.S. (Organisation for Economic Co-operation and Development [OECD] 2011). No country has yet to solve the fundamental problem of how to reimburse providers for providing health care to their populations. The U.S. fee-for-service model clearly does not work, but the capitated payments and global reimbursement mechanisms used in other countries lead to rationing of care and queues (Lee, Beales, Kinross, Burns, and Darzi 2013; Wilcox et al. 2007).

    Many of these problems are the result of a huge measurement gap: only a very few providers today—physicians, clinics, and hospitals—have valid measures of the outcomes they achieve or the costs they incur to treat individual patients for specific medical conditions. The lack of valid outcome information is partly a consequence of the fragmented way in which health care is delivered, with each provider entity responsible for only a component of the patient's complete care experience. But health care is a more complex setting for measuring outcomes than are manufacturing and most other service industries, which may explain why providers default to input and process metrics rather than patients' outcome metrics.

    The lack of valid cost measures in health care provider organizations might require accounting historians to explain. Hospitals have evolved an idiosyncratic system that assigns expenses to procedures and patients based on charges and allocation ratios known as Relative Value Units (RVUs) and not on the actual costs they incur to treat patients. Separately, physician's specialty societies determine, and periodically revise, RVUs for their procedures, which then get embedded into the list prices established through Medicare's Resource-Based Relative Value Scale (RBRVS) (Hsiao, Braun, Dunn, and Becker 1988a; Hsiao, Yntema, Braun, Dunn, and Spencer 1988b; Marciarille and DeLong 2011). Physician practices then measure the cost of their procedures by calculating a ratio of their practice costs to these list prices (ratio of costs-to-charges or RCC method). Health care administrators, seemingly unaware of the huge distortions and cross-subsidies embedded in their faulty cost systems, are in the situation described by former U.S. Defense Secretary Donald Rumsfeld as, “they know not what they do not know.”

    To summarize, few health care providers in the U.S. and rest of world have valid measures, by medical condition, on patient outcomes and costs. If you believe that “you can't manage what you don't measure,” then the current ineffectiveness and inefficiency of health care systems should not be a surprise. The best providers, lacking adequate data, have few ways to signal their superior capabilities to attract higher volumes at prices greater than their costs. Conversely, ineffective and inefficient providers remain in the system, delivering inadequate care at high societal cost, and depriving effective and efficient providers from delivering higher value to a larger population of patients (Birkmeyer et al. 2002; Birkmeyer et al. 2003). A poor industry structure with a dearth of measurements is a rich environment for accounting scholarship to play an important role through research and education on better ways to measure costs and outcomes.

    In the remainder of the paper, we describe the framework and preliminary results from an action research program conducted at multiple pilot sites in the U.S. and Europe. The program's goal is to explore how to remedy the severe measurement gaps in health care. We conclude by suggesting opportunities for accounting research in the sector.

    THE VALUE FRAMEWORK

    The over-arching goal for any health care system should be to increase the value delivered to patients (Porter and Teisberg 2006; Porter and Lee 2013). At present, however, many goals are advocated for health care delivery including quality, access, safety, and cost reduction. While each of these is individually desirable, none is comprehensive enough to serve as a unifying framework for health care delivery. Porter's framework (Porter and Teisberg 2006) defines value by two parameters: patient outcomes and cost. Value increases when outcomes improve with no increase in costs, or costs are reduced while delivering the same or better outcomes. Currently, however, health care systems have diverse incentives among their various participants. A provider's performance is measured with input and process metrics, such as certification of personnel and facilities, efficiency, access, quality, safety, and compliance. While these metrics are useful for internal cost and operational control, they are not sufficient to motivate health care providers to deliver more value—better outcomes and lower costs—to end-use customers.

    . . .

    RESEARCH OPPORTUNITIES

    The introduction of cost and outcome measures into health care delivery has just started, so the opportunities for research are immense. Every reader of this article is within walking, cycling, or a short driving distance to a potential field site and source of data. Developing, introducing, and implementing new measurements in this industry will require answering numerous technical questions—both conceptual and empirical—that can be informed by careful research. Our initial projects have focused on clinical departments delivering care to patients. Additional opportunities are to investigate cost assignments for important ancillary care departments such as radiology, laboratory, pharmacy, and central sterilization, as well as administrative support departments such as billing, laundry, housekeeping, and dietary. Researchers can explore the costs associated with medical mistakes, no-shows, administrative paperwork, inadequate documentation, processes that protect against malpractice claims, and end-of-life care.

    Beyond accounting and measurement issues, field studies of the leadership and change management issues from introducing new outcome and cost measurements would be fascinating. We know from past experience that introducing new measurement systems triggers individual and organizational resistance (Argyris and Kaplan 1994). Researchers should be able to study how health care leaders solve the behavioral issues arising from introducing change and modifying power relationships within health care providers. Behavioral researchers can also explore the informational processing issues when clinicians and administrators use multi-dimensional outcome and cost data to optimize medical processes.

    We have described how outcome and cost measurement allows for a new reimbursement mechanism to be introduced. What are the incentive and informational issues associated with changing the basis for reimbursement from fee-for-service, capitation, and global budgeting to bundled payments? Accounting scholars can participate in bundled payment experiments to study the tensions and conflicts as various players in the health care system attempt to work together to increase the value they deliver to patients, rather than to optimize within their own specialty and discipline. The complexity of interactions calls out for analytic research to sort out the informational and incentive issues among the various players in the system including patients, multiple providers, suppliers, and payers. Accounting historians can shed light on how health care systems, around the world, adopted reimbursement systems that are not aligned to deliver the best value to the end use customer, the patient. They can also explore how such a huge industry developed with so little calculation and reporting of outcomes and costs.

    The rationale for the Affordable Care Act in the U.S. is that costs will go down if more residents are insured and seek primary care rather than get treated, as charitable cases, when they show up in hospital emergency rooms. Is this true? How much additional resources do hospitals deploy to treat such patients and how many resources will no longer be needed when more patients are insured and seek care from primary care clinicians?

    Accounting scholars can participate in field experiments to document the value changes, both costs and outcomes, from introducing a new pharmaceutical or medical device into the treatment protocol for a medical condition. They can participate in field studies that document how innovative provider organizations restructure themselves to deliver the right care, at the right place, with the right mix of clinical and administrative personnel, and with high capacity utilization, to improve the value they deliver. Expertise in auditing of “soft” measures can be productively applied to the measurement and verification of the outcome measures that will be developed for each medical condition, and upon which future reimbursement and reorganization of the treatments will be based.

    In these ways, accounting scholars and educators can help to influence the future of one of the largest and most important sectors of society. The challenges are huge, but we already possess the tools that can be deployed to address the issues.


    Teaching Case
    "The Gatekeepers: A Case on Allocations and Justifications," by David Hurtt, Bradley E. Lail, Michael A. Robinson, and Martin T. Stuebs, SSRN, August 18, 2014 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2482610

    Abstract
    This case provides an opportunity for you to make accounting allocation choices, justify those choices, and subsequently consider the ramifications of those choices. Two different scenarios – one in the academic setting and one in the business setting – examine the incentives and reporting issues faced by managers and accountants – the gatekeepers in these reporting environments. For each scenario, you will read the case materials, related tables, and then answer the Questions for Analysis. Each scenario presents you with an allocation task. In the first scenario, you will need to assess group members’ contributions to a project and allocate points across the group. These point allocations contribute to the determination of individual group members’ grades. The second scenario is also an allocation task but in a business setting, specifically the segment reporting environment. Here the task is to allocate common costs across reporting segments. For advanced reading, you will want to consider Accounting Standards Codification (ASC) topic 820 which addresses segment reporting, as this can help guide you in the degree of flexibility, if any, allowed in determining how to allocate costs.

    Bob Jensen's threads on accounting theory ---
    http://faculty.trinity.edu/rjensen/Theory01.htm

    Bob Jensen's threads on case writing and teaching ---
    http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Cases


    "Management Accountant—What Ails Thee?" Editorial by Ranjani Krishnan, Journal of Management Accounting Research: Spring 2015, Vol. 27, No. 1, pp. 177-191 ---
    http://aaajournals.org/doi/full/10.2308/jmar-10461

    INTRODUCTION

    For decades management accountants have made substantial contributions to the practice, research, and teaching of business. Economists such as Holmstrom (1979), Holmstrom and Milgrom (1991), and Jensen and Meckling (1976) identified agency problems that could exist between the firm and its owners, discussed the informativeness of signals of managerial effort, and the optimal use of these signals in contracting. Management accountants calibrated the properties of the signals, identified optimal weighting schemes for the signals, determined the relative values of signals in contracts, and assessed the difficulty in designing goal congruent systems using these signals (Banker and Datar 1989; Feltham and Xie 1994; Datar, Kulp, and Lambert 2001). Terms such as “controllability,” “congruence,” and “balance,” which form the bedrock of modern accounting and control systems, were first discoursed in the management accounting literature. It is practically impossible to think of a major corporation that does not have a Balanced Scorecard (Kaplan and Norton 1992). Topics such as Activity Based Costing (ABC), Time Driven ABC, Customer Lifetime Value, Capacity Cost Allocation, Target Costing, and the Balanced Scorecard, are the staples of undergraduate, master's, and M.B.A. curricula throughout the world.

    Privately however, management accountants appear to have had two damaging hobbies—self-flagellation, and exchanging doomsday predictions. The same people who will laugh when told that a Zombie apocalypse is imminent have no trouble declaring (almost triumphantly) that the end of management accounting is within sight. The result is that we scare away the young, further damaging our dwindling numbers.

    Little respect is accorded to a discipline that insists on endless debates about its own theoretical and methodological boundaries. We have no trouble teaching our undergraduate or graduate students that management accounting “measures, analyzes, and reports financial and nonfinancial information that helps managers make decisions to fulfill the goals of an organization” (Horngren, Datar, and Rajan 2012, 4), or that “A fundamental purpose of managerial accounting is to enhance firm value by ensuring the effective and efficient use of scarce resources” (Sprinkle and Williamson 2007, 415).

    Continued in articl

    Saving Management Accounting in the Academy (by Sue Haka, former AAA President)

    I am involved with five university faculty to author a report for the American Accounting Association on reforms for university accounting course curriculums to shift the emphasis of teaching topics from financial to managerial accounting methods. It is a noble effort. What concerns me is how sensitive my co-writers are to the resistance from accounting faculty that this shift would be different from what accounting professors already teach. We will never move finance and accounting professionals from “bean counters to bean growers” if we continue with traditional practices.
    See below

    "Frustrations of a Mover and Shaker for Managerial Accounting," by Gary Cokins, SmartPros, October 2012 ---
    http://accounting.smartpros.com/x74303.xml

    Many who just read "managerial accounting" in this blog's title are not bothering to read this. Why? They do not care. They only care about external financial reporting for regulatory agencies, bankers, and investors. This frustrates me because I interpret this as their not caring about managers and employees who need better internal managerial accounting information for insights and foresight to make better decisions compared to what they are currently provided by their CFO's function.



     

    Should I laugh or cry?

    Allow me to share with you some examples of what frustrates me related to this topic.

    In a recent discussion thread in the website of the Institute of Management Accountants (IMA) there was a post that described how to calculate product and standard service-line costs. The writer meticulously listed the steps. In the final instruction they wrote to “allocate” the indirect and shared support expenses one should use broadly-averaged basis like the number of direct labor input hours, headcount, or square feet. I did not know whether I should laugh or cry! Where have they been the last few decades?

    This primitive cost allocation method totally violates the costing principle of a cause-and-effect relationship between changes in the amount of workload and the products and services that consume those expenses. Activity-based costing (ABC) resolves this. ABC has been researched and promoted since the 1980s. (I was trained in 1988 by ABC’s lead promoter, Harvard Business School’s Professor Robert S. Kaplan. I subsequently wrote several books on ABC.) After implementing my first ABC system, the company was shocked by how different the product costs and profit margins were compared to their existing “cost peanut butter spreading” method. They were exact in total, but not with the parts. I then thought the practice of ABC would take off like a rocket. It hasn’t, but its acceptance continues with a slow but increasing pace. Too slow for me.

    But wait. There is more!

    This blog may now appear to be like a television Ginza knives commercial. There is more!

    I am involved with five university faculty to author a report for the American Accounting Association on reforms for university accounting course curriculums to shift the emphasis of teaching topics from financial to managerial accounting methods. It is a noble effort. What concerns me is how sensitive my co-writers are to the resistance from accounting faculty that this shift would be different from what accounting professors already teach. We will never move finance and accounting professionals frombean counters to bean growers if we continue with traditional practices.

    Another example of my frustration involves adversarial competition for managerial accounting practices. Often driven by self-serving consultants, they advocate managerial accounting methods that only serve their interest. The late Theory of Constraints (TOC) guru Eli Goldratt proclaimed, “Cost accounting is enemy number one of productivity.” He proposed the throughput accounting method, which with investigation only applies under very special conditions of a 24 / 7 / 365 existence of a physical bottleneck like a heat treat oven in a foundry. Some lean accounting advocates slam ABC as being misguided. Both of these methods, if exclusively used, deny strategic analysts understanding of the profit margins of products, services, channels, and customers.

    Cutting through the Clutter

    I participated on a task force that recently published a report for the IMA titledThe Conceptual Framework for Managerial Accounting.” It is an exposure draft that anyone interested in it can review and comment on. Our task force’s mission was to determine key accounting principles to reflect economic reality that any managerial accounting system should comply with.

    Many organization’s existing practices would fail compliance with the report’s framework. With financial accounting, if the CFO gets the numbers wrong, they can go to jail! But when they get the managerial accounting information, they don’t go to jail. Nor should they. But at least CFOs should feel embarrassed and irresponsible that they are performing a disservice to their organization’s workforce who increasingly needs much better management accounting information from which to further apply business analytics.

    Continued in article

    "Management Accountant—What Ails Thee?" Editorial by Ranjani Krishnan, Journal of Management Accounting Research: Spring 2015, Vol. 27, No. 1, pp. 177-191 ---
    http://aaajournals.org/doi/full/10.2308/jmar-10461

    INTRODUCTION

    For decades management accountants have made substantial contributions to the practice, research, and teaching of business. Economists such as Holmstrom (1979), Holmstrom and Milgrom (1991), and Jensen and Meckling (1976) identified agency problems that could exist between the firm and its owners, discussed the informativeness of signals of managerial effort, and the optimal use of these signals in contracting. Management accountants calibrated the properties of the signals, identified optimal weighting schemes for the signals, determined the relative values of signals in contracts, and assessed the difficulty in designing goal congruent systems using these signals (Banker and Datar 1989; Feltham and Xie 1994; Datar, Kulp, and Lambert 2001). Terms such as “controllability,” “congruence,” and “balance,” which form the bedrock of modern accounting and control systems, were first discoursed in the management accounting literature. It is practically impossible to think of a major corporation that does not have a Balanced Scorecard (Kaplan and Norton 1992). Topics such as Activity Based Costing (ABC), Time Driven ABC, Customer Lifetime Value, Capacity Cost Allocation, Target Costing, and the Balanced Scorecard, are the staples of undergraduate, master's, and M.B.A. curricula throughout the world.

    Privately however, management accountants appear to have had two damaging hobbies—self-flagellation, and exchanging doomsday predictions. The same people who will laugh when told that a Zombie apocalypse is imminent have no trouble declaring (almost triumphantly) that the end of management accounting is within sight. The result is that we scare away the young, further damaging our dwindling numbers.

    Little respect is accorded to a discipline that insists on endless debates about its own theoretical and methodological boundaries. We have no trouble teaching our undergraduate or graduate students that management accounting “measures, analyzes, and reports financial and nonfinancial information that helps managers make decisions to fulfill the goals of an organization” (Horngren, Datar, and Rajan 2012, 4), or that “A fundamental purpose of managerial accounting is to enhance firm value by ensuring the effective and efficient use of scarce resources” (Sprinkle and Williamson 2007, 415).

    Continued in article

     

    "Saving Management Accounting in the Academy," by Sue Haka (former AAA President), AAA Commons, Last Edited February 10, 2012
    http://commons.aaahq.org/posts/98949b972d

    Discussion:
    Saving Management Accounting in the Academy
    Details:
    The long run place of management accounting in the academy seems in peril for several reasons. First, there is an ongoing migration of accounting topics to other disciplines. Second, evidence suggests that the diversity in management accounting research seems to be dwindling. Third, the value of our content for MBA programs is not apparent. Finally, our engagement with the management accounting practitioner community is weak.

    First-topic migration: I don't know about your experiences, but at my institution I must be ever vigilant about traditional management accounting topics migrating into management, marketing, or supply chain classes. While I am delighted that cost-volume-profit topics are important to my marketing colleagues, unfortunately the students that come to my management accounting class after having been "taught" CVP by my marketing colleagues cannot distinguish between fixed and variable costs! Other topics taught by my colleagues include ABC in supply chain and balanced scorecard in management. Making sure that students are required to take a management accounting class prior to classes where discussions about how ABC is important for supply chain decision making requires constant vigilance. Years ago management accounting virtually gave capital budgeting up to the finance department...is fair value measurement next!

    Second-research diversity: I have often been among those who have suggested that general accounting research is not sufficiently diverse (i.e. an overabundance of financial archival focus). I forgot my mother's phrase--when you point at others, three fingers point back at you! Recent reviews of JMAR topical areas suggest a lack of diversity within our discipline. These reviews show an overwhelming focus on performance measurement--in 2008 (2007) 48% (50%) of submitted articles were focused on performance measurement. Only one other category is over 12%. It seems that management accounting research is fairly narrow.

    Third-value in the MBA: Management accounting should be a bedrock of MBA programs. However, we have let financial accounting eclipse management accounting. MBA programs have, over the last decade, decreased accounting content and the majority of that reduction has come out of management accounting. Yet most MBAs become managers and management accounting should be highly value added for them.

    Finally-practitioner engagement: While our colleagues in auditing and financial accounting have opportunities to serve as fellows at the SEC or FASB or take a semester or year to work at one of the big four firms, management accounting faculty have few established programs allowing us to experience first hand many of the issues that we teach and write about. I believe creating these types of opportunities would help us diversify our research and convince others of the value of management accounting for MBAs and in the practicing communities.

    I'm sure you have other issues that imperil the discipline of management accounting. Please add your comments and discussion.

    Note the relatively large number of comments to this article

    Also see
    Accounting at a Tipping Point (Slide Show)
    Former AAA President Sue Haka
    April 18, 2009
    http://commons.aaahq.org/files/20bbec721b/Midwest_region_meeting_slides-04-17-09.pptm


    Recalling an Ancient Jensen and Thomsen TAR Paper on Work Sampling

    "Tracking Sensors Invade the Workplace Devices on Workers, Furniture Offer Clues for Boosting Productivity," by Rachel Emma Silverman, The Wall Street Journal, March 6, 2013 ---
    http://online.wsj.com/article/SB10001424127887324034804578344303429080678.html?mod=djemCFO_t

    Jensen Comment
    This article caught my eye, because years and years ago one of then-current Danish doctoral students, Torbin Thomsen, and I published an article in The Accounting Review on how to improve costing of direct and  indirect labor by work sampling of workers doing varied activities throughout each day. The particular application was inspired by my wife's duties in the medical laboratory of the huge VA hospital in Palo Alto (when I was still in graduate school at Stanford). Medical labs were much less computerized in those days, and lab techs performed a variety of daily tests of blood, urine, feces, and spinal taps.

    Interestingly, a famous book was latter written about this hospital ---
    http://en.wikipedia.org/wiki/One_Flew_Over_the_Cuckoo%27s_Nest_%28novel%29
    In also became a Academy Award winning film starring Jack Nicholson ---
    http://en.wikipedia.org/wiki/One_Flew_Over_the_Cuckoo%27s_Nest_%28film%29

    It was very difficult estimate the labor cost of individual types of tests (say blood cross-matching) since technicians darted from activity to activity throughout the work day and night. Torbin and I proposed a work sampling model for estimation of the the labor costs of laboratory tests.

    The problem with our approach was that it was too intrusive. When randomly signaled a technician would have to top what she/he was doing and record the activity and time. In 2013 we now have new tracking sensors that are both less intrusive and/or take the need for work sampling out of the picture. It's now possible to track each entire work day. Big Brother has arrived!

    "Statistical Analysis in Cost Measurement and Control," (with Carl T. Thomsen), The Accounting Review, Vol. XLIII, No. 1, January 1968

     


    GM sets the Spark off
    "General Motors Raises Its Ante on Electric Cars:  The Detroit automaker will soon debut its first all-electric vehicle, a fast-charging vehicle that also rides well," by Jessica Leber, MIT's Technology Review, November 16, 2012 --- Click Here
    http://www.technologyreview.com/news/507566/general-motors-raises-its-ante-on-electric-cars/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20121119

    Why It Matters

    Initial sales of electric cars have been sluggish, so the next generation of the vehicles will be crucial for the future of the technology.

    Charged up: The compact electric Chevrolet Spark is due to hit dealerships in 2013.

    The Chevrolet Spark EV isn’t General Motors’ first pure electric vehicle—that would be the EV1, which was quashed in 2003. But this time around, GM is more serious about these vehicles.

    GM showed off the battery-powered car and let journalists make test drives this week prior to its debut November 28 at the Los Angeles Auto Show. Compact, powerful, and easy to maneuver, the Spark EV looks like a good next step for GM into plug-in vehicles. However, its price has yet to be revealed. That will be crucial, because there has been limited demand for costly electric cars that can’t go long distances without being recharged.

    The Spark joins a list of all-electric cars that includes the Nissan Leaf, the Ford Focus Electric, and Tesla’s Model S. Sales of these plug-in electric vehicles, as well as electric-and-gas models like the Chevy Volt, are important not only for the carmakers, but also to establish markets for advanced battery technologies and battery charging infrastructure.

    By 2017, GM wants to build as many as 500,000 cars a year with electrification technologies, said Mary Barra, senior vice president for global product development. That’s not trivial, considering that today GM sells nine million vehicles annually. In addition to the Spark EV, which will begin with small production runs for limited U.S. and Korean markets, GM plans to make plug-in hybrids like the Chevy Volt and cars with “eAssist technology,” which is a form of hybrid technology. However, Barra says, GM will focus mainly on developing plug-in technologies rather than the traditional gasoline engine hybrids, where Toyota and Ford have made larger investments.

    Even as GM plans to send the Chevy Spark EV to dealerships in the middle of next year, the company is still struggling with the Volt, which, unlike the Spark, has a small gasoline tank to extend its battery range. The Volt has had a slow start since its 2010 debut (see “As GM Volt Sales Increase, That Doesn’t Mean It’s Successful”). GM won’t be close to its goal of selling 60,000 Volts this year. Last month it sold fewer than 3,000.

    But the Spark could help justify GM’s earlier investments. Its electric powertrain, which will be manufactured in Maryland, borrows heavily from the Volt. GM engineers tinkered with the design to achieve more horsepower and faster acceleration. For example, they custom-shaped each square copper wire inside the motor’s coil. Their goal is to broaden the car’s appeal by selling its “fun-to-drive factor.” I found that getting the car from 0 to 45 miles an hour down a short stretch of road required only a pleasantly light touch on the pedal.

    . . .

    In hopes of reducing “range anxiety,” or the worry about running out of charge, GM is making the Spark the first car on the market to use a new North American “fast-charging” standard, approved in October. In special charging stations equipped with the technology, a driver could power 80 percent of the battery in 20 minutes—compared to seven hours for a full charge at home. None of these fast-charging stations are on the road yet, but General Motors expects some will come online by the time the Spark gets into dealerships.

    Jensen Comment
    The Spark may make an excellent commuting alternative for many persons, but for distance travel there are serious drawbacks. The biggest worry is getting stranded where there are no power outlets for miles and miles. Tow trucks of the future may well have emergency charging technology, but it's still a pain waiting a hour or more for a tow truck to bring you some juice. The Volt looks like a better alternative except that the luxury-car price of a Volt, the limited electric power range that drops to less than 30 miles in cold weather, and the poor gas mileage have virtually eliminated the future of Volt production and sales.

    Cost savings are dubious for people who are single and now get by with only one car. The only alternatives are to invest in two cars or use gasoline car rental services when longer trips are planned.

    The bottom line is that, at this point in time, the Spark might be more trouble than it's worth for most car buyers except for commuters who already own multiple cars for their families.

    Possible Cost Accounting Student Projects
    Cost accounting students in teams might be assigned the task of comparing the Spark versus the Volt versus gasoline and diesel automobile alternatives under various lifestyle scenarios. One uncertainty in this equation is how states will adjust licensing fees for electric cars and serious hybrids that no longer contribute toward road maintenance costs with each gallon of gas purchased.

    Another complication is the varying cost of electric power across the 50 states. California, with its new carbon tax, will have very high electric charging rates and gasoline prices. It will be hard to compare the cost of Spark ownership in California with other states like Delaware. And then there are states like Texas where there are miles and miles of open spaces having no towns. It will take a very long time before Texas lines its highways with emergency charging stations. The same can be said for many other states like New Mexico, Arizona, Nevada, Utah, Montana, Alaska, etc.

    Another complication is the varying cost of electric power across the 50 states. California, with its new carbon tax, will have very high electric charging rates and gasoline prices. It will be hard to compare the cost of Spark ownership in California with other states like Delaware. And then there are states like Texas where there are miles and miles of open spaces having no towns. It will take a very long time before Texas lines its highways with emergency charging stations. The same can be said for many other states like New Mexico, Arizona, Nevada, Utah, Montana, Alaska, etc.


    Teaching Case in Cost and Managerial Accounting
    From The Wall Street Journal Accounting Weekly Review on March 29, 2013

    Boom Times on the Tracks: Rail Capacity, Spending Soar
    by: Betsy Morris
    Mar 27, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Managerial Accounting, Manufacturing, Supply Chains

    SUMMARY: This is quite a long article covering the recent revival of U.S. rail transportation as well as some of its up and down history. "North America's major freight railroads are in the midst of a building boom unlike anything since the industry's Gilded Age heyday in the 19th century-this year pouring $14billion into rail yards, refueling stations, additional track. With enhanced speed and efficiency, rail is fast becoming a dominant player in the nation's commercial transport system and a vital cog in its economic recovery." The investment boom is focused on making "existing rail lines more efficient and able to haul more and different types of freight."

    CLASSROOM APPLICATION: The article contains an excellent general discussion of management accounting issues about capital spending, use of technology, use of metrics, and measuring carbon footprint.

    QUESTIONS: 
    1. (Introductory) The first graphic related to the article shows "capital spending by the biggest freight railroads in the U.S." Define capital spending in general, then describe the types of capital spending that U.S. railroads have been doing over the last 8 to 10 years.

    2. (Introductory) What types of goods are railroads shipping? Against what other modes of transportation are railroads now effectively competing?

    3. (Advanced) Why is rail shipping "helping to make manufacturing in North America cost effective again"? In your answer, specifically state how transportation costs must be considered in the cost of, and therefore pricing of, any product an American producer will sell.

    4. (Advanced) What happened when the rail industry faced "a near-death experience in the 1970s"? Include in your answer a comment on how information technology and metrics can help change "how you run a railroad."

    5. (Advanced) How did UPS use its influence over its supply chain to further contribute to its railroad transportation suppliers' use of "technology and strategy"? In your answer, provide a brief definition of a supply chain.

    6. (Advanced) Union Pacific Corp.'s chief executive is concerned about "juggling capital investments with return to shareholders." Explain that statement

    7. (Advanced) The director of logistics and transportation at the Container Store Inc. says that one benefit of using railroads has been to cut his company's carbon footprint by 40%. What is a carbon footprint? In what external report might that information be published by the company?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Boom Times on the Tracks: Rail Capacity, Spending Soar," by: Betsy Morris, The Wall Street Journal, March 27, 2013 ---
    http://online.wsj.com/article/SB10001424127887324034804578348214242291132.html

    EPPING, N.D.—On a recent subzero day at a rail station here on the plains, a giant tank train stretches like a black belt across the horizon—as far as the eye can see. Soon it will be filled to the brim with light, sweet crude oil and headed to a refinery on Puget Sound. Another mile-long train will pull in right behind it, and another after that.

    Containers are loaded onto a train at the BNSF facility in Fort Worth.

    Increasingly, scenes like this are being played throughout the country. "Hot Trains" dedicated to high-priority customers like United Parcel Service Inc. UPS +0.55% roar across the country to deliver everything from microwaves to tennis shoes and Amazon.com AMZN +0.45% packages. FedEx Corp., FDX +0.56% known for its huge fleet of aircraft, is using more trains, too.

    Welcome to the revival of the Railroad Age. North America's major freight railroads are in the midst of a building boom unlike anything since the industry's Gilded Age heyday in the 19th century—this year pouring $14 billion into rail yards, refueling stations, additional track. With enhanced speed and efficiency, rail is fast becoming a dominant player in the nation's commercial transport system and a vital cog in its economic recovery.

    This time around, though, the expansion isn't so much geographic—it is about a race to make existing rail lines more efficient and able to haul more and different types of freight. Some of the railroads are building massive new terminals that resemble inland ports. They are turning their networks into double-lane steel freeways to capture as much as they can get of U.S. freight demand that is projected to grow by half, to $27.5 billion by 2040, according to the U.S. Department of Transportation. In some cases, rail lines are increasing the heights of mountain tunnels and raising bridges to accommodate stacked containers. All told, 2013 stands to be the industry's third year in a row of record capital spending—more than double the yearly outlays of $5.9 billion a decade ago.

    And in a turnabout few could have imagined decades ago, rail is stealing share from other types of commercial transport—most notably the trucking business, which is waylaid by high fuel prices, overloaded highways, driver shortages and regulations that are pushing up costs.

    Transport by rail is also relatively cheap. Though rising, U.S. freight rail rates are nearly half what they were three decades ago, according to the Association of American Railroads. And those bargains are helping to make manufacturing in North America cost effective again. Since 2007, more than $100 billion of foreign direct investments have been made in Mexico, Robert Knight, Union Pacific UNP +1.12% Chief Financial Officer, told analysts at a recent conference. He expects annual production of 2.7 million vehicles in that country to increase by another million by 2015.

    "We wouldn't have as many companies considering moving back to the U.S. or near-shoring," if not for rail, says Yossi Sheffi, Professor of Engineering Systems at MIT and director of its Center for Transportation and Logistics. "Some of it is the cheaper energy. But we could not be moving the oil around without rail. We could not have the huge amount of imports without the rail."

    A confluence of other factors is advancing the trend. The energy boom, for instance, is reviving industries like steel and chemicals. Higher labor and transportation costs in parts of Asia are triggering a surge in sourcing from nearby.

    "All those things have put the railroads into a great sweet spot for what's next in this economy," says Matthew K. Rose, chief executive officer of BNSF Railway. "Nobody wants to miss out."

    BNSF, purchased by Warren Buffett's Berkshire Hathaway Inc. BRKB +1.01% in 2010, is investing $4.1 billion on a list that includes locomotives, freight cars, a giant terminal southwest of Kansas City and new track and equipment for its oil-related business in the Bakken shale region of North Dakota and Montana.

    Union Pacific Corp. is spending $3.6 billion on a giant terminal near Santa Teresa, N.M. It is designing a new $400 million-$500 million bridge over the Mississippi at Clinton, Iowa, to replace an old drawbridge that routinely delays trains for hours at a time. It will double some track in Louisiana and Texas and expand rail yards there and in Arkansas to provide more capacity to chemical customers such as Dow Chemical Co. DOW +0.19% and Exxon Mobil Corp. XOM -0.52%

    CSX Corp. CSX +1.15% will spend $2.3 billion partly to finish the first phase of a multiyear project, raising highway bridges, enlarging mountain tunnels and clearing some 40-odd obstacles to make enough space to accommodate double-decker containers all the way from the Midwest to the mid-Atlantic ports.

    Kansas City Southern Railway Co. will spend $515 million. "We're a growth railroad," David Starling, its chief executive, told a securities analyst who questioned the expenditure in January. "The worst thing this team wants to be accused of is having some service deterioration because we didn't have the foresight to spend the money."

    Passenger rail is undergoing something of a renaissance, too. It was the passenger business that nearly killed the freight business in the 1960s and 1970s. Part of the legislation designed to save the railroads in the 1970s allowed them to shed the passenger business. Lately, the Obama administration has invested nearly $12 billion in passenger rail, according to the Department of Transportation, that has been used to fund 152 projects in 32 states.

    Trains may seem like relics of a bygone era. Not so. Steeled by a near-death experience in the 1970s—when many railroads filed for bankruptcy and braced for the threat of a government takeover—the railroads instead were largely deregulated. The survivors fought hard. They squeezed capacity, resolved labor issues, swallowed up weaker players and rebuilt. By the time rail's prospects began to brighten a decade ago, the executives were "a much younger, more IT, more metric-minded group," says William Galligan, vice president of investor relations at Kansas City Southern KSU +2.93% . "They had a whole new view toward how you run a railroad."

    Continued in article


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on April 5, 2013

    Airlines Haven't Reached Escape Velocity
    by: Justin Lahart
    Apr 02, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Behavior, Cost Management, Managerial Accounting, Product strategy

    SUMMARY: "As Warren Buffett noted in 2008, the airline industry historically has typified the worst sort of business: 'one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.' Originally run by pilots, the art of managing to provide sufficient capacity without giving oversupply that fells revenues and increases costs has proven elusive for all who have filled its management posts. "But after 29 bankruptcies in 30 years, and a string of deals culminating in this year's merger between AMR's American Airlines and US Airways Group, there is a growing belief that airlines have cut capacity to the point where they can make money over the long haul."

    CLASSROOM APPLICATION: Questions focus on managerial topics of capacity and product cost management for fuel.

    QUESTIONS: 
    1. (Introductory) Summarize the points in the article about the airline industry's difficult operating history.

    2. (Introductory) What are the factors pointing to a more positive outlook for airlines' future than its past?

    3. (Advanced) Define the term capacity. How have fuel prices "forced a new discipline on airlines" with respect to capacity? Explain your answer in terms of both the individual airline perspective and the overall industry perspective.

    4. (Advanced) "Increases in the cost of jet fuel" and "volatility in fuel prices in recent years" are both credited as cost behaviors forcing "discipline on airlines." What is the difference between these two cost behaviors?

    5. (Advanced) Suppose you are a manager responsible for securing fuel for an airline. What two tactics will you consider to manage the two fuel price issues discussed above?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Airlines Haven't Reached Escape Velocity," by Justin Lahart, The Wall Street Journal, April 2, 2013 ---
    http://online.wsj.com/article/SB10001424127887324883604578396500882855628.html

    In Greek myth, Icarus flew too close to the sun just once. Airlines have been doomed to do it over and over again.

    But lately, amid speculation that the industry has finally got its act together, investors have been flocking to it. The NYSE Arca Airline index is up 43% in the past six months. This means that, adjusted for inflation, the index would need to gain a mere 42% more…to reach where it began trading in 1994.

    Yes, the airline industry has been a miserable investment over the long haul. More miserable, in fact, than the airline index's record suggests since so many public airlines have gone bankrupt—many of them repeat offenders like Trans World Airlines, which filed for Chapter 11 for a third time before merging in 2001 with American Airlines, which filed for bankruptcy itself a decade later. As Warren Buffett noted in 2008, the airline industry historically has typified the worst sort of business: "one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money."

    But after 29 bankruptcies in 30 years, and a string of deals culminating in this year's merger between AMR's AAMRQ +2.58% American Airlines and US Airways Group, LCC -0.88% there is a growing belief that airlines have cut capacity to the point where they can make money over the long haul.

    Increases in the cost of jet fuel, along with volatility in fuel prices in recent years, have forced a new discipline on airlines. Because older aircraft are less fuel-efficient, it is much more difficult to simply lease some used aircraft, start a new airline, and undercut competitors than it used to be. Existing airlines are also less eager to expand capacity.

    The hope—for investors, if not travelers—is that with the persistent problem of excess capacity sorted, airlines will more easily be able to improve profit margins by charging ever-higher airfares.

    But CreditSights analyst Roger King notes that while this is a story he believes in, so far it is just a theory. "You can only charge people so much," he says. "But we don't know what that is."

    Indeed, at least for a coach-class ticket, airlines may face some real difficulty charging more. Witness the myriad fees for luggage and legroom that they have been tacking on: Surely, these aren't the ploys they would be stooping to if travelers had much stomach for paying more.

    Moreover, if the airlines really do manage to keep raising ticket prices and fees, nobody knows whether they will be able to stick with their capacity discipline for long. Higher prices have a funny way of making companies more expansion-minded, as this industry's history demonstrates only too well. And with fewer seats over which to spread their overheads, the airlines need to squeeze as much revenue as possible out of each one to generate profits.

    Continued in article

     

     

     



    Balanced Score Card --- http://en.wikipedia.org/wiki/Balanced_scorecard

    "Balanced Scorecard must adapt to remain relevant," by Arvind Hickman, CGMA Magazine, November 6, 2012 ---
    http://www.cgma.org/Magazine/News/Pages/20126794.aspx

    The management system of the future will need to adapt to a world that demands greater transparency, corporate responsibility, better risk management and changing patterns of human capital management, according to David Norton, co-founder of the most popular performance management system, the Balanced Scorecard.

    The Balanced Scorecard is claimed to be used by 70% of companies across the world. The key to its longevity and popularity, says Norton, has been its ability to adapt and provide solutions to changes in the broader economy.

    “The management system cannot lead change, it adapts to these broader macroeconomic things,” he says.

    “The question about [whether] the Balanced Scorecard is obsolete – the answer is ‘yes’. Every day it becomes partially more obsolete, as do the management systems in general that you are using.”

    Norton was speaking at the CGMA event “Kaplan and Norton: A contemporary performance” at the University of Edinburgh on Monday. The event was one of several events happening this week featuring Norton and his collaborator, professor Robert Kaplan, marking the 20th anniversary of the Balanced Scorecard.

    In a thought-provoking address, Norton laid out the five major challenges performance management systems must overcome to remain relevant in the next 10 to 20 years.

    1. Managing human capital will become a greater issue. Norton says this is due to what he describes as the “stratification of knowledge work”, which could involve organisations carrying out certain functions in countries where they can derive the most value.

    “What kind of knowledge work is best done here versus there? In the US we have a certain level of unemployment even though we have hundreds of thousands of jobs unfilled. Why? Because we don’t have trained workers to step in those jobs, they haven’t readapted in the face of the new economy.

    “That’s going to be a big deal and is probably the ultimate challenge for people who measure. How do I measure whether or not my human capital is adequate?”

    Norton believes part of the answer can be found in the "cause and effect" logic that underpins the Balanced Scorecard approach. Cause and effect describes how delivering performance on a perspective, such as financial success, can only be achieved by delivering on another perspective, such as customer satisfaction.

    “A new mathematics is required here,” he adds. “In the old world, I would measure something like employee turnover and I would look at it in isolation. But what we’ve learned through strategy mapping in the Balanced Scorecard is that performance comes from cause and effect relationships.

    "For example, if I want to increase revenue, I have to increase customer confidence and participation. To do that I have to find a critical process and improve it, and to do that I have to train people and give them technology. It's a clear set of "cause and effect" relationships that you find when you learn what a company's strategy is."

    2. The networked economy describes the growing interdependence companies have with internal and external suppliers.

    “Management systems of the last generation were designed with idea of the legal boundaries of an organisation as being the domain for which strategy and measurement was related,” Norton says. “With outsourcing, you find the legal boundaries start to become meaningless. If your IT department reports to you, it’s inside the legal boundaries. But if it is outsourced, it reports to you in a different way.”

    This also applies to a growing number of joint ventures as organisations need to manage what the priority of the joint venture is and whether it leans towards a specific partner or adopts a strategy that is different from that of the parent organisations.

    3. Transparency: A growing trend is the need for non-profit and governmental organisations to become transparent. Several governments have committed their governance systems to the Balanced Scorecard, such as the governments of the United Arab Emirates, the Philippines and Botswana.

    Each country and city has its own priorities, such as the creation of new businesses or to position itself as a leader in an industry sector.

    Norton says the challenge is to ensure performance management systems adapt to evolving strategies.

    4. A new role for corporations: Norton points out that the role of corporations in society is changing to recognise their impact on the environment and society, and management systems of the future must be designed with this in mind.

    “It’s not enough anymore to make money,” he says. “If you broaden the responsibility of an executive, think about the implications of that on the measurement system, instead of narrowly focusing on one dimension as a success indicator.”

    5. Risk: The management system of the future must take into consideration that organisations are becoming increasingly risk averse.

    “Half of any strategy is what do I do if I succeed, and the other half is what do I do if I fail. I think almost all of our attention in the past decade has gone on the upside. Now, through a combination of randomness and forces, we are seeing problems in the financial system, rogue traders, hurricanes, problems in quality control of health-care organisations – disasters all around us. That’s created an awareness that more time has to be spent on dealing with risk and particularly strategic risk.”

    On reflection: In outlining challenges for the future, Norton explains that in the past 20 years the Balanced Scorecard has had to negotiate several hurdles, including the shift from a products-based economy to a knowledge-based economy, exponential improvements in the speed of processes and systems, the decentralisation of the workforce and integration of governance systems across an enterprise.

    Continued in article

    Also Bob Kaplan Speaks
    At another event in the anniversary series, Balanced Scorecard co-founder Robert Kaplan explained how poor cost measurement is plaguing the U.S. health care system and what can be done to fix it. CGMA Magazine (11/6)

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     


    Why does the strategy being undertaken by Burger King result in revenue falling "by half over just two years"?

    Teaching Case from The Wall Street Journal Accounting Weekly Review on November 6, 2012

    As Profit Sinks, Burger King Notes Sales Improvement
    by: Julie Jargon and Annie Gasparro
    Oct 29, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Revenue Recognition

    SUMMARY: "Burger King, which had rested on a years-long strategy of serving big burgers aimed at fast food's heavy users, faltered during the economic downturn when its target market was hit by high unemployment. In 2010, 3G Capital Management LLC took Burger King private...[and added] a new menu of snack wraps, salads and smoothies intended to appeal to a broader group of customers...It is unclear whether the changes will be enough for Burger King to reclaim [its position as]...the No. 2 burger chain behind McDonald's by U.S. system-wide sales." The reference "system-wide" nods to the fact that these chains are franchise-owned but each also operates some stores from the corporate parent. "Many restaurant chains have been moving away from owning their restaurants...."

    CLASSROOM APPLICATION: The article may be used when covering revenue recognition for franchise sales.

    QUESTIONS: 
    1. (Advanced) Define the terms franchise, franchisor, and franchisee.

    2. (Introductory) According to the article, why are corporate parents for restaurant chains such as McDonald's and Burger King moving away from owning their restaurants? How do these entities earn revenues?

    3. (Advanced) Refer to the related article. Why does the strategy being undertaken by Burger King result in revenue falling "by half over just two years"?

    4. (Advanced) What costs do franchisors incur in earning their revenues?

    5. (Introductory) What unexpected cost factors impacted Burger King's profitability in the quarter ended September 30, 2012? How do these costs relate to the company's growth opportunities?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Burger King Tries Having Its Own Way
    by Spencer Jakab
    Oct 29, 2012
    Page: C1

     

    "As Profit Sinks, Burger King Notes Sales Improvement," by Julie Jargon and Annie Gasparro, The Wall Street Journal, October 29, 2012 ---
    http://professional.wsj.com/article/SB10001424052970203335504578086363514686362.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Burger King Worldwide Inc. BKW -2.88% said its profit plunged in the latest quarter, but pointed to signs that its strategy to broaden its appeal beyond hungry young men is starting to pay off.

    For its first full quarter since a new ownership group took it public, Burger King said its net profit fell 83%, mainly because of restructuring costs and unfavorable changes in foreign-exchange rates. But the burger chain said same-store sales rose 1.4%, beating analysts' expectations.

    Burger King, which had rested on a years-long strategy of serving big burgers aimed at fast food's heavy users, faltered during the economic downturn when its target market was hit by high unemployment. In 2010, 3G Capital Management LLC took Burger King private, ditched the King mascot and its irreverent ads, and started becoming more like McDonald's Corp. MCD -0.83% with a new menu of snack wraps, salads and smoothies intended to appeal to a broader group of customers.

    "We saw more women and people over 50 come in to our stores, which is good because they tend to have higher average checks and trade up to more premium items," Chief Financial Officer Daniel Schwartz said in an interview.

    It is unclear whether the changes will be enough for Burger King to reclaim the crown it lost earlier this year to Wendy's Co. WEN -1.95% as the No. 2 burger chain behind McDonald's by U.S. system-wide sales.

    Burger King this summer became public once again in a deal with hedge-fund manager William Ackman, whose U.K.-based Justice Holdings Ltd. bought 29% of Burger King. 3G Capital remains Burger King's principal shareholder with a 71% stake.

    Mr. Ackman urged the company to sell its corporate-owned restaurants to franchisees, to help insulate it from the volatility that comes when commodity and labor costs increase. Many restaurant chains have been moving away from owning their restaurants, so they can focus on managing their brands while collecting steady royalty fees.

    Burger King said putting ownership of its restaurants into franchisees' hands has encouraged franchise owners to remodel dated stores. Burger King said it plans to sell nearly all of its 12,600 restaurants to franchisees by the end of the year.

    The cost of converting those stores to franchise owners, as well as shifts in currency values that Burger King didn't expect, hit earnings in the latest quarter. Burger King reported a net profit of $6.6 million, or 2 cents a share, down from $38.8 million, or 11 cents, a year earlier. Revenue dropped 26% to $451.1 million. Analysts polled by Thomson Reuters had most recently forecast earnings of 14 cents a share on revenue of $440 million.

    The soft economy has affected Burger King, just as it did McDonald's, which earlier this month reported a 3.5% decline in third-quarter earnings. Burger King said it experienced a slowdown in customer visits from the second quarter, especially from those seeking value meals at other chains.

    Still, excluding business-combination expenses, realignment project costs and other items, adjusted per-share earnings rose to 17 cents from 16 cents a year ago.

    Systemwide same-store sales rose 1.4%, edging out the 1.2% growth estimate from analysts polled by Thomson Reuters.


    Note the short paragraph on "Subjective Probability"
    "A CFO’s Guide to Scenario-based Planning Using Econometrics." CFO Journal,  September 4, 2012 ---
    http://deloitte.wsj.com/cfo/2012/09/04/a-cfos-guide-to-scenario-based-planning-using-econometrics/

    Handling unexpected events, ranging from sudden competitive shifts within an industry to economic and political volatility, is never easy. But some companies seem better equipped to meet such challenges than others. As CFOs have pushed deeper into broader strategic roles for their organizations over the last decade, scenario-based planning has become an important tool that can help organizations adapt quickly to new threats and opportunities.

    Going further than traditional forecasting, scenario-based planning is not meant to predict the future, but to make decisions today that take into account alternative ways the future could turn out. At its best, scenario-based planning is a flexible tool that can assist in the development of strategies for operating in any of several contrasting business and economic environments that could lie ahead. Scenarios can be used to develop a wide range of plans, from fundamental changes in strategy caused by global paradigm shifts to tactical contingency planning focused on possible near-term developments.

    Business Uncertainties

    The starting point is the premise that business uncertainties should be highlighted rather than minimized when a company is defining strategy. “At the corporate level, scenarios can help a company establish an overall frame of reference for its strategic planning processes,” says Dwight Allen, director, Strategy Development, Deloitte LLP. “At the business-unit level, managers can use these scenarios to test and refine their existing strategies. The corporate development group can use the scenarios as input to make limited, expandable investments in assets that would facilitate adaptation to developments that are different from what business units are planning for but which are sufficiently plausible to justify some advance preparation.”

    . . .

    Distinguishing between Shorter- and Longer-term Initiatives

    It can be helpful to group the different applications of scenario-based planning into three tiers:

    First Tier: Longer-term macro-scenarios—These high level scenarios are developed to provide context for corporate-level strategic planning. They are “broad brush” and overarching scenarios. While these scenarios are at a higher level, they may be the most important as their input sets the direction and tone for the analysis and planning performed at the business-unit level. They also offer guidance as to what developments the business units may be discounting as they make their decisions on what market conditions to assume as they review and refine their strategies.

    Second Tier: Impact of macro-scenarios on business units—After the longer-term scenarios have been developed, the next step is to understand how each would impact the various business segments (units/markets/industries/etc). Competitive strategy will vary and should be tailored based on the intricacies of each business unit and its market. Once the potential impacts of each scenario have been identified and the appropriate strategic responses are defined, each business unit determines what future market conditions it will assume and what strategy it will adopt. In a company with many lines of business, the array of strategies will be correspondingly diverse.

    Third Tier: Ongoing, lower-level analyses—Once business units have implemented their strategies, additional, more tactical scenarios and analyses can be developed periodically as new uncertainties emerge. These scenarios help to analyze the significance of the new uncertainties and to experiment with different theories as to what additional developments might be on the way. The idea is not to develop a new strategy but to aid the business unit as it executes the strategy it has adopted.

    Leveraging Econometric Models Within Scenario-based Planning

    Econometric models can be used to flesh out scenarios with financial data that make the descriptions of future worlds less like science fiction and more grounded in the type of facts and figures executives use when making business decisions. Rather than communicating the characteristics of a scenario only through narrative descriptions, econometric models make it possible to define the specifics of the business environment—for example, stipulating GDP, inflation, IT investment, oil prices and corporate profits. And there is the option of taking the next step and modeling the impact of the scenario on a particular business, showing how it would affect metrics such as revenues, expenses, pricing and capital expenditures. For some management teams a scenario-based planning exercise gains credibility only when the scenarios have been given this quantitative dimension.

    Econometric models can be used in a variety of forward-thinking situations. “Models can be developed to illustrate how the conditions prevailing within the longer-term, macro-scenarios used in developing strategic plans would affect selected key market and business indicators,” says Carl Steidtmann, chief economist at Deloitte Research and a director with Deloitte Services LP. “This provides a more detailed, quantitative understanding of a scenario’s impacts than is typically possible when relying solely on a qualitative, narrative description,” he adds. Models can also be developed for shorter-term scenarios when executing the strategy a business has adopted.

    Common Challenges When Using Econometric Models

    Statistical analysis is not immune to human psychology. As with any process, there are places where error can be introduced when creating and using econometric models using multiple regression. While econometric modeling incorporates more quantitative analysis into scenario-based planning, it is important that the underlying risks being examined in a scenario-based planning model be both accurate and relevant to the organization.

    1.  Misinterpreting Correlation

    Multiple regression analysis is the cornerstone of econometric modeling. One obstacle to using this technique is that it can be difficult to interpret the relationship between each variable and the resulting behavior. In a linear regression, the output is directly correlated to a single input, but in a multiple regression, the correlation of one input is dependent on all other inputs. For example, it would be relatively easy to assess the direct relationship between, say, investment in information technology (IT) services and a technology company’s revenue. However, most real world econometric models and scenarios encompass multiple leading economic and business indicators. In this more complex model, the impact of IT investment may be very different depending upon the behavior of the other variables, such as GDP or corporate profits. It is important to assess the viability of each indicator within each modeling scenario.

    2.  Subjective Probability          

    When beginning the process of building a new model, numerous variables should be considered to reach a best-fit design. The challenge can lie in distinguishing between a model that looks sound statistically, and a model that looks sound from a logical business perspective. It helps to have a hypothesis about the variables in question. Regardless of how strong the model appears to be using a given variable, the model will not be reliable if there is not a strong business correlation.

    Continuous Monitoring for Changes in the Environment

    Once an econometric model is built and the financial impact of each scenario has been established, the business can assess the strategic actions that can be taken. A robust scenario-based planning effort using econometric analysis can enhance the competitive advantage of a business by positioning it to be more nimble and able to adapt to an ever-changing global environment.

    Related Resource

    Econometric Analysis for Scenario-based Planning


    Questions
    Is corporate budgeting is a time waster and a poor measure of performance?
    Do ERP systems help or hinder operating without a budget (not answered in the article below)

    "Freed from the Budget: Many companies see budgeting as a time-consuming exercise of limited value. Some are resorting to a radical fix: getting rid of the budget," by Russ Banham,  CFO.com, September 1, 2012 --- Click Here
    http://www3.cfo.com/article/2012/9/budgeting_budgets-rolling-forecasts-continuous-planning-beyond-budgeting-round-table-statoil-elkay-group-health-holt-cat

    In his book Winning, General Electric’s Jack Welch famously griped: “It sucks the energy, time, fun, and big dreams out of an organization. It hides opportunity and stunts growth. It brings out the most unproductive behaviors in an organization, from sandbagging to settling for mediocrity.”

    “It” is the corporate budgeting process. This much-hated annual exercise in setting targets, doling out resources, and providing incentives for employees is the way nearly all companies run their shops. Even organizations that have adopted monthly or quarterly rolling forecasts as a more agile way of reacting to events still produce a budget, for the most part.

    Now, a few companies are doing what others fantasize about: getting rid of the budget altogether, stomping out the century-old process for good. Their guru is Steve Player, program director at the Beyond Budgeting Round Table, a learning network with more than 50 corporate members. For years, Player has railed against budgeting, which he excoriates as an expensive waste of time. A charismatic consultant and speaker, Player has his converts. Among them is Statoil, the giant Norwegian oil-and-gas company, with $90 billion in 2011 revenue and operations in 36 countries.

    Statoil did away with traditional budgeting in 2005, and decided in 2010 to abolish the calendar year in its management processes whenever possible. “Not only does a budget take too much time, it is a bad yardstick for evaluating performance,” contends Bjarte Bogsnes, Statoil vice president of performance management development.

    He explains that a budget creates the opportunity for “gaming” the system. “Managers are instructed to deliver on an easy-to-achieve target, told what resources they have to get there, and then are incentivized for hitting that number,” Bogsnes says. “It prevents managers from seizing opportunities to create value.”

    Statoil’s radical approach is shared by three other companies profiled below: Elkay Manufacturing, Holt CAT, and Group Health Cooperative. Kenneth Merchant, a professor of accounting at the University of Southern California’s Marshall School of Business, has closely followed the Beyond Budgeting phenomenon, and estimates that at least 100 companies across the globe are on the same path. “A lot fall by the wayside or don’t reach the end destination of no budget at all,” says Merchant, who is also the school’s Deloitte & Touche LLP Chair of Accountancy. “Nevertheless, there is definite value in doing away with the budget,” he adds. “Getting to this point is the problem.”

    Sensible but Unreliable Player doesn’t mince words about his disdain for the “B” word. Budgets, he asserts, can foster unethical behavior and conflicts of interest. “When companies tie incentive compensation to reaching budget goals, they create a huge conflict of interest,” he says. “Managers are incented to submit proposed budgets with low goals. Instead of reaching for outstanding performance, the budget process becomes a game of negotiating the lowest acceptable target, which is often based on assumptions outside the managers’ control.” The process also leads managers to hoard information, says Player, “since no one wants to share information that can be used against them.”

    Budgets are also based on assumptions that are frequently wrong. They cost a ton of money, eat up platefuls of time, are out of date by the time they’re produced, and tend to strip local managers of their accountability, since their plans must be squeezed into the company’s goals, Player says. As a method of cost control, budgets are wanting, since managers tend to spend every cent they’ve been allocated, fearing they won’t get the same allocation the following year.

    “It’s a management process that can kill the organization,” declares Player. “It’s part of the dumb stuff that finance does and should stop doing.”

    Continued in article

    Jensen Comment
    Operating without a budget sounds like a bad idea to me. Generally the budgeting process is where the major decisions are made

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Performance Management Systems
    August 17, 2012 message from Jim Martin

    I am developing a new section on the MAAW web site for Performance Management Systems. This topic provides a broader, more holistic view, or extended framework of management control systems than previously presented in the literature. Although some of the books and articles with Performance Management in the title are focused on the human resource function, the main focus of MAAW's new section is on the broader view of performance management systems as a framework that can be used to describe the overall management features of an organization. For example, performance management systems include features such as mission, strategy, organizational structure, performance measures, feedback systems, and rewards.

    A number of books and papers have been published on this topic over the last ten years. From a research perspective, the best paper I have found so far is as follows: Ferreira, A. and D. Otley. 2009. The design and use of performance management systems: An extended framework for analysis. Management Accounting Research (December): 263-282. For a summary of that paper see http://maaw.info/ArticleSummaries/ArtSumFerreiraOtley2009.htm 

    There are many papers and books that examine the topic from a practice perspective. For example, the following author has written a series of papers that have appeared in Strategic Finance: Paladino, B. 2007. 5 key principles of corporate performance management: How do Balanced Scorecard Hall of Fame, Malcolm Baldrige, Sterling, Fortune 100, APQC, and Forbes award winners drive value? Strategic Finance (June): 39-45. For a note about this paper see http://maaw.info/ArticleSummaries/ArtSumPaladino2007a.htm

    To view the bibliography for Performance management systems see http://maaw.info/PerformanceManagementSystemsBibliography.htm 

    Many related papers are in the Control bibliography at http://maaw.info/ControllershipArticles.htm


    An Innovative Reference for a Cost/Managerial Accounting Course
    Some wonderful symphony orchestras have suspended operations because of the inability to manage costs

    Every symphony in the world incurs an operating deficit
    "Financial Leadership Required to Fight Symphony Orchestra ‘Cost Disease’," by Stanford University's Robert J Flanagan, Stanford Graduate School of Business, February 8, 2012 ---
    http://www.gsb.stanford.edu/news/headlines/symphony-financial-leadership.html

     What if you sat down in the concert hall one evening to hear Haydn’s Symphony No. 44 in E Minor and found 5 robots scattered among the human musicians? To get multiple audiences in and out of the concert hall faster, the human musicians and robots are playing the composition in double time.

    Today’s orchestras have yet to go down this road. However, their traditional ways of doing business, as economist Robert J. Flanagan explains in his new book on symphony orchestra finances, locks them into limited opportunities for productivity growth and ensures that costs keep rising.

     The symphonies’ financial problems are rooted in what has come to be known as the “cost disease,” a term coined in 1966 by two then-Princeton economics professors, William Baumol and William Bowen, in a study of the economics of the performing arts. “The labor requirements for the music are set by the composer. For the most part, you don’t toy around with that,” Flanagan says. Furthermore, it takes 25 minutes to perform a Haydn symphony. Speeding up the playing or substituting a robot or digital device for one of the players doesn’t appear on any music director’s solution list, at least not yet.

    U.S. manufacturing companies offset higher labor and materials costs through gains in productivity. They work to ensure that output rises for each person employed. Automakers, for example, have added hundreds of robots to their assembly lines. Productivity gains based on computer technology have also occurred in many white- collar fields, but performing arts groups haven’t found a way to do the same.

    Flanagan, the Konosuke Matsushita Professor of International Labor Economics and Policy Analysis, Emeritus, at the Graduate School of Business, has firsthand experience with the economics of playing music. He has played a clarinet and saxophone weekly for years in a 17-piece amateur jazz orchestra. He began investigating the finances of American symphony orchestras in 2006 and published a paper in 2008 that irritated more than a few symphony board members, managers, and musicians’ union officials, because it illuminated the fragile finances of orchestras, and questioned some management practices. In the last 20 years more than a dozen U.S. symphony orchestras declared bankruptcy.

    With assistance from data collected by others, Flanagan has analyzed the finances of orchestras in the United States, continental Europe, and Australia, and reported his findings in his book, The Perilous Life of Symphony Orchestras: Artistic Triumphs and Economic Challenges, published by Yale University Press in January 2012.

    The financial health of symphony orchestras in the United States continues down a perilous path of an ever-widening gap between operating revenues and expenses, he says, after studying the financial experience of the 63 largest domestic symphony orchestras between the 1987 and 2005 concert seasons. “Even the most artistically accomplished orchestras in the United States relentlessly have trouble balancing their books,” he says.

    Flanagan explores changes in operating revenues and expenses, searching for ways to narrow operating deficits. The book covers ticket pricing strategies, marketing activities, the rapid growth of artistic pay, and competition with other performing arts organizations for the time of potential patrons. He examines how tax policies, the economic capacity of a community, and orchestra policies influence the trends and determinants of nonperformance income, such as grants and donations from private and public sources. Because there is no guarantee that nonperformance income will exactly match operating deficits, the result is an uncertain financial future.

    Orchestras outside the United States face similar economic challenges even though they benefit from millions of dollars in direct government subsidies. “Every symphony in the world incurs an operating deficit,” Flanagan says, and, if the cost disease cannot be offset, “symphony orchestras will face increasing overall deficits.” For example, performance revenues of U.S. orchestras have declined from 60% of budgets in 1940 to 41% in the 2005-06 season.

    Classical music lovers in the United States often complain that U.S. governments should treat symphony orchestras as cultural necessities and support them with larger grants. In other countries grants often cover 50% and more of operating budgets. While direct federal government grants in the U.S. have fallen to what he describes as “a negligible level,” the value of federal government tax expenditures has soared. Those tax expenditures, defined as foregone government tax revenues, because individuals and corporations can deduct their donations from taxable income, now account for 96% of all federal government support to U.S. orchestras. Such tax expenditures are much less common abroad.

    Continued in article

    Human Resource Accounting for Financial Statements

    The value of human resource employees in a business is currently not booked and usually not even disclosed as an estimated amount in footnotes. In general a "value" is booked into the ledger only when cash or explicit contractual liabilities are transacted such as a bonus paid for a professional athlete or other employee. James Martin provides an excellent bibliography on the academic literature concerning human resource accounting ---
    http://maaw.info/HumanResourceAccMain.htm

    "Texas A&M Gathers Accountability Data on New Web Site," Chronicle of Higher Education, May 18, 2012 ---
    http://chronicle.com/blogs/ticker/texas-am-launches-new-web-site-in-response-to-demand-for-accountability/43387?sid=wc&utm_source=wc&utm_medium=en

    Bob Jensen's threads on human resource accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#TripleBottom

    Bob Jensen's threads on cost and managerial accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    New Years Day: What channel will carry the IMA versus AICPA faceoff?
    "IMA Ready to Compete with AICPA/CIMA Management Accounting Designation," AccountingWeb, December 28, 2011 ---
    http://www.accountingweb.com/topic/education-careers/ima-ready-compete-aicpacima-management-accounting-designation

    The Institute of Management Accountants (IMA), which has offered the Certified Management Accountant (CMA) credential since 1972 and represents more than 60,000 accountants and financial professionals in business worldwide, is facing "fierce competition" from a new management accounting designation – Chartered Global Management Accountant (CGMA) – that will be launched by the American Institute of Certified Public Accountants (AICPA) and the Chartered Institute of Management Accountants (CIMA) in January 2012, according to Jeffrey Thomson, IMA President and Chief Executive Officer. 
     
    AICPA voting members will be automatically eligible for the credential upon verifying three years of qualifying experience. CPAs who are members of both the AICPA and their state CPA society will receive a special discounted annual fee to maintain the CGMA credential. 
     
    "While IMA welcomes these organizations' recognition of the important role of management accounting, we have some serious questions about the designation, and we intend to stand up and be counted," Thomson told AccountingWeb in a recent interview. 
     
    Thomson has questioned the length of the grandfathering period and the fact that AICPA members qualify without passing a test. He also objected to the automatic enrollment. "It is our understanding that they must opt out of the designation initially."
     
    "Management accountants need to be able to make more judgmental analyses," Thomson said. "They need to pursue their credential and pass a rigorous, focused, relevant exam." He pointed out that in addition to passing a two-part exam, CMA candidates must fulfill both an education and experience requirement. 
     
    "At IMA, we are not just in the business of increasing our membership, although we are expanding our presence worldwide. We will continue to be focused on our mission, which is to respond to the market and to the needs of organizations and society."
     
    "The market and organizations have shown a need for accounting professionals working in business to be prepared to analyze, plan, and budget, and to understand their obligation to investors and their role in preventing fraud. Studies have shown a talent management gap in forward-looking activities among finance professionals. We have an obligation to fill that gap."
     
    "We expect finance and accounting personnel will choose to follow a professional management accounting path based on what the market and organizations have said that they need," Thomson said. "Surveys and focus groups have found that financial planners and individuals with knowledge of risk management, performance management, and measurement top the list of people they are looking to hire."
     
    "Statistics show that a high percentage of students who graduate with accounting degrees will go into public accounting and perform audits, but after a few years they move into finance departments of companies of all sizes where they are responsible for planning and budgeting. They have learned to analyze historic information, but many will have had only one course in management accounting as part of their undergraduate degree in accounting. Working in public accounting is a great way to start one's career, but an accountant in business still needs to acquire management accounting skill sets," Thomson said.
     
    "Working from a strong technical basis, the accountant working in finance needs to be able to go from data to decisions, from information to insights, and sit across the table as a trusted business advisor."
     
    "To have a great career, a young professional with an accounting degree needs to develop a well-rounded set of skills, but those skills have value at any stage in a career. I became a management accountant just two years ago after working in telecommunications for over twenty years, ending in a CFO role at AT&T. When I completed the 150 hours of required study for the CMA and passed both parts of the exam, I felt more competent, more rounded."
     
    "An aspiring CMA needs to possess the skills to perform:
    Looking ahead, Thomson concluded that "the market will determine the future of management accountant credentials. But the market is not as rational as we would like, and it is very forgiving. When an organization has credibility and has reached a critical mass, people do not ask the tough questions, often building in inefficiencies."

    Jensen Comment
    This may become less relevant when the prestigious accounting designations of the future are Certified Cognitors and Condorsers. In accountics science a mere PhD will no longer cut it. The prestigious accountics scientists will place their proud CEW credentials beside their names --- Certified Equation Writers.


    I think most of my wife's clothes were purchased from "Jauque Pennay".
    She was really, really disappointed when this famous mail order company dropped its mail order catalog
    But we still get this company's daily advertising mailings for 1-800 number orders from these mountains
    I keep the company's  Website a secret from her but that did not prevent our having more clothes on poles in the basement than you will find in the Concord NH department store

    I remember a short while back when the company's new pricing policy was announced with great fanfare
    Now this policy is an illustration of policy failure that we can teach to students.

    "J.C. Penney: Ditch the Risky Pricing Strategy," by Rafi Mohammed, Harvard Business Review Blog,, May 21, 2012 --- Click Here
    http://blogs.hbr.org/cs/2012/05/jc_penney_ditch_the_risky_pric.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    This could probably be written up as a great CPV case in managerial accounting, the purpose being to illustrate how important demand elasticity is to CPV analysis.


    That Arizona State U. can afford to offer such big discounts to employees of the coffee company suggests just how much higher-education institutions earn from distance learning.

    "Starbucks Plan Shines a Light on the Profits in Online Education Starbucks Plan Shines a Light on the Profits in Online Education," by Goldie Blumenstyk, Chronicle of Higher Education, June 27, 2014 ---
    http://chronicle.com/article/Starbucks-Plan-Shines-a-Light/147395/?cid=wc&utm_source=wc&utm_medium=en

    Jensen Comment
    Without mentioning it, Goldie has hit on what we teach in managerial accounting as "Cost-Profit-Volume (CPV)" analysis. The contribution margin is price minus variable costs. Such margins apply first to recovering fixed costs and then go to operating profits. Higher volume (sales) means that it's possible to make lower contribution margins profitable by lowering prices ceteris paribus.

    Key to CPV analysis is management of variable and fixed costs. The Starbucks plan is ingeniously designed to reduce costs. Firstly it applies only to the continuance of the last two years of college education. This avoids much of the cost associated with students in their first two years. Firstly, it avoids the need for so much remedial work since students that pass the first two years are less likely to need added remedial education. Secondly, such students are less likely to waste resources by dropping out. Thirdly, most of them will have had previous distance education such that they do not have to be initially trained on how to take distance education courses.

    Actually many universities are finding distance education courses more profitable than onsite courses. One reason is the demand function. Onsite courses often are quite sensitive to tuition pricing because students have to consider other costs such as commuting costs, child care costs, and maybe even boarding costs. Online students often avoid such costs and therefore are somewhat less sensitive to slightly higher online pricing. 

    There are many other things that case writers could build into the "Starbucks Case." These include such factors as operating leverage, sales mix analysis, and demand elasticity analysis. Also increasing employee benefits sometimes means that employees will work for lower cash wages.

    In any case, I think it would make sense for managerial accounting teachers to assign student teams to write up cases and solutions to the "Starbucks Case" and other real-world instances of distance education.

     


    Teaching Case on CPV Analysis

    From The Wall Street Journal Accounting Weekly Review on January 6, 2012

    Starbucks to Raise Prices
    by: Annie Gasparro
    Jan 04, 2012
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com WSJ Video
     

    TOPICS: Commitments, Cost Accounting, Cost Management, Managerial Accounting, Product strategy

    SUMMARY: Starbucks Corp. "said Tuesday it is raising prices an average of about 1% in the Northeast and Sunbelt regions...." Price increases will be posted for some but not all sizes of its brewed coffee products; the company "...isn't raising prices for packaged coffee sold at its cafes or at grocery stores." The article comments on pricing strategy, cost control, and profit margins. The related video discusses the company's purchase of a long term contract for coffee at high prices just before coffee prices fell overall.

    CLASSROOM APPLICATION: The article is useful to introduce manufacturing cost components and cost behavior with a simple product with which most students should be familiar.

    QUESTIONS: 
    1. (Introductory) Why is Starbucks raising the price of some of its locations for some of its products?

    2. (Introductory) On which products will Starbucks raise prices? In which locations? Why will the company's pricing vary by product and region?

    3. (Advanced) According to one statement in the article about Starbucks products, "...coffee represents a bigger portion of the cost of its packaged goods than of brewed coffee." What are the other cost components for a cup of brewed coffee that are not present in a package of whole coffee beans for sale in a grocery store?

    4. (Advanced) What was the impact of a contract for coffee purchases on Starbucks's costs for its product?

    5. (Advanced) Based on the discussion in the related online video, how does Starbucks expect coffee purchase costs to even out over the long term?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Starbucks to Raise Prices," by: Annie Gasparro, The Wall Street Journal, January 4, 2012 ---
    http://online.wsj.com/article/SB10001424052970203550304577138922045363052.html?mod=djem_jiewr_AC_domainid

    Starbucks Corp. is raising brewed-coffee prices in some regions to offset its higher costs.

    The Seattle chain said Tuesday it is raising prices an average of about 1% in the Northeast and Sunbelt regions, including such cities as Boston, New York, Washington, Atlanta, Dallas and Albuquerque, N.M.

    Starbucks didn't give details on all the areas where prices will increase but said most southern states are included. Prices won't rise in California and Florida.

    Starbucks has raised prices in its cafes annually since the recession began, though the company said its increases have been "far less" than those of its rivals.

    Starbucks will face higher commodity costs than some of its competitors in the coming months. The chain made contracts to buy coffee for the fiscal year that began in October because prices were rising and Starbucks wanted to eliminate the volatility of buying on the spot market. But the market for coffee soon fell, and Starbucks was stuck paying more than it would have otherwise.

    Over the past couple of years, Starbucks has topped the industry in sales and been able to manage commodity inflation, "not with pricing, but with a more efficient cost structure and strong traffic growth," Chief Financial Officer Troy Alstead said in November when the company reported earnings.

    Because the chain's high-end consumer base is less sensitive to prices than that of some rivals, Starbucks has said it didn't think increases would affect customer purchases, even in a struggling economy. Some chains, especially fast-food restaurants that focus on low prices, risk losing customers when prices rise.

    Starbucks shares rose 43% last year. The stock fell 73 cents, or 1.6%, to $45.29 in 4 p.m. composite trading Tuesday on the Nasdaq Stock Market.

    The latest change, which was reported earlier by Reuters news service, raises the cost of a "tall," or 12-ounce, coffee in some New York City stores by 10 cents to $1.85. Not all sizes will see price increases.

    Starbucks isn't raising prices for packaged coffee sold at its cafes or at grocery stores. That's where Starbucks faces the greater pressure on profit margins, largely because coffee represents a bigger portion of the cost of its packaged goods than of brewed coffee.

    Continued in article

    Bob Jensen's threads on managerial accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    From The Wall Street Journal Accounting Weekly Review on July 19, 2012

    Lobster Glut Slams Prices
    by: Jerry DiColo and Nicole Friedman
    Jul 16, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Contribution Margin, Cost Accounting, Fixed Costs, Managerial Accounting, Variable Costs

    SUMMARY: "Lobsters are a $300-million-a-year industry in Maine....Maine's thousand of independent lobstermen supply the vast majority of the world's clawed lobsters....[However, h]arbors up and down the coast of Maine are filled with idle fishing boats, as lobster haulers decide that pulling in their lobster pots has become a fruitless pursuit. Prices at the dock have fallen to as low as $1.25 a pound in some areas-roughly 70% below normal and nearly a 30-year-low for this time of year, according to fishermen, researchers and officials." The article describes the economic and fisheries reasons for this current debacle.

    CLASSROOM APPLICATION: The article may be used in a managerial accounting class to identify fixed and variable costs considered in decision-making for lobstermen to go out collecting a catch. It emphasizes economic factors beyond the lobstermen's control in facing these decisions.

    QUESTIONS: 
    1. (Introductory) Summarize the market conditions facing Maine lobstermen that led to a recent decision by a group of them not to go out on their boats to catch lobsters.

    2. (Advanced) Describe the costs you think are incurred to catch lobster. In your answer, identify which costs are variable costs and which are fixed costs.

    3. (Advanced) According to the head of the Massachusetts Lobstermen's Association, at prices below $4/lb, lobstermen cannot make a profit on their catch. Describe how you think profitability is measured to make this assessment, identifying the costs you gave in your answer to question 2 above.

    4. (Advanced) Is the $4 price per pound discussed above a wholesale price or a retail price? Support your answer.

    5. (Advanced) If prices offered to lobstermen are low, will you see a low price when you order lobster at a restaurant? Explain your answer based on information in the article.
     

    Reviewed By: Judy Beckman, University of Rhode Island"

    Lobster boats sitting idle on the Island of Vinalhaven in July 2012 ---
    http://en.wikipedia.org/wiki/Vinalhaven,_Maine

    "Lobster Glut Slams Prices Some Fishermen Keep Boats in Port; Outside Maine, No Drop for Consumers," by: Jerry DiColo and Nicole Friedman, The Wall Street Journal, July 16, 2012 ---
    http://professional.wsj.com/article/SB10001424052702304388004577529080951019546.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Before sunrise last Monday, in a parking lot by the water in Winter Harbor, Maine, a gathering of lobstermen came to a rare consensus: prices were too low to go fishing.

    "I've never seen them tie up [their boats] as a group like this before," said Randy Johnson, manager of the Winter Harbor Lobster Co-op. The 30 vessels in his co-operative have remained in port for a week straight.

    "I'm looking at all their boats as we speak," he said Friday when reached at the co-op, which sits across the bay from Bar Harbor "They all have a cut-off point [in price] where they can and can't fish," he said. "It's an impossible situation."

    Harbors up and down the coast of Maine are filled with idle fishing boats, as lobster haulers decide that pulling in their lobster pots has become a fruitless pursuit.

    Prices at the dock have fallen to as low as $1.25 a pound in some areas—roughly 70% below normal and a nearly 30-year-low for this time of year, according to fishermen, researchers and officials. The reason: an unseasonably warm winter created a supply glut throughout the Atlantic lobster fishery.

    Those prices have officials and lobstermen concerned about the fate of one of the state's most vital industries. "For some people it will be disaster, they are going to go bankrupt," said Bob Bayer, director of the Lobster Institute at the University of Maine.

    Retail lobster prices in Maine have started to fall along with the glut, and Mr. Bayer said that some fishermen have begun selling lobsters out of their trucks for as low as $4 a pound. But consumers elsewhere in the U.S. aren't likely to see bargains. The Maine lobsters that currently are in season can't be shipped long distances due to their soft shells, and retailers have other fixed costs that limit big price drops.

    "There could be a small effect, but I wouldn't expect much," Mr. Bayer said.

    Lobsters are a $300-million-a-year industry in Maine, according to Halifax, Canada, consulting firm Gardner Pinfold. Along with Canada, Maine's thousands of independent lobstermen supply the vast majority of the world's clawed lobsters, which have seen a population boom over the past three decades due to rising water temperatures and overfishing of cod and haddock, their main predators.

    Profit margins are low even in good years, but this summer the problem has intensified. The wholesalers that buy directly from lobstermen are paying less than it costs for many boats to turn a profit.

    "Anything under $4 [a pound], lobstermen can't make any money," said Bill Adler, head of the Massachusetts Lobstermen's Association, which publishes a weekly report on lobster prices in the U.S. and Canada.

    Mr. Adler, a former lobsterman, said the warm winter had two effects. It allowed Canadian lobstermen, who typically fish in the early spring, to bring in large catches due to the mild temperatures. And the lobsters that Maine fishermen catch in the summer months—the ones that can't be shipped live due to their softer shells—arrived six weeks earlier than normal.

    "The month of June might have been a record in the state of Maine for catch," said Peter Miller, a veteran lobsterman from Tenants Harbor. His business is struggling despite traps that have brought in hauls four times larger than normal.

    Enlarge Image image image Matthew Healey for The Wall Street Journal

    Lobsterman Joe Hutchinson stacks traps.

    The price slump has led some lobstermen to take drastic action. Patrick Keliher, the Commissioner of the Maine Department of Marine Resources, said his agency has investigated reports of lobstermen coercing others not to go out fishing in an effort to lower supplies and raise prices back to more normal levels.

    "Frankly, there were some fisherman that were trying to bully some people into not fishing. Most of it was veiled threats, and as soon as we started hearing about it, I made sure patrol was aware," said Mr. Keliher.

    On Monday, Mr. Keliher issued a statement warning that threats to cut lobster traps loose or force lobstermen to stay in port "will be met with targeted and swift enforcement." He added that any attempts to impose a broader fishing halt "may be in violation of federal antitrust laws."

    A shutdown is already taking place though, according to some Maine residents. In Knox County, which has several hundred licensed lobstermen, boats have stayed tied to their moorings for over a week, said Diane Cowan, executive director of the Lobster Conservancy in Friendship, Maine.

    "I don't know how they came to agree on this," said Ms. Cowan. "The boats are all at their moorings and all the lobster traps are all in the water."

    Ms. Cowan has lived in Friendship for 14 years. The town of about 1,200 residents has two churches and two lobster co-ops. Its harbor, which typically is filled with the sound of diesel engines as roughly 200 lobster boats motor in and out of the bay with their catches, has gone silent.

    Continued in article

    Jensen Comment
    Every summer in August we have Christmas in August with our Maine family and old friends (I taught at the University of Maine for ten years). We meet on Lincolnville Beach where the State of Maine Ferry departs for the Island of Vinalhaven. Actually the Wikipedia entry is misleading by recommending the ferry from Rockland when the ferry north of Camden at Lincolnville Beach gets you and your vehicle to Vinalhaven much faster.

    On Lincolnville Beach we stay at the Spouter Inn. In New England a "spouter" is a flowing spring of fresh water. This is the only source of water at the Spouter Inn. From the front deck we can look down at the best seafood restaurant in New England. The restaurant is simply called the Lobster Pound. Although I'd think I died and was in heaven with this restaurant's rich lobster stew and fried clams, while I still on earth I generally order a more healthy dinner of broiled Halibut. Actually, I lie. At least once on each trip I have lobster stew teaming with butter and on another day a huge platter of fried clams.

    We call our event Christmas in August because Erika and I got tired of getting caught in mountain blizzards when driving to and from Maine in December. It's a much safer drive when we celebrate Christmas in August on the coast of Maine. Camden by the way is a beautiful shore town favored by many executives (those 1% folks) who elected to retire on the coast of Maine ---
    http://en.wikipedia.org/wiki/Camden,_Maine
    Real estate is very expensive in the Camden Highlands.--- most certainly out of my price bracket.

    I have pictures of the Spouter Inn at
    http://faculty.trinity.edu/rjensen/Tidbits/Ocean/Set01/OceanSet01.htm
    You have to scroll down a bit to find those pictures.


    Case for CVP Analysis (Especially for middle tier restaurants where demand is highly price elastic)

    From The Wall Street Journal Accounting Weekly Review on September 1, 2012

    Soaring Food Prices Put Restaurants in a Bind
    by: Julie Jargon
    Aug 29, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Business Segments, Managerial Accounting, Profit Margin, Segmented Income Statements

    SUMMARY: Restaurant chains are in a pickle, caught between soaring ingredient costs and fears that raising prices will turn off their budget-conscious customers, who generally remain pessimistic about the economy. Companies like McDonald's Corp., Buffalo Wild Wings Inc. and Chipotle Mexican Grill Inc. are taking different approaches to the dilemma. Some are trying to pass on rising costs to customers to avoid squeezing their profit margins. Others are holding the line on prices or emphasizing their existing low-cost menu items to keep consumers coming through the door. Research has shown that diners are ordering more "value" items and fewer premium-priced entrees and appetizers, indicating they are trying to manage the size of their restaurant bills more than we've seen in a while.

    CLASSROOM APPLICATION: This article offers a nice bridge between managerial and financial accounting. We can use this article to discuss how management is using segmented income statements to manage profit margins in this tight economy. The companies are also carefully managing fixed and variable costs as raw material prices of food increase in the face of low consumer confidence. This is a great opportunity to show how the information and tools we teach in class directly relate to management decisions, strategy, and profitability.

    QUESTIONS: 
    1. (Introductory) What challenges are restaurants facing? How are they impacted both on the expense side and sales side?

    2. (Advanced) How are fast food restaurants analyzing the situation using segmented income statements to address these challenging times? How does segmenting the business's product lines and customers help with the company's overall profit margins?

    3. (Advanced) What segment of the fast food business is most successful? How is McDonald's management approaching each segment to make it more profitable? How does a segmented income statement and budgeting aid in this analysis?

    4. (Advanced) In the restaurant business, which types of costs are easiest to control? Which are more difficult? Are these costs more likely to be fixed, variable, or mixed costs? How can management work with each of these types of costs to survive and perhaps thrive in these kinds of economic times?

    5. (Advanced) How are different types of restaurants (fast food, mid-range, fine dining) being affected differently under these conditions? How can each type of restaurant use managerial accounting concepts to improve profitability?

    6. (Advanced) How would a contribution format income statement help management to make these decisions?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

     

    "Soaring Food Prices Put Restaurants in a Bind," by: Julie Jargon, The Wall Street Journal, August 29, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444082904577606983275066266.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Restaurant chains are in a pickle, caught between soaring ingredient costs and fears that raising prices will turn off their budget-conscious customers, who generally remain pessimistic about the economy.

    Companies like McDonald's Corp., MCD +0.89% Buffalo Wild Wings Inc. BWLD -1.94% and Chipotle Mexican Grill Inc. CMG -0.48% are taking different approaches to the dilemma. Some are trying to pass on rising costs to customers to avoid squeezing their profit margins. Others are holding the line on prices or emphasizing their existing low-cost menu items to keep consumers coming through the door.

    The worst drought in decades has driven up prices for foods including corn, chicken and beef this summer. Further complicating matters for restaurants and other retailers, consumer confidence in August fell to its lowest level since November 2011, the Conference Board said Tuesday.

    Earlier this month McDonald's attributed flat global same-store sales in July to waning consumer sentiment, and market-research firm NPD Group predicted that restaurant traffic would be flat for the next two years, dialing back its previous forecast of a 1% gain.

    "Restaurant operators are in a position where they don't have much of a choice but to raise prices because they operate on such thin margins," said Darren Tristano, executive vice president of restaurant consulting firm Technomic Inc.

    The pressure is greater on some chains than others. Fine and causal-dining restaurants can better stomach commodity-cost increases because of their higher-priced menus and ability to adjust portion sizes. "But when you're McDonald's, a lot of your products are priced to be 'value' offerings, so there's not a lot of room to absorb cost increases," Mr. Tristano added.

    "I'd probably order more from the value menu if prices go up," said 33-year-old Norma Rangel-Aponte, who was eating a snack-size McFlurry ice-cream dessert at a Chicago McDonald's recently. To save money, she said, she sometimes orders a side salad and tops it with the chicken from a snack wrap, rather than ordering a more-expensive chicken salad.

    Restaurant chains were in similar straits a few years ago. Food costs were high during parts of the recession because of rising global protein demand. Some chains reacted by heavily discounting their dishes to keep customers coming back, but their profit margins suffered.

    Others boosted prices modestly on inexpensive menu items, hoping that consumers would swallow the increases without much resistance. In January 2009 McDonald's raised the price of a double cheeseburger, a fixture of its Dollar Menu, to $1.19 to help defray higher beef and cheese costs. A spokeswoman said Tuesday that the double cheeseburger remains on the regular McDonald's menu at a suggested retail price of $1.19 to $1.29, depending on location.

    RBC Capital Markets analyst Larry Miller said his research has shown that diners are ordering more "value" items and fewer premium-priced entrees and appetizers, indicating they are trying to manage the size of their restaurant bills more "than we've seen in a while." The potential for weak or flat sales growth combined with rising costs is "downright scary to us," he added.

    Some chains are once again stressing cheaper menu items, offering promotions to help bring customers back more often and testing the water with small price increases. McDonald's recently created an "Extra Value Menu" featuring such items as a 20-piece Chicken McNuggets for $4.99. Starbucks Corp. SBUX -0.20% reintroduced "treat receipts" that give morning customers a discount if they return in the afternoon.

    Continued in article

    Jensen Comment
    Meanwhile increases in food and fuel do not affect inflation indices since the government now deceives us about the inflationary spiral for food and fuel prices by ignoring prices increases in food and fuel when adjusting for inflation.

    Government accounting is all done with smoke and mirrors ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    From the University of Pennsylvania (Wharton):  The U.S. Deficit is Tremendously Understated
    "A Proper Accounting: The Real Cost of Government Loans and Credit Guarantees," Knowledge@Wharton, December 5, 2012 ---
    http://knowledge.wharton.upenn.edu/article.cfm?articleid=3126


    "How a design project bred a blueprint for innovation," by Harvey Schachter, Globe and Mail, August 298, 2012 ---
    http://www.theglobeandmail.com/report-on-business/careers/management/how-a-design-project-bred-a-blueprint-for-innovation/article4505420/

    In 2005, Procter & Gamble, eager to accelerate its innovation, decided to try to institutionalize throughout the company the new, fuzzy notion of design thinking. It turned to Roger Martin, dean of the University of Toronto’s Rotman School of Management, one of the leading exponents of integrative and design thinking. He in turn gathered help from colleagues at Stanford University and the Illinois Institute of Technology.

    Their efforts proved so successful that it led to the creation of a DesignWorks studio at Rotman, led by executive director Heather Fraser, where they refined their methodology while working with companies such as Nestlé, Pfizer, Medtronic and Frito-Lay, as well as public institutions and government teams.

    Ms. Fraser now shares those ideas in Design Works, which argues that business design brings out the creative side of individuals in a workplace without compromising the rigour needed to have a meaningful impact on the market.

    “This approach has proven to get to bigger ideas faster, by engaging more minds in a common ambition, with the buy-in and traction required to make important things happen in a strategic and productive manner,” she writes.

    The approach revolves around three gears to get your innovation motor running:

    Gear 1: Empathy and understanding

    To understand the opportunity that might exist, you must start with empathy for others and an understanding of what matters to people. Usually, we rely on market reports and surveys to get a handle on potential customers. But she says that while that gives you a good measure of the customer characteristics, habits, and values that you believe to be important, it often does not contribute to a deeper understanding of their underlying motivations and unmet needs.

    “Understanding them more holistically entails understanding them more completely as individuals apart from the direct consumption or use of your current product or service,” she points out. “Considering the wider activity surrounding your products and services expands your perspective on opportunities to create value in new ways.”

    Gear 2: Concept visualization

    With that understanding, the hunt can begin in earnest for the breakthrough idea. You now have licence and ambition to explore new possibilities, including some that would have been considered beyond your operating scope, rather than limiting yourself to the familiar and obviously doable.

    You will pick from a variety of tools to generate ideas, design new and ideal experiences, develop multiple prototypes to test your ideas, and create with your potential customers the best possible offering.

    It will be vital, however, to stay focused on the user rather than becoming diverted at this stage by the organizational impact.

    Gear 3: Strategic business design

    Now you can move on to consider the organizational side of things, developing a strategy to deliver the vision. Ms. Fraser warns that this will take the same rigour and ingenuity required to develop your new breakthrough proposal. Often things can fall apart here, as organizations find themselves with lots of promising ideas but don’t know how to fit them with other ideas and programs into a formidable strategy.

    “Gear 3 … calls for a healthy dose of both creativity and analysis at appropriate points,” she notes. You’ll require solid collaboration from your team, detailed prototyping, and a plan that maps out some quick wins to keep enthusiasm high. She warns that this step is often the missing link in many innovation projects and why the initiatives fail to provide a solid return of investment.

    Prototyping is increasingly important to understanding whether ideas have possibilities. She urges you to keep the first efforts low-cost, and reveals that the DesignWorks studio generally limits itself in the early stages to $20, using cardboard, markers and Popsicle sticks. The idea is to communicate intent, not to resemble the final product. You’ll be less invested in it if you put the prototype together quickly with little money; and the people who test it will be able to give you more advice if they can use their imagination to fill in missing pieces.

    The first half of the book, about the three-gears process, is somewhat stilted despite the case studies woven in; it’s certainly not as absorbing as Designing for Growth, by Jeanne Liedtka and Tim Ogilvie. (And the horrendous choice of typeface – pretty, but sans-serif and very thin – added to my reading struggle, as it was physically hard to focus on the words. The irony of poor design choices in a book about design was not lost on me.)

    But the book’s second half – essentially a series of fast-paced, practical tips for implementing the ideas – was more enjoyable, and would be valuable to anyone interested in the business design path.

    Continued in article


    From The Wall Street Journal Accounting Weekly Review August 24, 2012

    Getting a Reprieve from Capital Punishment
    by: Justin Lahart
    Aug 20, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Capital Spending

    SUMMARY: "To look at the woeful earnings season that's wrapping up, the days of capital expenditure bolstering the U.S. economy seem numbered. But don't count it out yet....Spending on new equipment and software is usually a function of demand: whatever direction earnings growth is going is where capital spending will head within the next quarter or so."

    CLASSROOM APPLICATION: The article is useful to introduce economic reasoning behind fixed asset purchases and the related use of such financial statement measures in predicting future economic activity. Since the discussion includes computer software, it provides an up-to-date description of what is considered capital spending. Another topic in the article is Pepsi's foreign investment and sales generation which may be used to explain the concept of functional currency. INSTRUCTORS SHOULD REMOVE THE FOLLOWING ANSWER TO QUESTIONS 5 AND 6: In the discussion of Pepsi's foreign sales, if the Indian operations are organized as a corporation that is consolidated, then the functional currency of those operations is most likely the Indian rupee. Students should draw that conclusion from the fact that the operations are invested in India and the sales are generated there as well. For consolidation, translation at current rates should be done for purposes of consolidating international operations when a subsidiary's functional currency is its local currency.

    QUESTIONS: 
    1. (Advanced) What are capital expenditures? What items are included in the category of capital expenditures in this article?

    2. (Advanced) How are capital expenditures accounted for in U.S. company's books and records?

    3. (Introductory) According to the article, what was the growth rate in the second quarter of calendar 2012 in capital expenditures? From where do you think the U.S. Commerce Department obtains the information reported in the article?

    4. (Introductory) How does the survey of U.S. chief financial officers (CFOs) add to the understanding of the overall growth rate discussed in question 3 above?

    5. (Advanced) In the article, the author states "...The bulk of foreign sales by U.S. companies come from the operations they have in place overseas," and then describes Pepsi's operations in India. If these operations are organized as a corporate subsidiary, what currency do you think is likely to be considered the functional currency of this entity? Explain your answer.

    6. (Advanced) What is the implication of the functional currency for consolidation of Pepsi's Indian operations?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Getting a Reprieve from Capital Punishment," by: Justin Lahart, The Wall Street Journal, August 20, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444233104577595760843342058.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    To look at the woeful earnings season that's wrapping up, the days of capital expenditure bolstering the U.S. economy seem numbered. But don't count it out yet.

    S&P 500 earnings likely increased by just 0.9% in the second quarter versus a year earlier, according to S&P Capital IQ's latest estimates. For the third quarter, analysts are forecasting the first outright decline in profits since 2009.

    Spending on new equipment and software is usually a function of demand: Whatever direction earnings growth is going is where capital spending will head within the next quarter or so. Profits began to seriously weaken in mid-2007, for example, and by early 2008 capital spending had begun to shrink. So even though spending on equipment and software grew at a healthy 7.2% inflation-adjusted annual rate in the second quarter, according to the Commerce Department, its future pace is in doubt.

    But Europe's downturn and Asia's slowdown explain much of the weak growth in U.S. company earnings. So the dynamic isn't quite the same as it was in the last recession.

    In the second-quarter survey of chief financial officers he conducted with CFO Magazine, Duke Fuqua School of Business economist John Graham found stark differences in the capital-spending plans of U.S. firms booking most of their sales overseas and those with more domestic exposure.

    CFOs at companies booking more than half their sales in Europe, for example, expected spending to fall by about 5% over the next year. Companies with less than half their sales in Europe expected spending to increase by about 10%.

    U.S. exports are substantial, but the bulk of foreign sales by U.S. companies come from the operations they have in place overseas. For example, the Pepsi sold in India is made in India. U.S. Trust chief market strategist Joseph Quinlan estimates that such sales came to more than $6 trillion last year. That compares with U.S. exports of just over $2 trillion.

    That matters because just as overall profits dictate how much money companies spend, they tend to spend it in places where they are doing well. The fact that General Motors' GM -0.63% European operations are struggling, for instance, didn't stop it from renovating and restarting production at its former Saturn assembly plant in Spring Hill, Tenn.

    The better picture for capital spending in the U.S. doesn't shield big U.S. makers of equipment and software from the global malaise. Almost to a company they, too, have substantial operations overseas. But it does make things a little easier. And since many companies have underinvested in the years since the recession, there is potential for the U.S. to do some heavier lifting.

    Continued in article

     

     


    The Big Idea: How to Solve the Cost Crisis in Health Care
    "What Health Care Really Costs," Harvard Business Review Blog, August 18, 2011 --- Click Here
    http://blogs.hbr.org/ideacast/2011/08/what-health-care-really-costs.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Featured Podcast Interview Guest: Robert S. Kaplan, Harvard Business School professor and
    coauthor of the HBR article How to Solve the Cost Crisis in Health Care.

    "The Big Idea: How to Solve the Cost Crisis in Health Care," by Robert S. Kaplan and Michael E. Porter, Harvard Business Review, August 2011 ---
    http://hbr.org/2011/09/how-to-solve-the-cost-crisis-in-health-care/ar/1?referral=00134

    . . .

    Fortunately, we can change this state of affairs. And the remedy does not require medical science breakthroughs or top-down governmental regulation. It simply requires a new way to accurately measure costs and compare them with outcomes. Our approach makes patients and their conditions—not departmental units, procedures, or services—the fundamental unit of analysis for measuring costs and outcomes. The experiences of several major institutions currently implementing the new approach—the Head and Neck Center at MD Anderson Cancer Center in Houston, the Cleft Lip and Palate Program at Children’s Hospital in Boston, and units performing knee replacements at Schön Klinik in Germany and Brigham & Women’s Hospital in Boston—confirm our belief that bringing accurate cost and value measurement practices into health care delivery can have a transformative impact.

    Continued in article (for a fee)

    Jensen Comment
    The article does not address all aspects of the cost of healthcare, including the enormous cost of fraud in all aspects of healthcare from the funding of unneeded medical procedures to phony medical equipment invoices to substandard medications to medical services for people not eligible for funding of such services such as undocumented aliens who enter this country for the purpose of free obstetrics and other types of medical services.

    There is also the cost of malpractice insurance which is often ten times what it is in Canada because of differences between how malpractice claims are processed in Canada versus the United States (where 80% of the world's lawyers practice).

    Bob Jensen's threads on health care funding ---
    http://faculty.trinity.edu/rjensen/Health.htm


    Problems With Absorption Costing

    "Lots of Trouble:  U.S. automakers used a common accounting practice to justify huge run-ups in inventories, but the downside risks offer lessons for all manufacturers," by Marielle Segarra, CFO Magazine, March 2012, pp. 29-31 ---
    http://www.cfo.com/article.cfm/14620031?f=search

    It's no secret that in the years leading up to the Great Recession, the Big Three automakers were producing vehicles in excess of market demand, leading to large inventories on dealers' lots across the country. Now, some researchers say they know why the automakers acted as they did, and they are warning other manufacturers to avoid the same temptation.

    By coupling excess production with absorption costing, managers at GM, Ford, and Chrysler were able to boost profits and meet short-term incentives, according to professors at Michigan State University and Maastricht University in the Netherlands. (Their study on the topic was recognized in January for its contribution to management accounting by the American Institute of Certified Public Accountants and other groups.) Ultimately, however, the practice hurt the automakers, in part by driving up advertising and inventory holding costs and possibly causing a decline in brand image, the researchers say.

    From 2005 to 2006, long before GM and Chrysler filed for bankruptcy and appealed for federal aid, the automakers had abundant excess capacity. Then as now, they had enormous fixed costs, from factories and machinery to workers whose contracts protected them from layoffs when demand was low, says Karen Sedatole, associate professor of accounting at Michigan State and a co-author of the study.

    To "absorb" those massive costs, the automakers churned out more cars while using absorption costing, a widely used system that calculates the cost of making a product by dividing total manufacturing costs, fixed and variable, by the number of products produced. The more vehicles they made, the lower the cost per vehicle, and the higher the profits on the income statement. In effect, the automakers shifted costs from the income statement to the balance sheet, in the form of inventory.

    Under Statement of Financial Accounting Standards No. 151, companies can use absorption costing for "normal capacity" but must treat "abnormal" excess capacity as a period cost, according to Sedatole. But the standard doesn't clearly define what's normal, leaving room for companies to overproduce in order to lower unit cost. Companies that do so "are, in a way, managing earnings upward by trapping costs on the balance sheet as inventory, so they won't hit the income statement," she says.

    Eroding Brand Image But business leaders should think twice before adopting this tactic, cautions Sedatole. Even though they can make their companies appear more profitable in the short term by concealing excess capacity costs on the balance sheet, holding so much excess inventory can exact a price.

    "When [the dealers] couldn't sell the cars, they would sit on the lot," says Sedatole. "They'd have to go in and replace the tires, and there were costs associated with that." The companies also had to pay to advertise their cars, often at discounted prices. And by making their cars cheaper and more readily available, they may have turned off potential customers, she adds.

    "If you see a $12,000 car in a TV ad is being auctioned off for $6,000 at your local dealer, that affects your image of that vehicle," says Sedatole. This effect on brand image is difficult to quantify, but the researchers correlated 1% of rebate with a 2% decline in appeal in the J.D. Power and Associates Automotive Performance Execution and Layout Index.

    Some might argue that it's good strategy for a company already obligated to pay salaries to make products up to its capacity. "An economist would say as long as I could sell the car for more than its variable cost, I'm better off selling it," Sedatole says. But, she adds, "that's a very, very short-term way of thinking" because it neglects the costs that come with having a lot of excess inventory.

    Lessons Learned Using absorption costing to monitor efficiency can lead companies to make poor production decisions, says Ranjani Krishnan, professor of accounting at Michigan State and a co-author of the study (along with Alexander Brüggen, an associate professor at Maastricht University). A company that does this could seem to be growing less efficient when demand decreases. If a factory makes fewer cars this year than last year, for instance, its cost per car will look higher, and it may then overproduce in order to present itself more favorably to shareholders, consumers, and analysts.

    Instead, Krishnan suggests, companies should record the cost of excess capacity as an expense on their internal income statements, a practice that may help give them perspective.

    Another way to avoid overproduction is to change the way executives are paid. Like many companies, the automakers put their managers under pressure to deliver in the short term by structuring compensation incentives around metrics like labor hours per vehicle, which the industry's Harbour Report uses to compare automaker productivity. With fixed labor hours, the only way to look more efficient under this measure is to produce more cars.

    "A lot of this behavior was frankly driven by greed," says Krishnan. "If you look at the type of managerial incentives [the automakers] had during the time of our study, the executive-committee deliberations, it was all about meeting short-term quarterly traffic numbers or meeting analysts' forecasts so that they could get their bonuses."

    Continued in article


    Transfer Pricing of Intellectual Property Rights --- http://www.buildingipvalue.com/05_TI/031_034.htm


    "The Two-Part CMA Exam for 2010," by James Martin, MAAW's Blog, March 20, 2010 ---
    http://maaw.blogspot.com/2010/03/new-two-part-cma-exam-2010.html

    Also see http://maaw.info/ArticleSummaries/ArtSumBrauschWhitney2010.htm

    The MAAW Website is a tremendous open sharing site from James Martin ---
    http://maaw.info/

    What's new on MAAW?
    Multiple Choice Questions for Management Accounting
    James Martin added a summary page of links to multiple choice questions for 14 management accounting topics at http://maaw.info/ManagementAccountingMCQuestions.htm


    History of the CMA Examination and Revisions

    October 30, 2010 message from James Martin

    For an update and history of the CMA program see VanZante, N. R. 2010. IMA's
    professional certification program has changed. Management Accounting
    Quarterly
    (Summer): 48-51.

    or my summary of VanZante's article at

    http://maaw.info/ArticleSummaries/ArtSumVanZante2010.htm

    The information provided in this paper is very similar to the information
    provided by Brausch and Whitney earlier this year. However, VanZante adds a
    chronological history of the CMA program and explains why the CFM exam was
    discontinued and merged into the new CMA exam.

    For more information see MAAW's professional exams section at

    http://maaw.info/ProfessionalExamsMain.htm

    Bob Jensen's threads on managerial accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting


    Some Things You Might Want to Know About the Wolfram Alpha (WA) Search Engine:  The Good and The Evil
    as Applied to Learning Curves (Cumulative Average vs. Incremental Unit)
    http://faculty.trinity.edu/rjensen/theorylearningcurves.htm


    Human Resource Accounting for Financial Statements

    The value of human resource employees in a business is currently not booked and usually not even disclosed as an estimated amount in footnotes. In general a "value" is booked into the ledger only when cash or explicit contractual liabilities are transacted such as a bonus paid for a professional athlete or other employee. James Martin provides an excellent bibliography on the academic literature concerning human resource accounting ---
    http://maaw.info/HumanResourceAccMain.htm

    Bob Jensen's threads on human resource accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#TripleBottom

    What turned into a sick joke was the KPMG Twist applied to valuing the executives of Worldcom who later went to prison:

    KPMG’s “Unusual Twist”
    While KPMG's strategy isn't uncommon among corporations with lots of units in different states, the accounting firm offered an unusual twist: Under KPMG's direction, WorldCom treated "foresight of top management" as an intangible asset akin to patents or trademarks.
     
    See  http://faculty.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

    Punch Line
    This "foresight of top management" led to a 25-year prison sentence for Worldcom's CEO, five years for the CFO (which in his case was much to lenient) and one year plus a day for the controller (who ended up having to be in prison for only ten months.) Yes all that reported goodwill in the balance sheet of Worldcom was an unusual twist.

     

    Early experiments to book human resource values into the ledger usually were abandoned after a brief experiment. Investors and analysts placed little, if any faith, in human resource value estimates such as the R.G. Barry experiments years ago.

    There are many problems with assigning an estimated value to human resources. Aside from being able to unattribute future cash flow streams to particular employees, there's the enormous problem that employees are no longer slaves that can be bought, sold, and traded without their permission. And employees may simply resign at will outside the control of their employers, although in some cases they do so by paying contractual penalties that they agreed to when signing employment contracts.

    Another problem is bifurcation of the value of a valuable employee from the subset of other employees and circumstances such as group esprit de corps ---
    http://en.wikipedia.org/wiki/Esprit_de_corps_%28disambiguation%29
    A great pitcher needs a great catcher and seven other players on the field that can make great defensive plays. The President of the United States may be less important than the staff surrounding that President. A bad staff can do a lot to bring down a President. This had a lot to do with the downfall of President Carter.

    Another problems is that greatness of an employee may vary dramatically with circumstances. Winston Churchill was a great leader and inspiration in the darkest days of World War II. But his value should've been subject to very rapid accelerated depreciation. He was a lousy leader after the end of the war, including making some awful choices such as chemical weapons use on some tribes in Iraq.

    "Power From the People:  Can human Capital Financial Statements Allow Companies to Measure the Value of Their Employees?," by David McCann, CFO Magazine, November 2011, pp. 52-59 ---
    http://www.cfo.com/article.cfm/14604427?f=search

    If a company's most important assets are indeed its people, as corporate executives parrot endlessly, that's news to investors, analysts, and even, as it turns out, many companies.

    It is hardly a secret that the industrial economy that prevailed for two centuries has evolved into a talent-driven, knowledge-based economy. Still, extant accounting standards define "assets" mostly in terms of cash, receivables, and hard goods like property, equipment, and inventory, even though the value of many companies lies chiefly in the experience and efforts of their employees.

    Public companies are required to disclose virtually nothing about their human capital other than the compensation packages of top executives, and most are happy to report only that. The furthest most companies will go in reporting on human capital within their public filings is to mention "key-man" risks and executive succession plans.

    More than two decades ago, Jac Fitz-enz and Wayne Cascio separately pioneered the idea that metrics could shine a light on human-capital value. From their work grew the notion that formal reporting of such metrics could add value to financial statements. That discussion simmered quietly for many years, but recently it has grown more bubbly, as some of the best minds in human-capital management and workforce analytics work hard to influence the acceptance of such reporting.

    Some are crafting detailed structures for what they generally refer to as human-capital financial statements or reports, which would complement (but not replace) traditional financial reporting. Their goal is to quantify a company's financial results as a return on people-related expenditures, and express a company's value as a measure of employee productivity.

    To be sure, finance and human-resources executives alike have long considered many important aspects of human-capital value to be unquantifiable. That's why an effort by the Society for Human Resource Management, less-granular than some similar efforts but very well organized, shows promise to have a sizable impact. SHRM's Investor Metrics Workgroup, in conjunction with American National Standards Institute (ANSI), is developing recommendations for broad standards on human-capital reporting. The group plans to release its recommendations for public comment early in 2012. Should ANSI certify the standards, the next phase would be a marketing campaign aimed at investor groups and analysts, encouraging them to demand that companies provide the information.

    If demand for that data were to reach a critical mass, then presumably accounting-standards setters would eventually look at adopting some type of human-capital reporting, and the Securities and Exchange Commission and other regulators would subsequently get involved. Of course, that's a grand vision, and even its most optimistic proponents admit that it will take at least a decade, and probably twice that long, to fully materialize.

    But the SHRM group's chair, Laurie Bassi, is confident that the effort will succeed, however long it may take. "It's going to serve as a catalyst for change," says Bassi, a labor economist and human-capital-management consultant. "When investors start to demand this information, it's going to be a wake-up call for many, many companies. For some well-managed, well-run firms it won't be a stretch, but others will be hard-pressed to produce the information in a meaningful way."

    Bassi says that the driving forces behind the effort boil down to two things: "supply and demand, or, you might say, opportunity and necessity."

    On the supply/opportunity side, advancing technology and lower computing costs have greatly eased the collection and crunching of people-related data, enabling companies to get their arms around what's going on with their human capital in a much more analytic, metrics-driven way than was possible a few years ago. The demand/necessity side is that, driven by macroeconomic forces, human-capital management is emerging as a core competency for employers, particularly those in high-wage, developed nations.

    Something for (Almost) Everyone Investors and analysts aren't demanding human-capital reporting yet, but they might not need much prodding. Upon hearing for the first time about SHRM's project, Matt Orsagh, director of capital-markets policy for the CFA Institute, says that "it sounds fabulous. I want all the transparency and inputs I can have. Quantifying the worth of human capital would be fantastic, because right now you have to take it on faith, and I don't know if I can trust it."

    Predictably, some CFOs are less enthusiastic. "It's a fair point that the balance sheet doesn't recognize the value of human capital, and certainly not the full value of your intellectual property," says John Leahy, finance chief at iRobot, a publicly traded, $400 million firm. "For a high-growth technology company like ours, there is significant intrinsic value in the know-how and innovation of our people, which is why we've traded over the last couple of years at a fairly attractive multiple.

    Continued in article

    Bob Jensen's threads on human resource accounting are included at
    http://faculty.trinity.edu/rjensen/theory02.htm#TripleBottom 

    "The 50 Most Influential Management Gurus," by Clayton Christensen, Harvard Business Review Blog, November 2011 ---
    http://hbr.org/web/slideshows/the-50-most-influential-management-gurus/1-christensen
    Of course there's no Harvard bias whispering into this selection --- no it's shouting!
    Watch the video --- http://www.thinkers50.com/


    I didn't know there was a traditional camera and film industry remaining in the world
    From The Wall Street Journal Accounting Review on July 29, 2011

    Kodak Loss Widens on Silver Costs
    by: Matt Jarzemsky
    Jul 27, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Segment Margins, Cash Flow, Cash Management, Interim Financial Statements, Segment Analysis

    SUMMARY: "Eastman Kodak Co. posted a wider loss and burned through more than $300 million in cash in the second quarter as the traditional camera business continued to deteriorate and raw-material costs weighed on the bottom line."

    CLASSROOM APPLICATION: The article is useful for covering both the income statement and the statement of cash flows; the difference between the two is emphasized by a statement that Kodak shifted a pension contribution "from late last year to the latest quarter." Also covered are topics in segment reporting and raw materials cost as is evident from the title.

    QUESTIONS: 
    1. (Introductory) What is the difference between Eastman Kodak having "posted a wider loss" and having "burned through more than $300 million in cash"?

    2. (Advanced) Access the Eastman Kodak quarterly financial statements filed with the Securities and Exchange Commission (SEC) for the quarter ended June 30, 2011, available at http://www.sec.gov/Archives/edgar/data/31235/000003123511000117/ekq22011_10q.htm What was the company's loss in the current quarter versus one year ago? On what financial statement is this information found?

    3. (Advanced) What three business segments does Eastman Kodak operate? From where in the financial statements do you obtain this information?

    4. (Advanced) Compare all three segments' performance for both the six months and three months ended June 30, 2011 versus 2010. Which of the three is profitable? What has happened to that profitability?

    5. (Advanced) What accounting standards require the segment information the author analyzed to write this article? How does the required information help the author to analyze the company's results for this article?

    6. (Advanced) From what financial statements does the article's author identify that Eastman Kodak "used $322 milion in cash to fund its operations during the quarter"? (Hint: you may have to examine more than just the current 10-Q to answer this question.)

    7. (Advanced) "The company said...the comparison [of cash used in the quarter] is skewed by...the shifting of a pension contribution..." How would the shift described in this statement hurt this comparison? Does this shifting also affect the company's profitability this quarter? Explain your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Kodak Loss Widens on Silver Costs," by: Matt Jarzemsky, The Wall Street Journal,  July 27, 2011 ---
    http://professional.wsj.com/article/SB20001424053111903591104576469913184123314.html?mod=djem_jiewr_AC_domainid

    Eastman Kodak Co. posted a wider loss and burned through more than $300 million in cash in the second quarter as the company's traditional camera business continued to deteriorate and raw-material costs weighed on the bottom line.

    The results highlighted the challenges that remain as the company seeks to refocus its operations around commercial and consumer printing. Kodak suffered from expenses related to its turnaround effort as well as from the high cost of silver and a lack of income from intellectual-property settlements.

    Chairman and Chief Executive Antonio Perez said the Rochester, N.Y., company faces "the challenges typical in the creation of new businesses." He reiterated that Kodak expects to be profitable by 2012.

    The loss at the company's graphic-communication segment widened to $45 million from $17 million a year earlier amid higher raw-materials costs, as well as start-up expenses from expanding the commercial inkjet-printer business. The broader loss occurred even though revenue at the business rose.

    The loss at the consumer digital-imaging segment narrowed, reflecting higher printer-ink gross profits.

    While Kodak is seeking to build its inkjet-printer business, rival Lexmark International Inc. saw success paring its inkjet offerings in favor of higher-end gear. Lexmark said Tuesday it benefited from its increased focus on equipment, software and printing services for businesses.

    Meanwhile, at Kodak, the film, photofinishing and entertainment group—the company's only profitable business—continued to deteriorate. Earnings fell 94% to $2 million as sales dropped 14% on lower volume and pricing pressure.

    Kodak has struggled from the decline of traditional photography and has ought to fund a revamp using patent litigation. It said last week that it is exploring the sale of a valuable part of its U.S. patent portfolio.

    Overall, Kodak posted a loss of $179 million, or 67 cents a share, compared with a loss of $168 million, or 63 cents a share, a year earlier. The most-recent quarter and the year-earlier period included five cents and three cents a share, respectively, in items such as restructuring and tax impacts. Sales fell 4.5% to $1.49 billion.

    Silver is used in film manufacturing, and Kodak has said its production costs rise $10 million to $12 million for every one-dollar increase in the price of the metal. Silver rose to a record $49.79 an ounce in April. It has fallen since then, but remains twice as high as a year ago.

    Continued in article

     


    A great teaching case for students learning about capital budgeting and rationing

    From The Wall Street Journal Accounting Weekly Review on June 24, 2011

    Ford Ramps Asian Car Plans
    by: Jeff Bennett
    Jun 17, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Capital Budgeting, Capital Spending, Cost Management, Product strategy, Revenue Forecast

    SUMMARY: "Ford Motor Co. believes it can earn a 'competitive return' in China and India even as it rolls out string of new cars in those markets that will sell for much lower prices than the vehicles it sells in North America and Europe."

    CLASSROOM APPLICATION: The article is excellent for use in managerial accounting classes to discuss planned production in support of sales strategy and the particular need for target costing in this situation.

    QUESTIONS: 
    1. (Introductory) Why is Ford focusing on its planned auto sales in Asia and India?

    2. (Advanced) What is target costing? Why is that strategy particularly important in Ford's growth strategy described in this article?

    3. (Advanced) What other factors must the company consider as it designs "from the ground up" models for China and India "to sell at low prices"?

    4. (Advanced) Summarize Ford's production capacity issues in the Asia-Pacific region. How do these issues contribute to difficulties in planning production and estimating product costs?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Ford Ramps Asian Car Plans," by: Jeff Bennett, The Wall Street Journal, June 17, 2011 ---
    http://online.wsj.com/article/SB10001424052702304186404576390024237701428.html?mod=djem_jiewr_AC_domainid

    Ford Motor Co. believes it can earn a "competitive return" in China and India even as it rolls out a string of new cars in those markets that will sell for much lower prices than the vehicles it sells in North America and Europe.

    Over the next four years, Ford plans to expand to 15 from five the number of vehicles it sells in China. Some of the new cars will sell for less than $14,500, Ford's Asia Pacific and Africa President Joe Hinrichs said on Thursday. In India, Ford will sell eight models, up from three, with some selling for under $8,500 like its Figo subcompact, he said.

    Auto makers often find it difficult to make money on small, inexpensive cars because of it can cost hundreds of millions of dollars to develop a new model from the ground up.

    But Mr. Hinrichs said Ford is confident it can profitably sell low-cost cars in China and India by sharing the basic designs with other Ford units around the world, increasing the company's economies of scale. "We are making money there now and we can continue to," Mr. Hinrichs said at Ford's Dearborn, Mich., headquarters. "It's all about the scale and the cost base."

    Ford last week set a goal of increasing its global automotive sales by 50%, to eight million vehicles a year by 2020, with the bulk of the gain coming from the Asia-Pacific region. During the same period, the company also hopes to improve global automotive operating margins to about 9% from 6.1% last year.

    Mr. Hinrichs said Ford needs to develop new models that sell at low prices to be able to expand rapidly in Asia. Vehicles with sticker prices below $14,500 make up about 70% of the market in China, and while those under $8,500 account for 70% of the Indian market, according to Ford. Ford's best-selling vehicle in China today costs about $16,500; in India, its top seller costs about $7,600.

    Brian Johnson, an automotive analyst at Barclays Capital, said it will be a challenge for Ford. "If Ford can leverage the global engineering and the locally-tailored content to produce a cheap, but reliable product, then there is room for them to succeed," he said.

    Local Chinese and Indian auto makers "don't have the global scale" that Ford can leverage, while some other western car companies are not yet moving quickly into low-cost cars, he added. Tata Motors made a splash in India in 2009 when it began selling its small Nano car for about $2,500 although the vehicle ran into some problems when a faulty switch led to fires in three cars.

    Mr. Hinrichs took over Ford's Asia-Pacific region in late 2009 and was given the additional duties as China chief executive last year. Ford expects 45% of the global industry automotive sales to come from Asia-Pacific by 2020, dwarfing the more mature Americas market's 25%.

    Last year, Ford began building the $7,600 Figo at a plant in Chennai, India. It developed the car by starting with an older version of the Fiesta originally designed for the European market. Ford modified the vehicle and stripped out about $1,000 in cost to sell it at a much lower price in India, Mr. Hinrichs said.

    Ford's forthcoming models for China and India will be designed from the ground up to sell at low prices, Mr. Hinrichs said.

    One hurdle facing Ford in Asia is production capacity. Demand is outstripping supply despite $3.4 billion in plant construction or expansions projects that Ford has announced in China, India, Thailand and Africa.

    Construction on one of those new investments, an engine plant in Chongqing. China, began on Thursday. When open in 2013, the $500 million plant will enable the Changan Ford Mazda Automobile joint venture to double its output to 750,000 engines a year.

    Continued in article

    Bob Jensen's threads on managerial accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

    For capital budgeting and valuation, also see
    http://faculty.trinity.edu/rjensen/roi.htm


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on September 16, 2011

    With New Technology, Start-Ups Go Lean
    by: Angus Loten
    Sep 15, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Public Accounting

    SUMMARY: So often it is said that, regardless of economic cycles, accounting services are always needed. This article makes it clear that the nature of those services may be changing: one small start up firm's founder, Sam Rogoway of Near Networks, argues that "tasks that used to require extra workers can now be done online. 'You don't need an IT person or an accountant,' Mr. Rogoway says."

    CLASSROOM APPLICATION: The questions focus students' thoughts on the implications of the article for their professional development as accountants if they want to work with small businesses or build a private accounting practice.

    QUESTIONS: 
    1. (Introductory) What proportion of new job creation comes from start-up firms in the U.S. economy? What has happened to the number of those new jobs since 2008?

    2. (Introductory) According to the author and sources for this article, what types of jobs do small businesses now do without?

    3. (Advanced) What are the implications of this article for the services you can provide if you are an accountant wanting to work with small businesses or to build a private accounting practice?

    4. (Advanced) What are the implications of this article for the skills you must develop and continually improve as a professional accountant?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "With New Technology, Start-Ups Go Lean," by: Angus Loten, The Wall Street Journal, September 15, 2011 ---
    http://online.wsj.com/article/SB10001424053111903927204576570622331620408.html?KEYWORDS=With+New+Technology+Start-Ups+Go+Lean

    New businesses are getting off the ground with nearly half as many workers as they did a decade ago, as the spread of online tools and other resources enables start-ups to do more with less.
    The change, which began before the recession, may be permanent, according to some analysts. 

    "There's something long-term at work here," says Dane Stangler, research director at Ewing Marion Kauffman Foundation, a Kansas City, Mo., research group.

    Start-ups are now being launched with an average of 4.9 employees, down from 7.5 in the 1990s, according to a recent Kauffman Foundation study. In 2009, new independent businesses created a total of 2.3 million jobs, more than 700,000 fewer jobs than the annual average through 2008, the study found.

    Meanwhile, the overall number of start-ups has "held steady or even edged up since the recession," according to the study.

    Led by start-ups, small employers have generated 65% of net new jobs over the past 17 years, says the Small Business Administration. As such, steady declines in start-up size, which stretch back more than a decade, could explain the slow labor market recovery following the previous recession in 2001, as well as today, according to Brian Headd, an economist at the SBA's Office of Advocacy.

    "This is a significant change and not necessarily tied to business cycles," says Mr. Headd.

    Rather than purchasing the tools and manpower needed to run their companies, more small firms are renting, sharing or outsourcing resources, typically through online services, according to Steve King, a partner at Emergent Research, a research and consulting firm for small businesses.

    By tapping into Web-based business tools, Sam Rogoway earlier this month launched Near Networks, a nationwide video production firm, with only four employees. An entrepreneur based in Santa Monica, Calif., Mr. Rogoway says tasks that used to require extra workers can now be done online.

    "You don't need an IT person or an accountant. It's become so streamlined and user-friendly," Mr. Rogoway says. "We all wore different hats and collaborated on everything."

    Last year, Gil Harel launched BiteHunter, a search engine for restaurant discounts, with just three employees. Based in New York, the site used shared screens and other communications tools to work with developers in Russia, Uruguay and Israel.

    "Just to build the infrastructure to get a business off the ground used to take a lot of money and people. But things that you couldn't do in the past, you can no w do on your own," Mr. Harel says.

    Most small companies now buy supplies, pay bills and manage payroll on Web-based services, according to the National Small Business Association, a Washington, D.C.-based lobbying group.

    A recent survey of more than 500 small firms by Zoomerang, an online polling firm based in San Francisco, found a small but growing number are using shared, network-based applications—or so-called cloud computing—for everything from data storage and email, to customer service, mobile commerce, and finance and administration.

    Evan Saks, the founder of online mattress maker Create-a-Mattress, says manufacturing technology that ties orders to production—known as just-in-time manufacturing—and Web-based tools have done away with the need for inventory managers or warehouse staff, among other workers.

    Continued in article


    Teaching Case on Lean Accounting (accounting for lean manufacturing)
    The only things fat on a new Harley are the riders

    From The Wall Street Journal Accounting Weekly Review on September 28, 2012

    Harley Goes Lean to Build Hogs
    by: James R. Hagerty
    Sep 22, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management, Cost-Volume-Profit Analysis, Fixed Costs, Variable Costs

    SUMMARY: Harley-Davidson Inc. has implemented lean and flexible manufacturing procedures. According to the related video, the company can now produce as many vehicles as it always has with half the workforce it once employed. Manufacturing improvements came from automation but also from better organization and improved flexibility of worker abilities.

    CLASSROOM APPLICATION: The article is useful in a managerial or cost accounting course to cover lean manufacturing, fixed and variable costs, C-V-P or breakeven analysis, and operating leverage.

    QUESTIONS: 
    1. (Advanced) Define the terms lean manufacturing, fixed costs, variable costs, cost-volume-profit analysis, break-even analysis and operating leverage.

    2. (Advanced) By better organizing the Harley-Davidson operations out of 41 buildings and into one location, do you think the company reduced fixed costs, variable costs, or both? Explain.

    3. (Introductory) Traditionally, companies requiring significant investment in production costs, such as automobile and motorcycle manufacturers, face deep plunges in profits when demand falls off, such as it did during the 2009 recession. Why does this profit plunge occur? Identify how the related graphic entitled "Higher on the Hog" shows this phenomenon.

    4. (Introductory) How have the improvements in production at Harley made it more likely for the company "...to perform... and remain... profitable no matter what the business environment is"?

    5. (Advanced) Refer to your definitions in answer to question one. How did the changes at Harley affect operating leverage and the company's break-even point? Explain how operating leverage and cost-volume-profit analysis can be used to assess the answers you gave to questions three and four.

    6. (Introductory) What is operating profit margin? How have the company's improvements affected this measure?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Harley Goes Lean to Build Hogs," by James R. Hagerty, The Wall Street Journal, September 22, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443720204578004164199848452.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    If the global economy slips into a deep slump, American manufacturers including motorcycle maker Harley-Davidson Inc. that have embraced flexible production face less risk of veering into a ditch.

    Until recently, the company's sprawling factory here had a lack of automation that made it an industrial museum. Now, production that once was scattered among 41 buildings is consolidated into one brightly lighted facility where robots do more heavy lifting. The number of hourly workers, about 1,000, is half the level of three years ago and more than 100 of those workers are "casual" employees who come and go as needed.

    This revamping has allowed Harley to quickly increase or cut production in response to shifting demand. "This is a big bang transformation," said Ed Magee, a Louisiana-born ex-Marine officer who runs the York plant, one of the Milwaukee-based company's three big U.S. production facilities.

    The efficiency gains mean Harley should be able to raise its operating profit margin for the motorcycle business [excluding financing operations] to nearly 16% this year from 12.5% in 2009, said Craig Kennison, an analyst at Robert W. Baird & Co. in Chicago. Harley no longer needs peak production levels to achieve strong profits, he said.

    Overall, U.S. manufacturers generally are in better shape after slimming down and rethinking sloppy practices during the brutal 2008-09 recession. Total profits at domestic manufacturing companies, which were running at an annual rate of $363 billion in this year's first quarter, are up from $290 billion, five years ago, before the recession, according to government data.

    Companies often say they learned the lessons of the past, only to get blindsided by some unexpected twist in the economic cycle. But companies generally are in much stronger financial shape than they were a few years ago. "There is a focus on performance and remaining profitable no matter what the business environment is," said Daniel Meckstroth, chief economist at the Manufacturers Alliance for Productivity and Innovation, an economic research group in Arlington, Va.

    Like Harley and others, Caterpillar Inc., a maker of construction machinery, now relies more on "flexible" workers, including part-timers and people working for outside contractors. Caterpillar generally doesn't have to pay severance costs when it lets such workers go during slow periods. Flexible workers accounted for about 16% of its global workforce as of June 30, up from 11% at the end of 2009, when many of those workers were cut because of slumping orders.

    Harley got more serious about cutting costs when Keith Wandell became chief executive in 2009 amid a severe slump in motorcycle sales. On his first visit to the York plant, Mr. Magee recalled, Mr. Wandell declared the layout and working methods unsustainable. Harley began scouting sites for new plant to replace York and settled on Shelbyville, Ky. The company notified the International Association of Machinists and Aerospace Workers, or IAM, which represents York workers, that the plant would close and move to Kentucky unless they approved a new contract giving Harley more control over costs. Union members voted overwhelmingly to make concessions, and Harley stayed in York.

    Instead of 62 job classifications, the plant now has five, meaning workers have a wider variety of skills and can go where needed. A 136-page labor contract has been replaced by a 58-page document.

    Kim Avila, 49 years old, who has worked here for more than 17 years, said she saw the concessions as the only chance to preserve jobs. The pace of work is faster now, but she said managers and workers have more mutual respect and work together more smoothly. In the paint department, where she works, people used to do the same chore all day but now rotate through several tasks to avoid body strain and boredom. They are encouraged to fix some minor flaws in the finish themselves rather than kicking them to another department.

    Some items formerly made in York, such as brackets and screws, come from outside suppliers. Production fluctuates depending on day-to-day sales, so the company doesn't have to stock up well ahead of the spring peak-selling period and guess which models and colors will be popular.

    Similar changes are in the works at Harley plants in Kansas City, Mo., and near Milwaukee, Wis. In all, the restructuring will cut costs of doing business this year by at least $275 million, Harley estimates. "They've done a phenomenal job in reducing costs," said James Hardiman, an analyst at Longbow Research in Cleveland, who nonetheless has a neutral rating on the stock, due partly to uncertain demand.

    The transformation has been trying at times. Harley's Mr. Magee likened it to having "open-heart surgery as we were running the marathon" in that Harley had to maintain production in York as it rebuilt the plant. New software installed recently to guide production temporarily left the plant "constipated," one manager confided.

    Continued in article

    Jensen Comment
    I think many managerial accounting instructors have been too slow in upgrading their syllabi to include lean accounting beyond just JIT modules. A good reference for lean accounting is provided by our AECM friend Jim Martin ---
    http://maaw.info/JITMain.htm

    Bob Jensen's threads on managerial accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     


    How one of my favorite technology commentators discovered, as a kid, what we in accounting call CPV, CVP, PCV or whatever analysis

    "A Gadget Is More Than the Sum of Its Parts," by David Pogue, The New York Times, January 5, 2012 ---
    http://pogue.blogs.nytimes.com/2012/01/05/a-gadget-is-more-than-the-sum-of-its-parts/

    As a teenager growing up in the Cleveland suburbs, my first real job was at a Chick-fil-A restaurant in a local mall. I did everything: manned the cash register, made sandwiches and cleaned up.

    . . .

    It’d be fun to report that that job taught me important skills and precepts that followed me for the rest of my life, but that’d be pushing it.

    ¶That job did teach me, however, one important thing about the business world. My best friend, John, worked next door at a watch shop. He told me he could get incredible discounts on the watches — all I had to do was ask. I needed a watch, in fact, so I picked out a $200 model and asked what I’d have to pay. He said $60.

    ¶I was appalled. “You mean to tell me that your shop pays $60 for that watch, and then jacks up the price to $200 for the consumer? That’s outrageous! That’s practically robbery! You should be ashamed to work there!”

    ¶John was amused, and he proceeded to teach me a lesson. “Oh, really? That’s a big ripoff, huh? Well, let me ask you this: How much do you think Chick-fil-A pays for each of the chicken breasts?”

    ¶I calculated that in the massive quantities this chain purchased, it was maybe 40 cents.

    ¶“And the bun?” Maybe 4 cents. “The pickle?” One-tenth of a cent. “O.K., and how much do you sell the sandwich for?” $2.40.

    ¶Now, it’s been 30 years. All of the numbers in this story are vague recollections — I don’t need e-mail from chicken-farm vendors setting me straight. But I’m quite sure of the result: By the time I’d done the math, John had made me realize that my sandwich shop was marking up its product more than his watch shop. I was the one who should be ashamed.

    ¶Right?

    ¶I think of this transaction every time somebody does a “teardown analysis” of an iPhone, a Kindle Fire or some other hot new product. These companies buy a unit, take it apart, photograph the components and then calculate the price of each. Then they tally those component costs and try to make you outraged that you’ve paid so much markup.

    Continued in article

    Jensen Comment
    I eat three or more (usually more) times per day. But I've not bought a new Timex watch in the past ten years.

    CVP analysis becomes more interesting when we extend it to multiple products, operating leverage, and pricing (with demand functions). David Pogue adds complications when the sum is not equal to the summation of its parts.

     


    CVP:  Sales Mix Teaching Case
    From The Wall Street Journal Accounting Weekly Review on September 16, 2011

    Goodyear Rides Again
    by: Jeff Bennett
    Sep 15, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Cost Management, Cost-Volume-Profit Analysis, Fixed Costs, Managerial Accounting

    SUMMARY: "Five years ago,...Goodyear Tire & Rubber Co. was losing money, feuding with its workers and struggling to compete with foreign imports that undercut its prices at stores across the U.S....Rich Kramer, who took over as chief executive in April 2010 after overseeing operations and finance, says the key to its turnaround has been concentrating on fewer but higher priced products targeted more toward consumers than auto makers."

    CLASSROOM APPLICATION: Questions are focused on the management accounting concepts of sales mix, contribution margin, fixed cost, reducing unit costs in a high fixed cost environment through volume, and the accounting for R&D activities. Questions are linked to the Goodyear 10-Q filed on July 28 and available on the SEC's web site at http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000042582

    QUESTIONS: 
    1. (Advanced) Compare the operating results for the three and six months periods ended in June 30, 2011, versus 2010. What financial statement are you using to make this assessment? (Hint: you may access the Goodyear financial statements for the quarter ended June 30, 2011 by clicking on the live link to Goodyear Tire & Rubber in the online version of the article, then click on the Financials tab, scroll down the page to see Related Information at the bottom and click on SEC Filings at SEC.gov. Select the Interactive Data tab for the 10-Q filing made on July 28, 2011.)

    2. (Advanced) Compare the operating results for the three and six months periods ended in June 30, 2011, versus 2010. What financial statement are you using to make this assessment?

    3. (Introductory) What amounts that you discussed above are highlighted in the article to assess Goodyear's performance?

    4. (Introductory) According to the article, what factors are driving these dramatic changes? List all that you find.

    5. (Advanced) What is sales mix? How does profitability improve with improved sales mix? How does that focus on sales mix compare to the strategy of "being 'a consumer products company and not just an auto supplier company'"?

    6. (Advanced) Why does 'running factories at high volume" offset operating costs? How do these costs relate to the costs that are used to analyze potential profit improvement through sales mix?

    7. (Advanced) What activities described in the article are research and development (R&D) activities? How are R&D expenditures accounted for under U.S. GAAP? Given Goodyear's poor financial condition, how might decisions about savings on R&D activities have impacted the company's results?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Goodyear Rides Again:  Tire Maker Shed Costs, Cheaper Products to Build a Turnaround," by: Jeff Bennett, The Wall Street Journal, September 15, 2011 ---
    http://online.wsj.com/article/SB10001424053111904836104576556931352665352.html?KEYWORDS=Goodyear+Rides+Again

    Five years ago, the wheels had just about come off Goodyear Tire & Rubber Co. The 113-year-old tire maker was losing money, feuding with its workers and struggling to compete with foreign imports that undercut its prices at stores across the U.S.

    Today, this industry icon appears to have regained traction after a painful transformation. It downsized operations, found common ground with union leaders and fought imports by using technology to turn its tires into prized consumer products. Goodyear is now profitable with a smaller, highly skilled work force and selling more premium-priced tires.

    In the first half of the year, Goodyear sold 89.7 million tires, just 2% more than the year-ago period, but revenue was up 25% to $11 billion and income soared, to $143 million from a loss of $19 million.

    Rich Kramer, who took over as chief executive in April 2010 after overseeing operations and finance, says the key to its turnaround has been concentrating on fewer but higher priced products targeted more toward consumers than auto makers. Almost 75% of its tires now sell for $130 and up. Four years ago, almost 40% of the tires it produced were low-end tires retailing for about $60 apiece.

    "Our strategy in the past was based on volume. Now we look only to make the tire consumers want. It's easy to say but hard to do," said Mr. Kramer, 47.

    Its former strategy focused on running factories at high volume to offset operating costs. Now, the company is focused on being "a consumer products company and not just an auto supplier company," Mr. Kramer said.

    One key to Goodyear's turnaround has been better relations with its union employees. In 2006, it locked horns with the United Steelworkers union in a battle over retiree health care costs that led to a bitter, two-month strike.

    Eventually, the two sides reached an agreement that offered Goodyear a two-tiered wage system and more flexible work rules in exchange for putting $1 billion into a fund to cover the cost of health care for retired workers. The company also reduced its U.S. plants to 16 from 29; nine were part of a division that was sold.

    Enlarge Image GOODYEAR GOODYEAR

    Goodyear also committed to modernize its U.S. plants to produce more advanced, higher-end tires. Since the strike, the company has spent more than $900 million to upgrade its North American plants and equipment.

    "For us, it was the promise to invest in their plants and getting the $1 billion needed to cover our retiree health care costs that was the turning point," said USW vice president Tom Conway.

    Goodyear recently has begun building on its success with early consumer marketing efforts. Based on technology it developed to reduce rolling resistance on commercial truck tires, Goodyear applied the same materials to consumer tires in 2009, promising they could save as much as 2,600 miles worth of gas over the life of the tires.

    Other innovations include one of its early hot sellers, the Assurance TripleTred tire, which came out in 2004. Each tread embedded on the tire was designed to handle a certain road condition—water, ice and dry pavement. The product clicked with consumers and since has helped the Assurance brand sell more than 22 million tires in North America alone.

    "There has been some good progress in the last year or so in such areas as rationalizing facilities, eliminating high cost plants, lowering administrative costs and introducing some successful products such as Fuel Max," said Saul Ludwig, managing director of Cleveland-based stock analysts Northcoast Research. He said Goodyear is poised to cut costs further and open its first new factory since 1990 in China.

    Continued in article


    Online vendors of products like monthly unlimited downloads of movies from Netflix and downloads of eBooks into an Amazon Kindle present interesting challenges to CVP analysis where variable costs are minimal compared to fixed costs. In comparison, however the rental movie disks from Netflix and the sale of new hardcopy books from Amazon present more traditional CVP cases where contribution margins are considerably lower than the price.

    A Case on Relatively Large Fixed Costs in CVP Analysis
    From The Wall Street Journal Accounting Weekly Review on October 27, 2011

    High Fixed Costs Are Makings of Steel Trap
    by: Kelly Evans
    Oct 25, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Cost Management, Fixed Costs, Fixed Pricing, Managerial Accounting, Variable Costing, Variable Costs

    SUMMARY: Prices for hot-rolled steel dropped from about $900 a ton in April to about $670 a ton during the week of October 17 to 21, 2011. Columnist Kelly Evans compares the difficulty faced by two traditionally organized steel companies with high fixed costs-U.S. Steel and AK Steel-to Nucor which "operates smaller mills that it can more easily move on or off-line as the market fluctuates", i.e. turning those fixed costs into a step function, if not a true variable cost.

    CLASSROOM APPLICATION: The article is useful to introduce cost behaviors in managerial accounting courses.

    QUESTIONS: 
    1. (Introductory) Define the terms fixed cost and variable cost.

    2. (Advanced) Author Kelly Evans writes that "the trouble for U.S. Steel and AK Steel Holding...is that they have high fixed costs." Why do certain industries such as steelmaking have high fixed costs while other industries do not?

    3. (Introductory) How significant was this year's price drop for hot-rolled steel? How is the price for this product set?

    4. (Advanced) Why do high fixed cost make it difficult to manage a business during times of fluctuating prices for its end product?

    5. (Introductory) Is the "trouble" from high fixed costs avoidable? Explain the case of Nucor having "fared relatively better of late than U.S. Steel and AK Steel."

    6. (Introductory) Based on the description you've given above, define the type of cost structure that Nucor Steel has used to produce its steel end products.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "High Fixed Costs Are Makings of Steel Trap," by: Kelly Evans, The Wall Street Journal, October 25, 2011 ---
    http://online.wsj.com/article/SB10001424052970203911804576651580445851722.html?mod=djem_jiewr_AC_domainid

    The steel market is still awaiting its second-half blastoff.

    The U.S. has, for the moment, managed to cast off recession fears, and Chinese manufacturing activity apparently rebounded in October. Yet the price of steel—on whose skeleton these economies are built—remains depressed. Benchmark hot-rolled steel had dropped in price from about $900 a ton in April to about $670 a ton as of last week. On Tuesday, earnings from a pair of American steelmakers may underscore the market's duress.

    The larger of the two, U.S. Steel, is expected to post third-quarter earnings of about 52 cents a share, according to analysts polled by Thomson Reuters. While an improvement from the company's loss a year earlier, that is well below the $1.17 a share analysts were expecting just three months ago. Moreover, the view among analysts may still be too rosy: Steel Market Intelligence, a research firm, predicts the company will post earnings of just 36 cents a share, and lower its fourth-quarter earnings target, too.

    The trouble for U.S. Steel, and AK Steel Holding, which is expected to report a one-cent loss, is that they have high fixed costs. That makes them especially vulnerable to steel-price declines. The result has been a more-than-50% drop in the share prices of both companies this year, as steel prices have sold off. By contrast, steelmaker Nucor operates smaller mills that it can more easily move on- or off-line as the market fluctuates. This has offered it and other "mini-mills" some cushion as prices collapse.

    Continued in article

     

    "Netflix Drops Most Since 2004 After Losing 800,000 Customers," Business Week, October 25, 2011 ---
    http://www.businessweek.com/news/2011-10-25/netflix-drops-most-since-2004-after-losing-800-000-customers.html

    Jensen Comment
    This illustration (case?) offers quite a lot for class discussion or possibly even a term paper on the topic of CPV Analysis in cost/managerial Accounting courses. What should be the optimal price of a product that has a very high fixed cost and almost no variable cost, as is the case for online video downloads when the royalty costs are fixed?

    Variable royalty costs are quite another matter, and I really do not know how Netflix contracts with copyright holders.

    Also movie disk rentals are quite another matter since there are variable costs for postage, disk recording, disk purchase, disk handling, etc.

    What is interesting is the implication for CPV analysis of most any online product for which the variable cost is epsilon, including Kindle books, eTextbooks, etc.

    Remind students of what happens to pricing analysis and breakeven analysis when the contribution margin (p-v) approaches p.

     


    This Could Make an Interesting Managerial/Cost Accounting Case (CVP Analysis in the Real World)

    "How Travelers Could Lose in American's Web Ticket War," by Kayla Webly, Time Magazine, January 6, 2010 ---
    http://www.stumbleupon.com/su/1xBg8J/www.time.com/time/business/article/0,8599,2040936,00.html
    Thank you Robert Harris for the heads up.

    An ongoing battle between American Airlines and online travel agents Orbitz and Expedia has played out for weeks with more fervor, unlikely alliances and backstabbing than the last season of The Apprentice. When American and Orbitz failed to reach terms on a new distribution agreement, the airline ordered its schedule dropped from the popular travel website on Dec. 21. Just a few days later, pre-empting its own distribution dispute, Expedia hid American's listings from its search results, making it difficult but not impossible to book an AA flight on the website. Then, once Expedia's agreement with American ended Dec. 31, it dropped the carrier from the site, calling the airline's strategy "anti-consumer and anti-choice."

    There's no question that part of American's motivation is to cut costs, which George Hobica, founder of Airfare Watchdog, says the airline is "desperate" to do. In bypassing the online travel agents, American saves on distribution costs, but can also raise its ticket prices more easily, since its fares won't be displayed directly beside those of its competitors. (See the top 10 travel moments of 2010.)

    An ongoing battle between American Airlines and online travel agents Orbitz and Expedia has played out for weeks with more fervor, unlikely alliances and backstabbing than the last season of The Apprentice. When American and Orbitz failed to reach terms on a new distribution agreement, the airline ordered its schedule dropped from the popular travel website on Dec. 21. Just a few days later, pre-empting its own distribution dispute, Expedia hid American's listings from its search results, making it difficult but not impossible to book an AA flight on the website. Then, once Expedia's agreement with American ended Dec. 31, it dropped the carrier from the site, calling the airline's strategy "anti-consumer and anti-choice."

    There's no question that part of American's motivation is to cut costs, which George Hobica, founder of Airfare Watchdog, says the airline is "desperate" to do. In bypassing the online travel agents, American saves on distribution costs, but can also raise its ticket prices more easily, since its fares won't be displayed directly beside those of its competitors. (See the top 10 travel moments of 2010.)

    Continued in article


    April 7, 2011 message from Francine McKenna

    HuffingtonPost:
    $817 an hour. Are professors worth what they're getting paid?
    http://huff.to/dXxZx6 

    Original Tweet: http://twitter.com/HuffingtonPost/statuses/55973110557581312

    April 7, 2011 reply from Bob Jensen

    Hi Francine

    I think the title put on this by Huffington Post is misleading. The "worth" of somebody in a profession must focus as much or even more on the worth of the benefits of that person vis-a-vis the cost. My wife had four (soon to be five) very expensive surgeries from one of the outstanding spine surgeons in the world. We can aggregate the cost of this Boston surgeon's billings, but how in the world would we ever measure his benefit or worth?
    http://faculty.trinity.edu/rjensen/Erika2007.htm

    Incidentally he's also one of the most important surgical residency teachers in the shadows of the Harvard Medical School. How do we measure the value of his contributions to the future surgeries performed by all the surgical residents who've worked closely with this surgeon?

    Similarly we can aggregate the cost of having Dennis Beresford for 14 years at the University of Georgia. But how in the world would we ever measure his "worth?" How do we measure the value of his contributions to all the accounting students who've worked closely with this remarkable professor of accountancy?.

    Of course we could also argue that the benefit of 23-year old Ms. Kinder teaching kindergarten in South Chicago is invaluable. About the only way we have of comparing a unique Harvard spine surgeon with a kindergarten teacher is how much it takes to replace them with professionals having comparable skills. I would argue that Ms. Kinder can be replaced for a whole lot less money than my wife's very uniquely qualified spine surgeon.

    However, comparing their annual compensation is only a very, very rough way to measure "worth" to society. Like you, I hesitate to conclude that the "worth" of Stanley O'Neal was the $160 million it took to get him out the door. Compensation is confounded by a whole lot of factors other than societal "worth."
    .
    "Stanley O'Neal who is leaving Merrill Lynch after giving it a big fat gift of a $8 billion dollar write-off thanks to risky investments. The board just can't help but feed this obesity epidemic. They're giving him $160 million plus in severance for his troubles as he heads for the door. At some point, the nation's corporations, or most pointedly, their corporate boards, will realize throwing money at their CEOs is probably not the best idea"
    "Obesity Epidemic Among CEO Pay," The Huffington Post, November 1, 2007 ---
    http://www.huffingtonpost.com/eve-tahmincioglu/obesity-epidemic-among-ce_b_70810.html 

    Related to this is the vexing issue of computing the cost of degrees awarded such as an undergraduate degree in art history versus a PhD in accountancy ---
    Issues in Computing a College's Cost of Degrees Awarded ---
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm#CostAccounting 

    Here are my earlier threads on the controversial Texas A&M costing study that focused more on comparing the cost of degrees awarded than the "worth" of Aggie professors like Ed Swanson.or Tom Omer.

    Also see ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     

    Texas A&M Case on Computing the Cost of Professors and Academic Programs

    Jensen Comment
    In an advanced Cost/Managerial Accounting course this assignment could have two parts. First assign the case below. Then assign student teams to write a case on how to compute the cost of a given course, graduate in a given program, or a comparison of a the cost of a distance education section versus an onsite section of a given course taught by a tenured faculty member teaching three courses in general as well as conducting research, performing internal service, and performing external service in his/her discipline.

    From The Wall Street Journal Accounting Weekly Review on November 5, 2010

    Putting a Price on Professors
    by: Stephanie Simon and Stephanie Banchero
    Oct 23, 2010
    Click here to view the full article on WSJ.com



    TOPICS: Contribution Margin, Cost Management, Managerial Accounting


    SUMMARY: The article describes a contribution margin review at Texas A&M University drilled all the way down to the faculty member level. Also described are review systems in place in California, Indiana, Minnesota, Michigan, Ohio and other locations.
    CLASSROOM APPLICATION: Managerial concepts of efficiency, contribution margin, cost management, and the managerial dashboard in university settings are discussed in this article.


    QUESTIONS:
    1. (Introductory) Summarize the reporting on Texas A&M University's Academic Financial Data Compilation. Would you describe this as putting a "price" on professors or would you use some other wording? Explain.

    2. (Introductory) What is the difference between operational efficiency and "academic efficiency"?

    3. (Advanced) Review the table entitled "Controversial Numbers: Cash Flow at Texas A&M." Why do you think that Chemistry, History, and English Departments are more likely to generate positive cash flows than are Oceanography, Physics and Astronomy, and Aerospace Engineering?

    4. (Introductory) What source of funding for academics is excluded from the table review in answer to question 3 above? How do you think that funding source might change the scenario shown in the table?

    5. (Advanced) On what managerial accounting technique do you think Minnesota's state college system has modeled its method of assessing campuses' performance?

    6. (Advanced) Refer to the related article. A large part of cost increases in university education stem from dormitories, exercise facilities, and other building amenities on campuses. What is your reaction to this parent's statement that universities have "acquiesced to the kids' desire to go to school at luxury resorts"?

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES:
    Letters to the Editor: What Is It That We Want Our Universities to Be?
    by Hank Wohltjen, David Roll, Jane S. Shaw, Edward Stephens
    Oct 30, 2010
    Page: A16

    "Putting a Price on Professors," by Stephanie Simon and Stephanie Banchero, The Wall Street Journal, October 23, 2010 ---
    http://online.wsj.com/article/SB10001424052748703735804575536322093520994.html?mod=djem_jiewr_AC_domainid

    Carol Johnson took the podium of a lecture hall one recent morning to walk 79 students enrolled in an introductory biology course through diffusion, osmosis and the phospholipid bilayer of cell membranes.

    A senior lecturer, Ms. Johnson has taught this class for years. Only recently, though, have administrators sought to quantify whether she is giving the taxpayers of Texas their money's worth.

    A 265-page spreadsheet, released last month by the chancellor of the Texas A&M University system, amounted to a profit-and-loss statement for each faculty member, weighing annual salary against students taught, tuition generated, and research grants obtained.

    Ms. Johnson came out very much in the black; in the period analyzed—fiscal year 2009—she netted the public university $279,617. Some of her colleagues weren't nearly so profitable. Newly hired assistant professor Charles Criscione, for instance, spent much of the year setting up a lab to research parasite genetics and ended up $45,305 in the red.

    The balance sheet sparked an immediate uproar from faculty, who called it misleading, simplistic and crass—not to mention, riddled with errors. But the move here comes amid a national drive, backed by some on both the left and the right, to assess more rigorously what, exactly, public universities are doing with their students—and their tax dollars.

    As budget pressures mount, legislators and governors are increasingly demanding data proving that money given to colleges is well spent. States spend about 11% of their general-fund budgets subsidizing higher education. That totaled more than $78 billion in fiscal year 2008, according to the National Association of State Budget Officers.

    The movement is driven as well by dismal educational statistics. Just over half of all freshmen entering four-year public colleges will earn a degree from that institution within six years, according to the U.S. Department of Education.

    And among those with diplomas, just 31% could pass the most recent national prose literacy test, given in 2003; that's down from 40% a decade earlier, the department says.

    "For years and years, universities got away with, 'Trust us—it'll be worth it,'" said F. King Alexander, president of California State University at Long Beach.

    But no more: "Every conversation we have with these institutions now revolves around productivity," says Jason Bearce, associate commissioner for higher education in Indiana. He tells administrators it's not enough to find efficiencies in their operations; they must seek "academic efficiency" as well, graduating more students more quickly and with more demonstrable skills. The National Governors Association echoes that mantra; it just formed a commission focused on improving productivity in higher education.

    This new emphasis has raised hackles in academia. Some professors express deep concern that the focus on serving student "customers" and delivering value to taxpayers will turn public colleges into factories. They worry that it will upend the essential nature of a university, where the Milton scholar who teaches a senior seminar to five English majors is valued as much as the engineering professor who lands a million-dollar research grant.

    And they fear too much tinkering will destroy an educational system that, despite its acknowledged flaws, remains the envy of much of the world. "It's a reflection of a much more corporate model of running a university, and it's getting away from the idea of the university as public good," says John Curtis, research director for the American Association of University Professors.

    Efforts to remake higher education generally fall into two categories. In some states, including Ohio and Indiana, public officials have ordered a new approach to funding, based not on how many students enroll but on what they accomplish.

    Continued in article

    Jensen Comment
    This case is one of the most difficult cases that managerial and cost accountants will ever face. It deals with ugly problems where joint and indirect costs are mind-boggling. For example, when producing mathematics graduates in undergraduate and graduate programs, the mathematics department plays an even bigger role in providing mathematics courses for other majors and minors on campus. Furthermore, the mathematics faculty provides resources for internal service to administration, external service to the mathematics profession and the community, applied research, basic research, and on and on and on. Faculty resources thus become joint product resources.

    Furthermore costing faculty time is not exactly the same as costing the time of a worker that adds a bumper to each car in an assembly line. While at home in bed going to sleep or awakening in bed a mathematics professor might hit upon a Eureka moment where time spent is more valuable than the whole previous lifetime of that professor spent in working on campus. How do to factor in hours spent in bed in CVP analysis and Cost-Benefit analysis? Work sampling and time-motion studies used in factory systems just will not work well in academic systems.

    In Cost-Profit-Volume analysis the multi-product CPV model is incomprehensible without making a totally unrealistic assumption that "sales mix" parameters are constant for changing levels of volume. Without this assumption for many "products" the solution to the CPV model blows our minds.

    Another really complicating factor in CVP and C-B analysis are semi-fixed costs that are constant over a certain time frame (such as a semester or a year for adjunct  employees) but variable over a longer horizon. Of course over a very long horizon all fixed costs become variable, but this generally destroys the benefit of a CVP analysis in the first place. One problem is that faculty come in non-tenured adjunct, non-tenured tenure-track, and tenured varieties.

    I could go on and on about why I would never attempt to do CVP or C-B research for one of the largest universities of the world. But somebody at Texas A&M has rushed in where angels fear to tread.

    Bob Jensen's threads on managerial and cost accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting 

    Bob Jensen's threads on higher education controversies are at
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm


    A course illustration of ethics and questionable uses of misleading cost accounting

    "Colleges Spend Far Less on Educating Students Than They Claim, Report Says," by Robin Wilson, Chronicle of Higher Education, April 7, 2011 ---
    http://chronicle.com/article/Colleges-Spend-Far-Less-on/127040/

    While universities routinely maintain that it costs them more to educate students than what students pay, a new report says exactly the opposite is true.

    The report was released today by the Center for College Affordability and Productivity, which is directed by Richard K. Vedder, an economist who is also an adjunct scholar at the American Enterprise Institute and a Chronicle blogger. It says student tuition payments actually subsidize university spending on things that are unrelated to classroom instruction, like research, and that universities unfairly inflate the stated cost of providing an education by counting unrelated spending into the mix of what it costs them to educate students.

    "The authors find that many colleges and universities are paid more to provide an education than they spend providing one," says a news release on the report, "Who Subsidizes Whom?"

    The report's authors used data from the U.S. Education Department's Integrated Postsecondary Education Data System, or Ipeds, to conclude that more than half of students attend institutions that take in more per student in tuition payments than what it actually costs them to deliver an education.

    The chief reason universities inflate the figures on what they spend to educate students, says the report, is that institutions include all of their spending—whether it is directly related to instruction or not—when calculating what it costs them to provide an education. In reality, says the report, depending on the type of institution, it can cost universities much less to educate students than what the institutions bring in through tuition charges.

    "This study finds that education and related spending is only a portion of many institutions' budgets," says a news release on the study, "and that many schools spend large amounts on things unrelated to educating students."

    The report uses Dartmouth College as a poster child to illustrate the gap between the actual costs of providing an education and what an institution says it spends. On its Web site, the report says, the Dartmouth College Fund maintained that while the institution charged undergraduates about $50,000 each in academic 2009-10, the college actually spent about $104,400 per student. While the center's report notes that Dartmouth indeed spent more over all per student than what it took in through tuition payments, "this does not mean that students are being subsidized because not all of that spending is used toward specifically educational purposes."

    For example, says the report, Dartmouth said it spent $37,000 per student on "academic support," $24,000 per student for research, $15,000 for "institutional support," and $12,000 for "student services." But, says the report, "very little of that $88,000 is properly attributed to the cost of providing an education."

    A spokesman for Dartmouth said it is legitimate for institutions to count research expenditures as part of instruction. Dartmouth faculty members are "renowned as teacher-scholars who involve their students in their scholarship," said the spokesman. "Discovery of knowledge is a key part of Dartmouth’s fundamental mission and a liberal-arts education."

    The report criticizes colleges for stating that they subsidize their students' education, saying "conventional wisdom is often wrong" in that regard.

    Continued in article

    Bob Jensen's threads on cost accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Question
    Is your managerial/cost accounting course largely detached from the real world?

    "Book Indicates Wrigley Faithful Care More About Beer Prices Than Winning: Chicagoist ," Chicagoist, April 4, 2011 ---
    http://chicagoist.com/2011/04/04/book_indicates_wrigley_faithful_car.php 
    Thanks to Jim Mahar for the heads up.

    Leave it to a University of Chicago economist to lend credence to the belief that Wrigley Field is a background to being the World's Largest Beer Garden 81 times a year. Booth School of Business Finance Professor Tobias "Toby" Moskowitz is one of the co-authors of the new book Scorecasting. Moskowitz and Sports Illustrated senior writer Jon Wertham analyzed economic data related to baseball at Wrigley Field in relation to attendance and found that, more often than not. the one factor that tended to lead to decreases in attendance was increases in beer prices, even as tickets to Cubs games became more expensive.

    Per the University of Chicago magazine;

    From 1984 to 2009, “attendance was more than four times more sensitive to beer prices than to winning or losing.” That sensitivity is evident at the concession stand. A beer at Wrigley Field, Scorecasting reports, costs just $5, cheaper than everywhere except at Arizona Diamondbacks and Pittsburgh Pirates games.

    Tickets to Cubs games, on the other hand, have followed a different trajectory. Since 1990, prices have increased 67 percent (the league average is 44.7 percent). Only the New York Yankees and the Boston Red Sox command more.

    Yet people have continued to pay Wrigley Field’s escalating cover charge, filling the stadium to 99 percent capacity. Across town at US Cellular Field, ticket prices and attendance rise and fall based on White Sox wins and losses, but the same beer will run you a buck-fifty more than at Wrigley.

    Continued in the article

    Jensen Comment
    This illustration might be used to illustrate the enormous gap between CPV analysis in the real world versus the pathetic simplification assumptions we make for CPV models in our cost and managerial accounting textbooks.

    Firstly, the single product models where only one product bears the fixed cost almost never arise in the real world except in maybe for farmers who only grow one crop such as Kansas wheat or Idaho potatoes. But this leaves our students unprepared for the real world where they rarely encounter single-product firms.

    Secondly, when we teach multiple-product CPV analysis we make the totally unrealistic assumption that product/sales mix ratios are constant over the relevant range. This leaves our students unprepared for the real world where they rarely encounter fixed product/sales mix ratios even in a relatively narrow relevant range.

    The above Wrigley Field CPV problem from the real world illustrates a situation where two products, beer and park seating tickets, share common fixed costs but do so in a complicated way that makes the assumption of a fixed product/sales mix ratio is totally inappropriate. Pricing is especially complicated because at low seating prices we have more patrons who potentially but not necessarily will buy more beer. But at low beer prices we will apparently sell more seating tickets, but this becomes complicated by so many other factors. Demand appears to be more elastic to beer pricing than to ticket pricing according to findings in the above article. Add to this the park attendance complications caused by Cubs rankings in the National League, popularity of certain stars that emerge such a leading home run hitter, weather, unemployment, traffic, parking, and other factors affecting park attendance and beer drinking.

    It might be of great value if some accounting professors collaborated to write a case about Wrigley Field CPV analysis leading up to pricing decisions and other variables that we commonly analyze in CPV analysis such as operating leverage.

    It might be of great value if readers would tell us how they go beyond the textbooks to prepare students for real world complications of CPV analysis.


    Teaching Case on Supply Chains and Value Chains

    Not Really 'Made in China'
    by: Andrew Batson
    Dec 16, 2010
    Click here to view the full article on WSJ.com
     

    TOPICS: Product strategy, Supply Chains

    SUMMARY: "One widely touted solution for current U.S. economic woes is for America to produce more of the high-tech gadgets that the rest of the world craves. Yet two academic researchers have found that Apple Inc.'s iPhone-one of the most iconic U.S. technology products-actually added $1.9 billion to the U.S. trade deficit with China last year. How is this possible? Though the iPhone is entirely designed and owned by a U.S. company, and is made largely of parts produced by other countries, it is physically assembled in China. Both countries' trade statistics therefore consider the iPhone a Chinese export to the U.S. So a U.S. consumer who buys what is often considered an American product will add to the U.S. trade deficit with China."

    CLASSROOM APPLICATION: The article is useful in a managerial accounting class or an MBA class. Questions ask students to discuss the concepts of product cost, period cost, value chains, and supply chains, then consider the impact of these accounting concepts as they are used in discussing issues in the world economy.

    QUESTIONS: 
    1. (Advanced) What are the three cost components of any product?

    2. (Advanced) What other period costs also contribute to production of any product such as the iPhone and the iPad discussed in this article?

    3. (Introductory) What component of the iPhone and iPad product costs and period costs are incurred in China? In the U.S.? In other parts of the world?

    4. (Advanced) What is a value chain? How do both product costs and period costs reflect amounts in the value chain for a product?

    5. (Advanced) What is a supply chain? How is the functioning of today's global supply chain impacting the statistics traditionally used to assess international trade?

    6. (Introductory) How do the researchers cited in the article use the components of a value chain to improve analysis of global supply chains?

    "Not Really 'Made in China'," by: Andrew Batson, The Wall Street Journal, December 16, 2010 ---
    http://online.wsj.com/article/SB10001424052748704828104576021142902413796.html?mod=djem_jiewr_AC_domainid

    One widely touted solution for current U.S. economic woes is for America to come up with more of the high-tech gadgets that the rest of the world craves.

    Yet two academic researchers estimate that Apple Inc.'s iPhone—one of the best-selling U.S. technology products—actually added $1.9 billion to the U.S. trade deficit with China last year.

    How is this possible? The researchers say traditional ways of measuring global trade produce the number but fail to reflect the complexities of global commerce where the design, manufacturing and assembly of products often involve several countries.

    "A distorted picture" is the result, they say, one that exaggerates trade imbalances between nations.

    Trade statistics in both countries consider the iPhone a Chinese export to the U.S., even though it is entirely designed and owned by a U.S. company, and is made largely of parts produced in several Asian and European countries. China's contribution is the last step—assembling and shipping the phones.

    So the entire $178.96 estimated wholesale cost of the shipped phone is credited to China, even though the value of the work performed by the Chinese workers at Hon Hai Precision Industry Co. accounts for just 3.6%, or $6.50, of the total, the researchers calculated in a report published this month.

    A spokeswoman for Apple said the company declined to comment on the research.

    The result is that according to official statistics, "even high-tech products invented by U.S. companies will not increase U.S. exports," write Yuqing Xing and Neal Detert, two researchers at the Asian Development Bank Institute, a think tank in Tokyo, in their report.

    This isn't a problem with high-tech products, but with how exports and imports are measured, they say.

    The research adds to a growing debate about traditional trade statistics that could have real-world consequences. Conventional trade figures are the basis for political battles waging in Washington and Brussels over what to do about China's currency policies and its allegedly unfair trading practices.

    "What we call 'Made in China' is indeed assembled in China, but what makes up the commercial value of the product comes from the numerous countries," Pascal Lamy, the director-general of the World Trade Organization, said in a speech in October. "The concept of country of origin for manufactured goods has gradually become obsolete."

    Mr. Lamy said if trade statistics were adjusted to reflect the actual value contributed to a product by different countries, the size of the U.S. trade deficit with China—$226.88 billion, according to U.S. figures—would be cut in half.

    To correct for that bias is difficult because it requires detailed knowledge of how products are put together.

    Continued in article

    Bob Jensen's threads on managerial accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting


    Chris Deeley in Australia and I have been corresponding regarding an antique learning curve paper that I published nearly 20 years ago. You can read some of our correspondence at http://faculty.trinity.edu/rjensen/theorylearningcurves.htm
    In that correspondence I discuss the good and evil of the Wolfram Alpha computational search engine.

    Chris also sent me his latest working paper on an entirely different topic (which I've not yet found time to delve into). I asked if I could serve up the paper to my AECM friends and others. When I find time I would like to test some of his formulas in Wolfram Alpha. Chris is skeptical.

    September 23, 2010 message from

    Bob
    Yes, by all means post my working paper on general annuities on the AECM website. I suspect that Wolfram Alpha may not be able to handle this sort of thing. In fact, I wouldn’t be surprised if the application of standard maths has created and entrenched the error. Chris

    Chris Deeley
    Senior Lecturer in Accounting & Finance
    School of Accounting,
    Faculty of Business
    Charles Sturt University,
    Locked Mail Bag 588
    Wagga Wagga, NSW 2678
    Ph: +612 69332694 Fax: +612 69332790
    Email: cdeeley@csu.edu.au 
    Web:www.csu.edu.a u

    I put his paper on one of my Web servers. I'm sure that Chris will appreciate any comments that you have regarding this technical topic. It may be a good exercise for accounting and finance students to study this paper.

    "IDENTIFICATION AND CORRECTION OF A COMMON ERROR IN GENERAL ANNUITY CALCULATIONS," by Chris Deeley, Charles Sturt University, Australia., September 23, 2010 Working Draft ---
    http://www.cs.trinity.edu/~rjensen/temp/DeeleyAnnuityCorrections.pdf

     


    Potentially a Great Case for Managerial Accounting Courses:  How can Harry Potter movies be financial losers?
    "'Hollywood Accounting' Losing In The Courts:  From the math-is-hard dept," TechDirt ---
    http://www.techdirt.com/articles/20100708/02510310122.shtml

    If you follow the entertainment business at all, you're probably well aware of "Hollywood accounting," whereby very, very, very few entertainment products are technically "profitable," even as they earn studios millions of dollars. A couple months ago, the Planet Money folks did a great episode explaining how this works in very simple terms. The really, really, really simplified version is that Hollywood sets up a separate corporation for each movie with the intent that this corporation will take on losses. The studio then charges the "film corporation" a huge fee (which creates a large part of the "expense" that leads to the loss). The end result is that the studio still rakes in the cash, but for accounting purposes the film is a money "loser" -- which matters quite a bit for anyone who is supposed to get a cut of any profits.

    For example, a bunch of you sent in the example of how Harry Potter and the Order of the Phoenix, under "Hollywood accounting," ended up with a $167 million "loss," despite taking in $938 million in revenue. This isn't new or surprising, but it's getting attention because the income statement for the movie was leaked online, showing just how Warner Bros. pulled off the accounting trick:

    In that statement, you'll notice the "distribution fee" of $212 million dollars. That's basically Warner Bros. paying itself to make sure the movie "loses money." There are some other fun tidbits in there as well. The $130 million in "advertising and publicity"? Again, much of that is actually Warner Bros. paying itself (or paying its own "properties"). $57 million in "interest"? Also to itself for "financing" the film. Even if we assume that only half of the "advertising and publicity" money is Warner Bros. paying itself, we're still talking about $350 million that Warner Bros. shifts around, which get taken out of the "bottom line" in the movie accounting.

    Now, that's all fascinating from a general business perspective, but now it appears that Hollywood Accounting is coming under attack in the courtroom... and losing. Not surprisingly, your average juror is having trouble coming to grips with the idea that a movie or television show can bring in hundreds of millions and still "lose" money. This week, the big case involved a TV show, rather than a movie, with the famed gameshow Who Wants To Be A Millionaire suddenly becoming "Who Wants To Hide Millions In Profits." A jury found the whole "Hollywood Accounting" discussion preposterous and awarded Celador $270 million in damages from Disney, after the jury believed that Disney used these kinds of tricks to cook the books and avoid having to pay Celador over the gameshow, as per their agreement.

    On the same day, actor Don Johnson won a similar lawsuit in a battle over profits from the TV show Nash Bridges, and a jury awarded him $23 million from the show's producer. Once again, the jury was not at all impressed by Hollywood Accounting.

    With these lawsuits exposing Hollywood's sneakier accounting tricks, and finding them not very convincing, a number of Hollywood studios may face a glut of upcoming lawsuits over similar deals on properties that "lost" money while making millions. It's why many of the studios are pretty worried about the rulings. Of course, these recent rulings will be appealed, and a jury ruling might not really mean much in the long run. Still, for now, it's a fun glimpse into yet another way that Hollywood lies with numbers to avoid paying people what they owe (while at the same sanctimoniously insisting in the press and to politicians that they're all about getting content creators paid what they're due).

    Bob Jensen's threads on case learning are at
    http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Cases

    Bob Jensen's threads on return on investment
    http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on management accounting
    http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting

    Bob Jensen's threads on accounting theory are at
    http://faculty.trinity.edu/rjensen/theory01.htm


    Teaching Case on Cost-Profit-Volume (CPV) Analysis

    From The Wall Street Journal Accounting Weekly Review on August 20, 2010

    Piece by Piece: The Suppliers Behind the New BlackBerry Torch Smartphone
    by: Jennifer Velentino-Devries and Phred Dvorak
    Aug 17, 2010
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com WSJ Video

    TOPICS: Cost Accounting, Cost-Volume-Profit Analysis, Managerial Accounting

    SUMMARY: The article was written based on analysis and component price estimates by research firm iSuppli after dismantling Blackberry's new Torch smartphone. The product was assembled in Mexico from parts made by at least 7 companies headquartered in the U.S., South Korea, the U.K., Germany, Japan, and Switzerland. Questions ask students to identify manufacturing cost components, determine gross profit, and consider what manufacturing costs are not separately identified when a company buys completed components for assembly.

    CLASSROOM APPLICATION: The article is appropriate for an introductory level managerial accounting class.

    QUESTIONS: 
    1. (Introductory) What are the three components of cost for any manufactured product?

    2. (Introductory) What is the total cost of the components of the new BlackBerry Torch as estimated by iSuppli?

    3. (Advanced) Assuming that the cost shown in the article comprises all of the cost identified in your answer above, what is the gross profit earned on each sale of the Torch? What is the gross profit rate on this product? In your answer, define the difference between each of these amounts.

    4. (Advanced) What other costs might be included in the cost of selling this product beyond the component costs shown in this article? What other costs will Research in Motion (RIM) incur in selling this product that are never included in product cost? In your answer, define the terms period cost and product cost.

    5. (Introductory) View the video that is affiliated with this article. How many Torch smartphones were sold on the opening weekend for this product? What is the possible result of this sales level?

    6. (Introductory) According to the related video, what is the lowest price at which this new phone is offered? Recalculate the answers you gave to question 4 above based on this selling price.

    Reviewed By: Judy Beckman, University of Rhode Island

    "Piece by Piece: The Suppliers Behind the New BlackBerry Torch Smartphone," by: Jennifer Velentino-Devries and Phred Dvorak, The Wall Street Journal, August 17, 2010 --- http://online.wsj.com/article/SB10001424052748704868604575433751932669646.html?mod=djem_jiewr_AC_domainid

    Research In Motion Ltd.'s latest iPhone challenger, the BlackBerry Torch 9800, hasn't yet made a killing where it matters the most: at the cash register.

    Analysts say retail spot checks show sales of the Torch, which began in the U.S. at AT&T Inc. stores Thursday, have been unimpressive—particularly in comparison with other recent smartphone debuts.

    Analysts at RBC Capital Markets and Stifel Nicolaus both put weekend sales at around 150,000 phones. In comparison, Apple Inc. said it sold 1.7 million iPhone 4 units in the first three days. To be sure, many Torch sales will likely go to RIM's core business clients, who can be slower to adopt the latest models.

    RIM declined comment; AT&T didn't respond to requests for comment.

    The plodding start isn't great news for RIM, which is losing market share in the important North American market to snazzier rivals like the iPhone. The Torch, RIM's first phone with a touchscreen and slide-out keyboard, comes with revamped software and a faster Web browser, which address some of the complaints against previous BlackBerry models.

    But so far it's had a limited rollout: The Torch is only available—at least for now—through AT&T for $199.99, with a two-year service contract. RIM hasn't yet said when it will go on sale internationally or through other carriers.

    BlackBerry users could also be waiting to upgrade current phones with the new operating system, rather buying an entirely new phone, analysts say. The new software is set to roll out to existing devices in the coming months and promises to make it easier for developers to offer third-party applications. The platform also makes improvements in the way BlackBerry users can tap into social networks like Facebook and media from iTunes and Windows Media Player.

    Like other high-profile smartphones, the Torch has been disassembled by research firms to identify key components to help spot trends in the electronics industry. Two research firms, iSuppli and UBM TechInsights, concluded the new phone relies heavily on parts used in earlier RIM products. ISuppli said it was assembled for RIM in Mexico, though it didn't identify what company carried out that work.

    Experience WSJ professionalEditors' Deep Dive: Smartphone Rivals Face OffPC MAGAZINE Android Boosts Smartphone SalesThe Toronto Star The Curse of SuccessDow Jones International News Nokia N8 to Boost High-End CompetitivenessAccess thousands of business sources not available on the free web. Learn MoreISuppli estimated the total cost of the Torch's components at $171, plus $12 for manufacturing. The most expensive single part of the Torch, iSuppli said, is the display and touchscreen assembly, at an estimated cost of $34.85. The screen supplier was unknown. Memory chips, supplied by South Korea's Samsung Electronics Co., accounted for $34.25 of the Torch's component costs, the firm said.

    The chip that serves as the electronic brains of the Torch--and also provides so-called "baseband" functions to manage communications--was supplied by Marvell Technology Group Ltd., a company in Santa Clara, Calif., that primarily uses manufacturing services in Taiwan to build chips it designs. ISuppli put the price of that chip at $15.

    UBM TechInsights pointed out that the Marvell chip operates at a speed of 624 megahertz, where some high-end phones have chips that operate at 1 gigahertz--providing a substantial performance advantage.

    Bob Jensen's threads on management accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting


    From The Wall Street Journal Accounting Weekly Review on February 11, 2011

    Weather Whacks Airlines' Revenue
    by: Mike Esterl
    Feb 03, 2011

    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Accounting, Disclosure, Disclosure Requirements, Financial Accounting, Managerial Accounting, Revenue Forecast, Revenue Recognition

    SUMMARY: "A whopping 52,742 flights have been canceled at U.S. airports since Dec. 1, 2010, or 4.98% of those scheduled....The cancellations came in a period when travel demand is normally weaker anyway and airlines struggle to reap profits....'Given that the first quarter is always a tough one even in good years, a major storm that lasts several days and hits several hubs could make or break the quarter,' said John Heimlich, chief economist at the Air Transport Association...."

    CLASSROOM APPLICATION: The article is useful to help students see the impact of external shocks such as the weather on company profits and to understand the disclosure process leading to analysis in the article. It may be used in any level of accounting class covering revenue recognition, fixed and variable costs, and quarterly reporting and disclosure.

    QUESTIONS: 
    1. (Introductory) Airline tickets are paid for in advance. Given that passengers have paid their fares, why do canceled flights cause revenues to decline?

    2. (Introductory) "By flying fewer flights [due to weather-related cancellations], carriers also lower their costs." What types of costs are reduced in this way, fixed costs or variable costs? Define each of these costs in your answer.

    3. (Advanced) Why is the first quarter of the year always a "tough one" for airlines to earn profits, even disregarding the effects of snowstorms? In your answer, comment on the role of high fixed costs in times of weak demand and revenues. Are costs reduced when this demand falls as they are due to weather-related flight cancellations?

    4. (Advanced) "...Many carriers don't disclose the financial impact of storms until weeks later, if at all..." Consider requirements for quarterly financial reporting. Why should an airline company disclose the impact of a storm on its revenues and profits? How could a company management justify not disclosing these effects?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Weather Whacks Airlines' Revenue," by: Mike Esterl, The Wall Street Journal, February 3, 2011 ---
    http://online.wsj.com/article/SB10001424052748704775604576120531230435802.html?mod=djem_jiewr_AC_domainid

    This week's winter storm is cutting into the revenues of several U.S. airlines, which already were weighed down by rising fuel prices.

    A series of rugged winter weather events since December already had slashed those airlines' revenues by tens of millions of dollars, according to the companies involved and industry analysts.

    Carriers canceled more than 5,000 flights, or roughly 20% of those scheduled nationwide, for a second day in a row Wednesday as the storm barreled across much of the country. Chicago was a no-fly zone, more than 1,000 flights were canceled in New York and hundreds more were scratched in Dallas.

    A whopping 52,742 flights have been canceled at U.S. airports since Dec. 1, 2010, or 4.98% of those scheduled, according to FlightStats, a flight-tracking service. That represented the highest tally in the past five winters over the same time period and a bit more than double last winter's rate.

    The cancellations came in a period when travel demand is normally weaker anyway and airlines struggle to reap profits.

    "Given that the first quarter is always a tough one even in good years, a major storm that lasts several days and hits several hubs could make or break the quarter," said John Heimlich, chief economist at the Air Transport Association, an umbrella group for U.S. carriers.

    Many Wall Street analysts expected most U.S. airlines to post losses in the first quarter, but to still book a profit for 2011 as more travelers take to the skies and fares increase.

    "I think at this point we're talking tens of millions of dollars in lost revenue. I don't think we're talking hundreds of millions,'' said Helane Becker, an analyst at Dahlman Rose, of the storms' impact so far in 2011.

    The U.S. airline industry rode a rebounding economy to its first profit in three years in 2010. But the outlook has turned cloudy as fuel expenses—which make up 25% or more of carriers' overall costs—head higher. Each $1 increase in the price of a barrel of crude oil adds an estimated $400 million to U.S. airline industry costs annually.

    Weather has a more muted impact on airlines. By flying fewer flights, carriers also lower their costs. Many passengers often rebook on subsequent flights, making for fuller planes and helping further cut costs.

    U.S. airlines also managed to book their first fourth-quarter profit in a decade in the most recent reporting period ended Dec. 31, 2010—despite the major December storm that wreaked havoc on holiday travel.

    But many carriers don't disclose the financial impact of storms until weeks later, if at all, creating uncertainty. Airlines said Wednesday it was too early to estimate the effect of this week's storm on their first-quarter financial performance. Some may provide initial estimates in the coming weeks as they roll out their monthly traffic reports.

    Delta Air Lines Inc., the second-largest U.S. carrier by traffic, recently estimated that storms in the first half of January alone would drag down its first-quarter profit by $30 million. It also disclosed that December storms slashed its fourth-quarter profit by $45 million.

    Continued in article

    Jensen Comment
    Additional considerations when teaching this case include the possible factoring in of global warming. I read where my wife and I can expect more and more snow each winter up here in the White Mountains and that other parts of the world can expect more and more snow, rain, and flooding. The reason is supposedly increased moisture in the air caused by warmer ocean temperatures. In the past industries like transportation, hotels, and agriculture factored in "normal" weather losses in prices. When does abnormal commence to become normal?

    And there are tradeoffs. Whereas snow storms in the heartland of the United States greatly impacted the bottom line of hotels and airlines, here in the mountains of New England the hotels and ski resorts flourished with increased business due to the "best" snow depths in decades. Instead of flying to the Rocky Mountains of the west to ski, many skiers in Boston, Hartford, NYC, Philadelphia, etc. packed up their cars and headed for the deep snows of Vermont, Maine, and New Hampshire. How the West was Lost become How the East was Won.


    A Two-Part Teaching Case: The Cost of Quality Versus the Cost of Poor Quality
    Two decades ago, managerial and cost accounting textbooks and courses began to run modules on the "cost of quality" or to be more accurate the cost of poor quality. The following case fits into these types of modules.

    From The Wall Street Journal Accounting Weekly Review on May 21, 2010

    FDA Widens Probe of J&J's McNeil Unit
    by: Jonathan D. Rockoff
    May 18, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Cost Management, Product Recall, Quality Costs

    SUMMARY: On April 30, 2010, Johnson & Johnson "...recalled a number of over-the-counter medicines for children and infants after receiving complaints from consumers and discovering manufacturing problems. The company also closed the plant in Fort Washington, PA, that made the recalled products until it fixes the issues and can assure quality production....The FDA conducted a routine inspection of the Fort Washington plant last month. Agency inspectors found that the J&J unit received 46 complaints from consumers between June 2009 and April 2010 regarding 'foreign materials, black or dark specks' in certain medicines.'" The FDA has now widened its investigation and the J&J McNeil Consumer Healthcare unit that makes these products is conducting a comprehensive quality assessment over all its manufacturing operations. "Some parents say the recall has weakened J&J's sterling reputation for quality. The recall has also prompted a congressional investigation of the company's handling of consumer complaints and the adequacy of the FDA's inspections."

    CLASSROOM APPLICATION: Questions focus on concepts in the cost of quality.

    QUESTIONS: 
    1. (Introductory) How crucial is the concept of quality to Johnson & Johnson operations and profitability?

    2. (Advanced) Define the terms "cost of quality" or "quality cost" and related concepts of 'prevention costs" and "appraisal costs."

    3. (Advanced) Which of the categories of quality costs-prevention or appraisal-is about to increase significantly at J&J? Explain your answer.

    4. (Advanced) Define the concepts of "internal failure costs" and "external failure costs."

    5. (Advanced) The FDA and congress may investigate J&J's handling of consumer complaint. Under what part of the quality control process does handling these complaints fall under?

    Reviewed By: Judy Beckman, University of Rhode Island

    "FDA Widens Probe of J&J's McNeil Unit," by: Jonathan D. Rockoff, The Wall Street Journal, May 18, 2010

    The Food and Drug Administration has widened its investigation into the recent recall of certain Johnson & Johnson children's medicines and is now inquiring into manufacturing across the company's consumer health-care unit.

    J&J's McNeil Consumer Healthcare makes a range of products for adults and kids, notably Benadryl, St. Joseph aspirin, Motrin, Tylenol and Zyrtec.

    On April 30, the company recalled a number of over-the-counter medicines for children and infants after receiving complaints from consumers and discovering manufacturing problems. The company also closed the plant in Fort Washington, Pa., that made the recalled products until it fixes the issues and can assure quality production.

    The recall of the liquid children's medicines was the third by the J&J unit since last September. An FDA spokeswoman said there had been no specific complaints about products from other McNeil facilities. But given the history of recent recalls, the FDA wanted to make sure there weren't any similar manufacturing problems and to identify any steps the agency must take to prevent the problems from recurring.

    Besides Fort Washington, J&J's McNeil unit has plants in Lancaster, Pa., and Las Piedras, Puerto Rico.

    "We're doing our due diligence," said FDA spokeswoman Elaine Gansz Bobo.

    The J&J unit "is conducting a comprehensive quality assessment across its manufacturing operations and continues to cooperate with the FDA," a company spokeswoman said.

    Some parents say the recall has weakened J&J's reputation for quality. The recall has also prompted a congressional investigation of the company's handling of consumer complaints and the adequacy of the FDA's inspections. The House Committee on Oversight and Government Reform has asked J&J Chief Executive William Weldon to testify at a hearing on May 27.

    The FDA and J&J have told the committee they will cooperate and are in the process of answering its questions, and the committee expects that Mr. Weldon will attend, said Kurt Bardella, a spokesman for Rep. Darrell Issa (R., Calif.), the panel's ranking Republican.

    A J&J spokesman said the company is communicating with the committee and will respond appropriately to the panel's request but declined to say if Mr. Weldon will appear.

    The recall last month involved more than 40 different Tylenol, Benadryl, Motrin and Zyrtec products for children and infants. Some of the medicines had higher concentrations of active ingredient than specified, and some products may contain tiny metallic particles left as a residue from the manufacturing process, according to J&J's McNeil unit.

    The FDA conducted a routine inspection of the Fort Washington plant last month. Agency inspectors found that the J&J unit received 46 complaints from consumers between June 2009 and April 2010 regarding "foreign materials, black or dark specks" in certain medicines. The FDA also said bacteria contaminated raw materials to be used to make several lots of Tylenol products for children.

    FDA has begun to review all complaints it has received to determine whether the recalled products caused any serious side effects. The agency has said the chances that the recalled products could cause harm were remote, but warned parents not to use the products as a precaution.

    Update on June 3, 2010
    From The Wall Street Journal Accounting Weekly Review on June 3, 2010

    J&J Recall Probe Expands to Others
    by: Jonathan D. Rockoff
    Jun 03, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Cost Accounting, Managerial Accounting, Product Recall

    SUMMARY: "A Congressional probe of a Johnson & Johnson unit's manufacturing problems is spreading beyond the company's recent recall of its children's medicines to withdrawals of other over-the-counter products." The House Committee on Oversight and Government Reform also contacted Blacksmith Brands about its recall of PediaCare cough and cold medicines. The company purchased the Pedia line from J&J's McNeil Consumer Healthcare unit in 2009 and those products also were made in the same facility in which the other problem products were made.

    CLASSROOM APPLICATION: This review follows on initial coverage of this issue on 5/20/2010. Questions focus on concepts in the cost of quality for management accounting classes and on implications for financial accounting and reporting for product recalls for financial accounting classes.

    QUESTIONS: 
    1. (Advanced) Define the terms "cost of quality" or "quality cost" and related concepts of 'prevention costs" and "appraisal costs."

    2. (Introductory) Which of the categories of quality costs-prevention or appraisal-are occurring at Johnson &Johnson's McNeil unit and at Blacksmith Brands, who bought J&J's PediaCare medicines, in response to manufacturing defects in over the counter medicines?

    3. (Advanced) Define the concepts of "internal failure costs" and "external failure costs."

    4. (Introductory) The FDA and Congress also are investigating J&J's use of an outside contractor "after discovering in late 2008 that some Motrin wasn't dissolving correctly." Under what part of the quality control process does the cost of using such a contractor fall? Specifically comment in light of J&J's statements about the purpose of hiring the contractor.

    5. (Advanced) Summarize the financial accounting and reporting implications of a product recall such the one that Blacksmith Brands has issued for PediaCare cough and cold medicines.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    More Children's Medicine Made at J&J Facility Is Recalled
    by Jonathan D. Rockoff
    May 29, 2010
    Online Exclusive

    "J&J Probe Expands to Other Products," by: Jonathan D. Rockoff, The Wall Street Journal, June 2, 2010 ---
    http://online.wsj.com/article/SB10001424052748704515704575283103714261396.html?mod=djem_jiewr_AC_domainid

    A Congressional probe of a Johnson & Johnson unit's manufacturing problems is spreading beyond the company's recent recall of its children's medicines to withdrawals of other over-the-counter products.

    The House Committee on Oversight and Government Reform asked Blacksmith Brands on Tuesday for further information about its recall last week of PediaCare cough and cold medicines. Those products were made by J&J at the same Fort Washington, Pa., plant that produced children's Tylenol and other recalled kids drugs.

    J&J's McNeil Consumer Healthcare unit had recalled certain Benadryl, Motrin, Tylenol and Zyrtec pain and cold medicines for children on April 30 because of manufacturing problems including the potential for metal particles in the products. J&J has temporarily shut the plant.

    A spokesman for Blacksmith Brands, of Tarrytown, N.Y., called the committee's request standard in the event of recalls and said the company would cooperate. Blacksmith Brands bought the four recalled PediaCare products from J&J's McNeil unit last year, and had arranged prior to the recall for other plants to make them starting in July.

    The House committee sought information from WIS International, a merchandising consultant, as part of its examination of McNeil's handling of defective Motrin pain relief pills, according to a person familiar with the investigation.

    In 2008, J&J's McNeil unit discovered that some of the pills weren't dissolving correctly. It hired a contractor to purchase the product from store shelves, according to documents released at the Congressional committee hearing last week.

    The contractor advised its workers to buy up the Motrin packages, and to act like customers, making no reference to this being a recall, according to a memo released at the hearing.

    In July 2009, McNeil issued a recall of the Motrin product.

    Colleen Goggins, who oversees J&J's consumer group, told lawmakers last week that the company didn't have "any intent to mislead or hide anything" and that it had told the FDA it had hired a contractor to statistically sample the products. A J&J spokeswoman said it is looking into the contractor's work and would report back to the committee.

    She wouldn't comment on whether WIS International was the contractor in the memo.

    An entity called "WIS" is named in the contractor's memo.

    Officials at the company did not return messages left Wednesday seeking comment. On Tuesday, Dave Haller, vice president of sales, account management and marketing, said: "We don't comment on activities for our clients, and Johnson & Johnson is not a client of ours." He would not say whether J&J or one of its units had been a client in the past.

    WIS International, which has headquarters in San Diego, Calif., and Mississauga, Ontario, counts inventory on behalf of retailers, hospitals and other kinds of firms. It also helps manufacturers recall tainted products from retail store shelves.

    The company's website says it has "worked on recalls and product purchases ranging from a few hundred stores to nearly 60,000."

    May 21. 2010 reply from James R. Martin/University of South Florida [jmartin@MAAW.INFO]

    Bob,

    Using these cases is a good place to introduce and compare the various quality models including Juran's Zero defects, Taguchi's Loss function, and Deming's Robust quality philosophy.

    (http://maaw.info/ConstrainoptTechs.htm#Quality Models Compared). It also leads to the Six Sigma approach to quality (http://maaw.info/SixSigmaSummary.htm), many other concepts and arguments related to quality (http://maaw.info/QualityRelatedMain.htm), and the controversy over constrained optimization concepts in general (http://maaw.info/ConstrOptMain.htm).

    Bob Jensen's threads on managerial and cost accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#ManagementAccounting


    Managerial Accounting:  Rapid Plant Assessment (RPA)

    From James R. Martin http://maaw.info 
    To CPAS-L show details 12:43 PM

    The following article describes a lean assessment technique referred to as the rapid plant assessment (RPA) process.

    Goodson, R. E. 2002. Read a plant - fast. Harvard Business Review (May): 105-113.

    According to Goodson, using the RPA process during a plant tour can indicate if a factory is truly lean in as little as 30 minutes. The process includes two assessment tools, the RPA rating sheet, and the RPA questionnaire. The information provided by these tools can be used to influence decisions related to benchmarking, continuous improvement, competitor analysis, and acquisitions. It is also a very useful tool for teaching students about lean enterprise concepts.

    For a summary of the RPA process see http://maaw.info/ArticleSummaries/ArtSumGoodson2002.htm


    Question
    Do big bonuses lead to worse performance?

    "Does Bigger Bonus Equal Worse Performance?Around the turn of every year, bankers can think of only one thing: the size of their bonuses," by Dan Ariely, Wall Street Technology, June 18, 2010 ---
    http://wallstreetandtech.com/career-management/showArticle.jhtml?articleID=225700612&cid=nl_wallstreettech_daily
    Thanks Jagdish!

    Around the turn of every year, bankers can think of only one thing: the size of their bonuses.

    Even beyond bonus season, they run different scenarios and assumptions, trying to calculate their number.

    This distracts them so much that the bigger the bonus at stake, the worse the performance, according to behavioral economist Dan Ariely, who lays out his theory in his new book "The Upside of Irrationality" (HarperCollins, $27.99).

    "For a long time we trained bankers to think they are the masters of the universe, have unique skills and deserve to be paid these amounts," said Ariely, who also wrote the New York Times bestseller "Predictably Irrational."

    "It is going to be hard to convince them that they don't really have unique skills and that the amount they've been paid for the past years is too much."

    Ariely's findings come as regulators try to rein in Wall Street's bonus culture after the 2008 financial collapse. The financial industry argues it needs to pay large bonuses to attract and motivate its top employees.

    In an experiment in India, Ariely measured the impact of different bonuses on how participants did in a number of tasks that required creativity, concentration and problem-solving.

    One of the tasks was Labyrinth, where the participants had to move a small steel ball through a maze avoiding holes. Ariely describes a man he identified as Anoopum, who stood to win the biggest bonus, staring at the steel ball as if it were prey.

    "This is very, very important," Anoopum mumbled to himself. "I must succeed." But under the gun, Anoopum's hands trembled uncontrollably, and he failed time after time.

    A large bonus was equal to five months of their regular pay, a medium-sized bonus was equivalent to about two weeks pay and a small bonus was a day's pay.

    There was little difference in the performance of those receiving the small and medium-sized bonuses, while recipients of large bonuses performed worst.

    SHOCK TREATMENT

    More than a century ago, an experiment with rats in a maze rigged with electric shocks came to a similar conclusion. Every day, the rats had to learn how to navigate a new maze safely.

    When the electric shocks were low, the rats had little incentive to avoid them. At medium intensity they learned their environment more quickly.

    But when the shock intensity was very high, it seemed the rats could not focus on anything other than the fear of the shock.

    This may provide lessons for regulators who want to change Wall Street's bonus culture, Ariely said. Paying no bonus or smaller bonuses could help fix skewed incentives without loss of talent.

    "The reality is, a lot of places are able to attract great quality people without paying them what bankers are paid," Ariely said. "Do you think bankers are inherently smarter than other people? I don't." (Reporting by Kristina Cooke; Editing by Daniel Trotta)

    Bob Jensen's threads on outrageous compensation are at
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation


    "Dan Ariely: The Mind's Grey Areas:  By controlling situations that create conflicts of interest, we can combat frauds and scandals better," Forbes, June 2010 --- Click Here
    http://www.forbes.com/2010/06/15/forbes-india-dan-ariely-the-minds-grey-areas-opinions-ideas-10-ariely.html?boxes=Homepagelighttop

    My interest in the irrationality of human behavior started many years ago in hospital after I had been badly burned. If you spend three years in a hospital with 70% of your body covered in burns, you are bound to notice several irrationalities. The one that bothered me in particular was the way my nurses would remove the bandage that wrapped my body. Now, there are two ways to remove a bandage. You can rip it off quickly, causing intense but short-term pain. Or you can remove it slowly, causing less intense pain but for a longer time.

    My nurses believed in the quick method. It was incredibly painful, and I dreaded the moment of ripping with remarkable intensity. I begged them to find a better way to do this, but they told me that this was the best approach and that they knew the best way for removing bandages. It was their intuition against mine, and they chose theirs. Moreover, they thought it unnecessary to test what appeared (to them) to be intuitively right.

    After leaving the hospital, I started doing experiments that simulated these two ripping methods. And I found that the nurses were wrong: Quick ripping turned out to be more painful than slow ripping. In my experiments, I discovered a collection of tricks that could have been used to lessen the pain or manage it more effectively. For instance, they could have started from the most painful part of the treatment and moved to less painful areas to give me a sense of improvement; they could have given me breaks in between to recover. There are great lessons to be learned from such experiments, lessons that apply to economics, markets, policymaking and even our personal lives.

    Is there an idea you believe can change the world? Describe it in the comments section at the bottom of this story, and Forbes could publish your idea.

    As it turns out, it is not that useful, and sometime even costly, to base our decisions on our intuitions. Instead, we need to inject some science in the way we go about everyday life because if one merely keeps following his instincts, he will continue making the same (preventable) mistakes.

    Over the years, I have examined many topics related to the mistakes we all make when we make decisions, and one topic that I have explored in some depth is that of cheating behavior, and I would like to describe this in a bit more depth.

    Money as a Motivator

    June 18, 2010 message from Bill Ellis [bill.ellis@furman.edu]

    Daniel Pink - Drive
    http://www.youtube.com/watch?v=u6XAPnuFjJc

    Bob,

    Here’s Daniel Pink’s latest book. This time he presents theories on motivation. This clever YouTube clip is a great animation explaining a point made in the book.

    Bill Ellis, CPA, MPAcc
    Furman University
    Accounting UES
    864-908-4743
     

    June 19, 2010 reply from Bob Jensen

    Hi Bill,

    What a great animation video that makes such good points about compensation.

    By the way, this animated video reminds me of why BYU’s variable-speed videos are so successful for teaching basic accounting --- http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#BYUvideo 

    Bob Jensen


    The Price of Perfection:  That Straw That Saved the 10 Millionth Camel's Back 
    Contemplate the flip side of my argument. A 100 percent safe car is impossible to build. As a manufacturer approaches 100 percent safety, the manufacturing costs increase exponentially. The real question is what is the customer (or society) willing to pay for safety as it approaches 100 percent safe. Most consumers would be willing to pay $20,000 for a car that is 99.8 percent safe but not $100,000 for a car that is 99.9 percent safe. Are the customers wrong? How would they react to Washington bureaucrats telling them they had to pay an additional $80,000 for an incremental 1/10 of 1 percent of safety?
    Armstrong Williams, "Toyota’s Deadly Secret." Townhall, March 2, 2010 ---
    http://townhall.com/columnists/ArmstrongWilliams/2010/03/02/toyota%e2%80%99s_deadly_secret
    Jensen Comment
    I purchased a new Subaru in the Cash for Clunkers Program. I traded in my father's 1989 Cadillac that looked and ran like the day it was new. It accumulated 70,000 miles of absolutely trouble free driving. Now the Subaru cost me $19,700 plus some extras for heated seats and the extended warranty.

    Subaru is rated the most safe car in its class, but would I have done this deal if the trade-in price had been $87,000 for some added safety protection currently not available on new vehicles? Probably not, even though the old Cad I traded in did not even have air bags or various other safety features that are standard on a 2010 Subaru. Of course, up here we call it a rush hour traffic if we see two other vehicles on I-93 at 8:00 a.m. or 6:00 p.m.

    This begs the question of how much we should be forced to pay for epsilon improvements in safety? Of course I'm not talking about unsafe cars that lurch ahead uncontrollably or have defective braking systems. But my old Cad was extremely tried and true with respect to not having such severe safety hazards. In fact, the sheer complexity of my new Subaru with all its computerized controls of almost everything make it more of a risk in some ways as I drive to the village for milk and bread or a hair cut.

    This also applies to costs of production of goods and services. Some medical procedures now cost ten times more than in 1990 for safety benefits that may only save one life out of ten million people. It certainly seems worth it if you're life is the one saved, but in the grand scheme of things is this added protection really a luxury that society can no longer afford? The same question might be raised about many of the current OSHA requirements for working Americans. How many wannabe workers cannot find jobs because of more stringent OSHA requirements?

    Up here in the mountains, a small construction company that does a lot of building repair work laid off all of its full-time workers because of the cost of Workmen's Compensation Insurance. The former workers became "independent contractors" who now negotiate their own fees and no longer have benefits like employer-paid health insurance. Outsourced workers are paid by the job rather than the hour such that they, in turn, sometimes take more safety risks in their rush to finish jobs quickly.

    From The Wall Street Journal Accounting Weekly Review on May 11. 2012

    Toyota's Profit, Outlook Soar as Full Production Recovers
    by: Yoshio Takahashi
    May 09, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Earning Announcements, Earnings Forecasts, Fixed Costs, Foreign Currency Exchange Rates, Variable Costs

    SUMMARY: "Buoyed by a five-fold surge in net income in the fiscal fourth quarter and a return to full production capacity, an upbeat Toyota Motor Corp. on Wednesday forecast a doubling of profits in the current fiscal year through March 2013."

    CLASSROOM APPLICATION: The article is useful in both financial and managerial accounting classes, or an MBA class, to combine topics in these two areas. Specific topics addressed are quarterly versus full year results, management guidance and earnings forecasts, fixed costs in heavy industries such as automobile manufacturing, and (for more advanced students) the impact of foreign currency exchange rates on operating results.

    QUESTIONS: 
    1. (Advanced) Access the announcement of financial results for the fiscal year ended March 31, 2012, available on the SEC web site at http://www.sec.gov/Archives/edgar/data/1094517/000119312512220104/d335606dex991.htm#toc. What does Toyota management say about its results for that year?

    2. (Introductory) Compare the discussion of annual results with the description in the WSJ article. On what information does the author focus analysis of results?

    3. (Introductory) Describe how the graphic related to the article summarizes the focus described in your answer above.

    4. (Advanced) Refer again to the filing by Toyota Motor Corp. What factors influenced output of automobiles in 2011 and 2012?

    5. (Advanced) Consider the nature of automobile manufacturing, typically described as heavy manufacturing. How does reduced output impact companies in this industry? Why does returning output to "normal" provide significant profit increases? In your answer, define the terms fixed and variable costs.

    6. (Introductory) Again refer to the Toyota Motor Corp. SEC filing. What management guidance about future sales and profits does the company provide?

    7. (Advanced) Why does the company have to state that the forecasted information is "...based on the assumption the dollar will average ¥80 and the euro ¥105 during the period"? Specifically describe the effect that different exchange rates might have on these expected results of operations.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Toyota's Profit, Outlook Soar as Full Production Recovers," byYoshio Takahashi, The Wall Street Journal, May 9, 2012 ---
    http://blogs.wsj.com/drivers-seat/2012/05/09/toyotas-profit-outlook-soar-as-full-production-recovers/?mod=djem_jiewr_AC_domainid

    Buoyed by a five-fold surge in net income in the fiscal fourth quarter and a return to full production capacity, an upbeat Toyota Motor Corp. on Wedneday forecast a doubling of profits in the current fiscal year through March 2013.

    Japan’s largest car maker by volume recorded a net profit of ¥121.0 billion ($1.51 billion) in the three months ended March, up from ¥25.4 billion a year earlier, marking the first quarterly growth in six quarters. The result beat analysts’ estimates for ¥112.9 billion net profit in a poll compiled by data provider FactSet.

    The company sees its net profit more than doubling to ¥760 billion in the current fiscal year through March. In the just-ended fiscal year, Toyota’s net profit dropped 30.5% to ¥283.56 billion. Sales for this fiscal year are seen rising 18.4% to ¥22.000 trillion, while operating profit is expected to nearly triple to ¥1.000 trillion.

    The upbeat outlook comes after a series of difficult challenges for Toyota over the last few years, including high-profile quality-control issues and natural disasters at home and abroad. The Japanese company ceded the title of world’s biggest auto maker to General Motors Co. last year.

    “In recent years, we have suffered periods of hardship,” said Toyota President Akio Toyoda at a press conference. “This year, I am determined to show tangible results of all our internal efforts,”

    The outlook for the fiscal year is based on the assumption the dollar will average ¥80 and the euro ¥105 during the period, compared with ¥79 and ¥109 in the previous 12 months.

    The marginally higher dollar rate for this fiscal year will slightly ease the pressure of the strong yen on its bottom line.

    But with the car maker in the midst of drive to increase exports from Japan to make up for lost production last year, Toyota Chief Financial Officer Satoshi Ozawa warned that sensitivity to any fluctuations in the dollar will rise this fiscal year.

    Each weakening of the dollar by one yen, will cut the company’s operating profit by ¥35 billion this fiscal year, larger than ¥32 billion in the last fiscal year, he said.

    Toyota joins Honda Motor Co. in projecting a substantial turnaround in the current fiscal year, underscoring how Japan’s auto industry aims to win back customers lost to U.S., German and South Korean rivals.

    Honda, Japan’s third biggest car maker by volume, in late April reported a 61% jump in net profit and said it expects its net profit to more than double to ¥470 billion for this fiscal year.

    Analysts expect Nissan Motor Co. to join its two major local rivals in forecasting a bright profit outlook when it releases January-March results and its projection for the year on Friday.

    Continued in article

    "The Prius V and Its Entune System," by David Pogue, The New York Times, May 3, 2012 ---
    http://pogue.blogs.nytimes.com/2012/05/03/the-prius-v-and-its-entune-system/

    When our 12-year-old minivan finally gave up the ghost, it was time to go car shopping.

    I didn’t want another minivan; driving around a gas-guzzling seven-seater didn’t make much sense when 98 percent of my trips involve one child and one driver. I definitely didn’t want an S.U.V.; in the 18 years I’ve lived in Connecticut, I have yet to encounter a flash flood or a sudden mountain on the way to the grocery store. Yet I wanted something roomier than my beloved Honda Fit. I love it, but two of my three children are now teenagers, so it has become a tight Fit indeed.

    I finally settled on the brand-new Prius V, which is an enlarged Prius.

    Toyota’s always been the leader in hybrid motors, and I’ve always loved the regular Prius. The Prius V (pronounced “vee,” not “five”) is something like a crossover Prius. To my children’s delight, it has as much room as a small S.U.V.; the back seats offer 30 percent more space than the regular Prius, and they even recline.

    I think it’s a great-looking car, too; Toyota finally eliminated the stupid support bar that used to block the back window. And the ride is perfect.

    Of course, you’re not going to go zero to 60 in five seconds in this car. But it gets 44 miles a gallon and produces one-tenth the pollution of a regular car, which makes me very happy.

    Best of all (for a technophile like me), the Prius V is the first Toyota to incorporate a new electronics system, Entune. The concept is brilliant; the dashboard touch screen offers buttons for apps like Bing, Traffic, Weather and Pandora radio that connect to the Internet through your phone. It works with iPhone or Android phones, as long as you’ve downloaded the necessary Entune phone app and signed up for a free account.

    For days, though, I couldn’t get the system to work. I’d paired my iPhone with the car’s Bluetooth system in seconds, so I could play music and make phone calls wirelessly with no problem at all. (A nice touch: your Bluetooth music fades and pauses when you get a phone call, even when you’re not sending the phone call through the car’s sound system.) But whenever I tried to use one of the car’s apps, I got a message that said something like, “No connection to the Internet.”

    It took some Googling to unearth the bizarre glitch. The Prius can see the Internet connection only when the iPhone is wired to the dashboard’s USB jack. It can’t connect over Bluetooth. (Android phones, on the other hand, work wirelessly.) Toyota indicates that it will fix that iPhone-specific shortcoming shortly.

    Once the problem was solved, though, I saw the potential instantly. Once I entered my Pandora name and password, I could tune in to any of my custom-made “radio stations” as I drove (with a watchful eye on my monthly Verizon data limit, of course). I could see the gas prices of nearby gas stations right on my dashboard, without having to pull off the highway.

    Wildest of all, Entune works with the car’s GPS system. Whenever it’s guiding you to a destination, it uses your phone’s Internet connection to download traffic data, and it spots coming traffic jams before you do. Suddenly, the dashboard screen might say, “Traffic jam in 2.1 miles, average speed 10 m.p.h.” You’re offered two buttons: Accept and Detour. That’s right; with one tap on the screen, you can direct the Prius to find its own way around the traffic jam.

    Continued in article

     


    Question
    What are the two manufacturing models (old versus new) attributed to Japanese creativity?

    Hint
    The older creative model is sometimes called the Kanban Model. Instead of having a linear manufacturing model invented by Henry Ford, the "line" is really a grouping of U-shaped work stations containing something where workers are trained to take over for each other on any work station inside the U. Hence a special feature is that there is less likely to be a major slow down at bottlenecks in Henry Ford's original line. The U-Shaped stations are often grouped in parallel lines to reduce the bottleneck risk even further.

    The Japanese model also consisted of the concept of Just-In-Time inventory in which the raw material needed for production arrives at the plant, in theory, at the instant it is needed on the line. Hence huge cushions of raw material are no longer needed --- http://en.wikipedia.org/wiki/Just-in-time_(business)
    However, JIT does not always work as well in the U.S. as it does in Japan. Firstly, the suppliers and buyers of raw materials are much more closely related in Japan's virtual men's club of business systems. Secondly, Japan is much smaller than the United States and has a much, much more efficient freight train service that overcomes trucking road jams. Manufacturers have much greater trust that raw materials really will arrive on schedule.

    The JIT system, if successful, changes cost accounting as well as costs themselves. The costs of carrying inventory (especially financing costs) are almost eliminated.

    But the Kanban is much, much more ---
    http://en.wikipedia.org/wiki/Kanban

    The Kanban is also important because it led to innovations in cost accounting and managerial accounting in general. Most importantly the Japanese were innovative in accounting for the costs of poor quality or quality control breakdowns.

    The "new" Japanese manufacturing model is featured in the case below:

    Teaching Case
    From The Wall Street Journal Accounting Weekly Review December 3, 2009

    Sharp's New Plan Reinvents Japan Manufacturing Model
    by Daisuke Wakabayashi
    Dec 01, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Cost Accounting, Fixed Costs, Just-In-Time Inventory Management

    SUMMARY: In Sakai city, Sharp has just opened, six months early, the most expensive manufacturing site ever built in Japan. "Even Sharp...acknowledged that the company only gave the green light to proceed during a boom period for LCD-panel demand, and that a similar choice might not be made in today's market." Two factors are expected to reduce costs of operations at the site: One is the size of the glass used to make the LCDs. Sharp is using the industry's biggest...which allow the company to produce 18 40-inch LCD panels from a single substrate-more than double the eight 40-inch panels per sheet it uses at its other LCD television panel-making factory. The other factor: Sharp has [moved] suppliers on site [in] a kind of hyper-"just-in-time" delivery system."

    CLASSROOM APPLICATION: The article can be used to cover just in time and other manufacturing cost issues in management or cost accounting.

    QUESTIONS: 
    1. (Introductory) What is the Japanese manufacturing model referred to in the headline?

    2. (Advanced) In general, how do just-in-time systems help to save costs in any manufacturing facility?

    3. (Introductory) How has this model been changed by the factory built by Sharp? Why does the author call it a "hyper-'just-in-time' delivery system?

    4. (Advanced) What savings from economies of scale, besides the just-in-time system, are Sharp executives hoping to obtain from the new manufacturing plant?

    5. (Advanced) What risks are evident in Sharp's decision to invest in technology in Japan rather than spend funds on labor elsewhere? In your answer, comment on the risks of high fixed costs in economic downturns.

    Reviewed By: Judy Beckman, University of Rhode Island

    "Sharp's New Plan Reinvents Japan Manufacturing Model," by Daisuke Wakabayashi, The Wall Street Journal, December 1, 2009 --- http://online.wsj.com/article/SB10001424052748704498804574559820344775310.html?mod=djem_jiewr_AC

    Sharp Corp.'s new production complex in western Japan is massive by any measure: It cost $11 billion to build and covers enough land to occupy 32 baseball stadiums. But it carries a meaning as large as its physical size. It's a litmus test for the future of Japanese high-tech manufacturing.

    The facility, considered the most expensive manufacturing site ever built in Japan, started churning out liquid-crystal display panels last month, and Sharp's new flagship televisions featuring the energy-efficient LCD panels go on sale in the U.S. next month. Sharp moved forward the factory's planned opening by six months, saying the new plant would help it be more competitive.

    "When you look to the next 10 or 20 years, the existing industrial model doesn't have a future," Toshihige Hamano, Sharp's executive vice president in charge of the Sakai facility, said in an interview. "We had to change the very concept of how to run a factory."

    Located in Sakai city along Osaka prefecture's waterfront, the complex represents Japanese industry's biggest gamble in LCD panels to remain competitive with rivals from South Korea, Taiwan, and China.

    The factory's size accommodates two main factors. One is the size of the glass used to make the LCDs. Sharp is using the industry's biggest, or "10th generation," sheets, which allow the company to produce 18 40-inch LCD panels from a single substrate—more than double the eight 40-inch panels per sheet it uses at its other LCD television panel-making factory.

    The other factor: Sharp has decided to try and cut costs by moving suppliers on site, a kind of hyper-"just-in-time" delivery system.

    The plant currently employs 2,000 people—roughly half from Sharp and half from its suppliers—although the work force will ultimately reach 5,000 as it adds production of solar panels as well.

    It remains to be seen whether it makes sense for Sharp to keep seeking ever more-sophisticated production in Japan, or, as competitors have, to simply use less advanced production techniques at lower costs in places like China.

    CLSA research analyst Atul Goyal warned in a report last month that the company is making a mistake by "chasing technology" with the new factory.

    In the past, such efforts by Japanese electronics makers have resulted in costly capital investments, only to be confronted with limited appetite for cutting-edge technology and then eventually outflanked by a cheaper alternative.

    Even Sharp's Mr. Hamano acknowledged that the company only gave the green light to proceed during a boom period for LCD-panel demand, and that a similar choice might not be made in today's market.

    Rival Samsung Electronics Co. has said it is looking into building a new LCD-panel factory using even bigger glass sheets than Sharp, while LG Display Co. has said it plans to build a new factory in China using current glass size.

    Sharp announced the Sakai project two years ago when LCD demand was surging and the company had produced five straight years of record profit. When consumer spending ground to a halt in late 2008, Sharp didn't cut costs and curb production quickly enough. Saddled with excess inventory, Sharp posted the first annual loss in nearly 60 years in the fiscal year ended March 31, 2009.

    The experience taught Sharp a painful lesson that its supply chain needed to be leaner and its production more efficient, especially if the factory was going to be in Japan, where the strong yen and expensive labor force put the company at a disadvantage to its Asian competitors.

    Sharp aims to streamline the costly LCD-panel production process by moving 17 outside suppliers and service providers inside its factory walls to work as "one virtual company."

    In the past, Sharp kept suppliers within driving distance. Now they are all within the same facility. Supplies are sent not by truck from a nearby factory but by automated trolleys snaking from one building to another.

    The suppliers, which include Asahi Glass Co. and Dai Nippon Printing Co., built and paid for their own facilities and are renting the land from Sharp.

    Despite their location inside the plant, Sharp says its suppliers are permitted to sell their products to other companies.

    At Sakai, Sharp has also linked its computer systems with suppliers so an order to the factory alerts suppliers right away. In the past, Sharp would email or call suppliers and place orders, creating a longer lag time.

    Sharp wouldn't disclose how much, if any, cost savings will result from manufacturing LCD panels at Sakai, but analysts estimate a 5% to 10% savings.

    Corning Inc. the world's largest maker of LCD glass substrates, built a factory next to Sharp's Sakai plant. Corning says the arrangement reduced total order cycle time from an average of one to two weeks to a matter of hours. Corning also says the proximity reduced the damage risk in transporting massive glass sheets on trucks.

    While Sharp is a long-standing customer, Corning said it was concerned initially that building a factory on site would mean that it was "hitching its wagon" to Sharp since it's the only customer for such large glass substrates. Ultimately, Corning decided to proceed based on its faith in Sharp's Sakai plans.

    "There's nothing like it anywhere," said James Clappin, president of Corning Display Technologies.

    December 5, 2009 reply from James R. Martin/University of South Florida [jmartin@MAAW.INFO]

    I have been working on MAAW's Japanese Management Section for about 15 years. For a considerable amount of material on JIT, Kanban, etc. see:http://maaw.info/JapaneseMain.htm

    See also: http://maaw.info/Chapter8.htm

     Bibilography, articles summaries, chapter on JIT,etc.

    James R. Martin


    CPV Teaching Case: Increases in Airline Capacity Stir Worries that Turnaround Will Stall
    That "Fixed Cost" that we seldom analyze properly in CPV teaching ases is far more complicated in the real world than in academe
    One complication arises when some prices/revenues rise much higher for some "excess" capacity
    Another complication arises where reductions in capacity may dynamically be more expensive to replace later on

    From The Wall Street Journal Accounting Weekly Review on October 1, 2010

    Increases in Airline Capacity Stir Worries that Turnaround Will Stall
    by: Susan Carey, The Wall Street Journal, September 25, 2010
    Click here to view the full article on WSJ.com  --- Increases in Airline Capacity Stir Worries that Turnaround Will Stall

    TOPICS: Cost Accounting, Cost Management, Managerial Accounting SUMMARY: "A hedge-fund executive whose firm is an active airline investor said he worries about three things [with respect to this industry]: a fuel spike, a double-dip recession, and 'somebody messing up this capacity story.'" The "capacity story" is that "U.S. airlines battled through some recent tough years by dramatically contracting to put a floor under prices and steer their way out of money-losing routes. [But] now that a turnaround is underway, they [the airlines] are growing again." CLASSROOM APPLICATION: The article may be used in teaching managerial and cost accounting topics in capacity and the theory of constraints. QUESTIONS: 1. (Introductory) Define capacity in general, as the concept applies to any industry.

    2. (Advanced) Define the following types of capacity: theoretical capacity, practical capacity, capacity demand, used capacity, and excess capacity.

    3. (Advanced) "Carriers want full flights, but not so full that they have to turn away high-yielding business travelers." Explain this statement using the terms for capacity defined above.

    4. (Introductory) How is capacity measured in the airline industry?

    5. (Advanced) What was the capacity problem while the airlines were losing "$58 billion in the past nine years"?

    6. (Introductory) How are airlines monitoring each others' behavior in terms of capacity?

    7. (Advanced) Specifically explain what the author means when she writes that airlines are "poring over investor guidance issued by their peers," including in your answer a definition of the term "investor guidance."

    Reviewed By: Judy Beckman, University of Rhode Island

    "Increases in Airline Capacity Stir Worries that Turnaround Will Stall," by Susan Carey, The Wall Street Journal, September 25, 2010 ---
    http://online.wsj.com/article/SB10001424052748703793804575511992849149902.html?mod=djem_jiewr_AC_domainid

    U.S. airlines battled through some recent tough years by dramatically contracting to put a floor under prices and steer their way out of money-losing routes.

    Now that a turnaround is underway, they are growing again. Airlines are taking deliveries of some new planes, flying their existing aircraft more hours per day and even some, like Delta Air Lines Inc., are bringing a few planes out of desert storage.

    This has led some investors and rival carriers to worry that the industry could drift back toward the problem that brought bankruptcies and massive losses earlier this decade: too many seats in the air.

    The reduction of seats offered and miles flown in the past couple of years erased a decade of industry growth and allowed airlines to raise fares while packing their planes fuller than ever. Passengers paid 14% more to fly a mile in August than they did a year earlier, and industry passenger revenue rose 17%, boosted by fees for services like checking bags that once were free.

    Consumers, frustrated by rising prices, new fees and packed planes, would welcome the return of the industry's old ways. "Flying is almost the new Greyhound bus," said Linda Greenberg-Hanessian, an anthropologist and jewelry designer in Hyde Park, Ill. "You're paying more for less. I can't remember a plane with an empty middle seat."

    But investors worry that carriers will quickly forget the lessons of the recession and add more seats than demand warrants. Carriers want full flights, but not so full that they have to turn away high-yielding business travelers. And they don't want to cede market share to rivals who are restoring growth more quickly than they are.

    All the big U.S. airlines are expected to report profits in the third quarter, amid rising ticket prices, moderate fuel costs and lower expenses after several years of ruthless cost cutting. In one sign that the industry is maintaining discipline, few new airplanes are on order, a reversal of the past, when recovery often triggered large new orders.

    Still, capacity, as measured by available seat-miles, or the number of seats offered by the distance they fly, is creeping back, with the smaller carriers leading the pack. The U.S. industry added 0.7% in domestic capacity in the second quarter, after more than two years of shrinkage, and an additional 3.4% in the current quarter, according to data compiled from published schedules by Innovata LLC for the Air Transport Association.

    Schedules indicate that the industry will raise domestic capacity by 2% in the fourth quarter, compared with a year earlier, and 3.2% in the first three months of 2011, the trade association said. International capacity by all airlines flying in and out of the U.S. is expected to rise 9.2% in the fourth quarter and 10% in the first quarter of next year.

    These additions have investors on edge. A hedge-fund executive whose firm is an active airline investor said he worries about three things: a fuel spike, a double-dip recession and "somebody messing up this capacity story."

    As long as each airline continues to exercise restraint, everybody benefits financially, said Douglas Runte, a managing director at Piper Jaffray & Co. "A rogue airline adding a lot of capacity individually benefits while diminishing results in aggregate," he said. "It also potentially spurs a competitive response by other airlines."

    Airlines habitually keep close tabs on each other, but the pursuit has taken on new urgency lately. Carriers are watching for signs that rivals are stepping up capacity in a way that could spoil newfound pricing power in an industry that lost $58 billion in the past nine years. They are plumbing public schedule data, poring over investor guidance issued by their peers and monitoring aircraft deliveries and retirements.

    Delta was the source of much consternation this summer. In July, it said it expected to boost its overall capacity, including that of its regional partners, by 5% to 7% in the fourth quarter. That is a much more robust forecast than those of its largest rivals, which caused Delta stock to swoon briefly. The company also took delivery of 15 new planes this year and is taking 10 of its aircraft out of temporary storage and returning them to service, further fanning the worry.

    Morgan Stanley airline analyst William Greene estimates that Delta's overall capacity will grow by 8% in the fourth quarter, based on its published schedule, he said in a recent research note.

    By contrast, Mr. Greene sees UAL Corp.'s United Airlines growing by 2% in the fourth quarter, and Continental Airlines Inc., AMR Corp.'s American Airlines and US Airways Group Inc. adding 4%.

    Delta said it cut capacity in the 2009 fourth quarter much more deeply than its rivals and is simply rectifying its mistake. The Atlanta-based carrier, the world's largest by traffic, said it expects its 2010 fourth-quarter capacity to be 2% to 4% lower than the same quarter in 2008. And it intends to grow just 1% to 3% in all of 2011.

    The company, which merged with Northwest Airlines in 2008, still foresees ending 2010 with a net 91 fewer aircraft than it had at the start and is planning to cull another 20 or 30 planes next year.

    "The merger has allowed us to become more efficient," Hank Halter, Delta's chief financial officer, said in an interview. "We remain very diligent about capacity discipline."

    United Airlines has been one of the most conservative airlines on the capacity front. Still, some rivals griped when it put a retired 747 back into service over the summer. But the big plane served only as a spare and will be leased to another airline this fall to fly outside of the U.S.

    Bob Jensen's threads on managerial and cost accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#ManagementAccounting


    Five Online Managerial Accounting Cases

    Our AECM friend Richard Sansing (Dartmouth) provides four of his own managerial accounting cases free on the Web. I found them linked at the AAA Commons at http://commons.aaahq.org/posts/c989f70fc8
    I commend Richard for open sharing, but I request that in the future that he save these files as htm or pdf files instead of doc files. It makes many of us nervous to download doc files to a Windows machine because of possible macro viruses, although in this case I'm not at all worried.

    Users might get especially high on the sour mash case.

    Richard also shares his managerial accounting syllabus (as a pdf file) at http://commons.aaahq.org/posts/8bf3b52bb2

    Thank you for sharing Richard.
     

    Below is another managerial accounting case shared by the WSJ.

    From The Wall Street Journal Accounting Weekly Review on February 5, 2010
    Teaching Case for Cost-Profit-Volume Analysis and Foreign Currency

    Nintendo Net Falls Despite 'Robust' Holiday Sales
    by: Daisuke Wakabayashi
    Jan 28, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Contribution Margin, Cost-Volume-Profit Analysis, Financial Accounting, Financial Statement Analysis, Fixed Costs, Managerial Accounting, Ratios, Variable Costs

    SUMMARY: Nintendo Co. said year-end holiday sales were "robust," suggesting that its Wii game console had regained its footing after a slowdown in demand, though a strong yen and price cuts continued to push down the company's profit. To cope with slowing demand for the Wii, Nintendo cut prices by 20% to $200 ahead of the holiday shopping season. Revenue also suffered from a strengthening of the yen against the euro and U.S. dollar, resulting in lower overseas income when converted into yen terms.

    CLASSROOM APPLICATION: The example in this article offers a case study in the analysis of pricing, volume, variable costs, and financial statement analysis. It also offers an example of how foreign currency exchange rates can affect profitability. Nintendo's decision to decrease pricing generated more volume, but profitability decreased. Students will see how decision-making can come to life with this real-life, current case study.

    QUESTIONS: 
    1. (Introductory) Please explain contribution margin analysis. How does it work, and what value does it offer? What are the differences between a conventional income statement and a contribution margin income statement?

    2. (Introductory) Use the contribution margin analysis and income statement to show what happened with Nintendo's financial results. How were variable and fixed costs affected in Nintendo's plan? What does the contribution margin income statement illustrate that is not as evident in a regular income statement?

    3. (Introductory) What is cost-volume-profit analysis? What are some of the tools? What valuable information can a manager gain from this type of analysis? Apply CVP analysis tools to the Nintendo situation. What are some of your observations?

    4. (Advanced) What financial statement analysis tools or ratios could Nintendo management use to analyze the causes for the decrease in profitability? How could management use these tools to make changes and forecasts for the future?

    5. (Advanced) What non-financial performance measures should management use to analyze company performance? What competitive factors should they be considering? What do you project for the future of the industry? How should your projections be integrated into Nintendo's planning, forecasting, and management?

    6. (Advanced) How is it that a firm can increase its sales volume, but experience a decrease in profitability? What steps can managers take to insure that increased profitability results increases in sales volume? Was there anything Nintendo management should have done differently? What should they do for the future?

    7. (Advanced) Why would management decide to cut the price of its product? What results was management hoping to achieve? What other factors are at play that could hinder that goal?

    8. (Advanced) What is the impact of the foreign currency exchange rates on Nintendo's profitability? Under what conditions do exchange rates increase profitability? In what ways could they hurt profitability? How could international firms manage this risk?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Nintendo Net Falls Despite 'Robust' Holiday Sales," by Daisuke Wakabayashi, The Wall Street Journal, January 28, 2010 ---
    http://online.wsj.com/article/SB10001424052748704878904575030403095545036.html?mod=djem_jiewr_AC_domainid

    Nintendo Co. said year-end holiday sales were "robust," suggesting that its Wii game console had regained its footing after a slowdown in demand, though a strong yen and price cuts continued to push down the company's profit.

    Nintendo said group net income was 192.6 billion yen ($2.14 billion) for the nine months ended Dec. 31, down 9.4% from a profit of 212.52 billion yen a year earlier. Revenue fell 23% to 1.182 trillion yen, while operating profit fell 41% to 296.66 billion yen.

    To cope with slowing demand for the Wii, Nintendo cut prices by 20% to $200 ahead of the holiday shopping season. Revenue also suffered from a strengthening of the yen against the euro and U.S. dollar, resulting in lower overseas income when converted into yen terms.

    The Wii remains the top seller among the current generation of game consoles, outpacing sales of Microsoft Corp.'s Xbox 360 and Sony Corp.'s PlayStation 3. However, demand started to slow last year and competitors, especially Sony's PS3, are closing the gap.

    Nintendo had a strong holiday quarter boosted by the introduction of "New Super Mario Bros. Wii," which sold 10.6 million units world-wide after its November release.

    Hiroshi Kamide, analyst at KBC Securities, said Nintendo can expect brighter prospects with the release of software such as the new Mario Bros. game and coming sequels of game franchises such as "Zelda" and "Metroid" later this year.

    "It really demonstrates that once Nintendo puts out its own software, its fortunes turn around pretty quickly," Mr. Kamide said.

    For its fiscal year ending March 31, Nintendo said it will keep its current forecast for a net profit of 230 billion yen on revenue of 1.5 trillion yen. Analysts polled by Thomson Reuters are forecasting a full-year net profit of 226.52 billion yen.

    Nintendo on Thursday didn't release figures for the quarter ended Dec. 31, following the company's usual practice of not doing so until the day after releasing year-to-date figures. Based on Nintendo's results earlier in the fiscal year, its fiscal third-quarter results appear to have fallen from the year-earlier period but surpassed expectations of a profit of 120.5 billion yen from analysts polled by Thomson Reuters.

    The company kept its console sales targets unchanged for the year. It still aims for Wii sales of 20 million units. In the previous fiscal year, Wii sales totaled 26 million units.

    It expects Wii software sales to reach 192 million units in the fiscal year, compared with a previous estimate of 180 million, but Nintendo says the rise is the result of how it categorizes software it sells bundled with hardware versus a substantive difference in its view of the market.

    Nintendo's sales projection for DS handheld consoles is pegged at 30 million units, unchanged from the company's previous forecast. The company continues to expect DS software-title sales of 150 million units.


    From The Wall Street Journal Accounting Weekly Review on February 12, 2010

    Cost Cutting Boosts Profits
    by: Paul Vigna and John Shipman
    Feb 05, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Degree of Operating Leverage, Financial Accounting, Financial Statement Analysis, Fixed Costs, Horizontal Analysis, Managerial Accounting, Operating Leverage, Variable Costs

    SUMMARY: Fourth-quarter earnings for U.S. companies so far have rocked compared with a year ago. The question for this year: How much more can earnings improve? Despite modest sales growth, corporations have managed to craft their profit growth mainly through massive cost cutting. For the trend to continue, companies will need to drive the top line, and that looks to be a key challenge for an economy where demand is depressed, with at least 10% of the work force unemployed and another large swath underemployed. The S&P 500 companies are just breaking a string of nine-straight quarters of profit declines. Many are going to be reluctant to eat into that newfound earnings growth by ramping up the work force, given that compensation is one of the largest costs for any company.

    CLASSROOM APPLICATION: This article discusses increased profitability currently occurring in many businesses. Much of the gains in profitability have come from cost-cutting measures. Even with an increase in profitability, many firms are reluctant to hire as conditions improve because of continued uncertainty about the economy. The reporters offer a considerable amount of data and discussion to serve as a basis of a classroom discussion of financial statement analysis, horizontal analysis, and operating leverage.

    QUESTIONS: 
    1. (Introductory) What are the current conditions for many companies in the U.S.? What seems to be the main reason for increased profitability? What are some of the signs that the companies are doing better?

    2. (Advanced) What are some potential problems with a company's strategy to grow profitability through cost-cutting? What are the long-term prospects for success using this strategy?

    3. (Advanced) What information in the article leads you to believe that the economy is improving? What information indicates that the economy will be affected, at least for a while?

    4. (Introductory) What is financial statement analysis? What is horizontal analysis? What information provided in the article uses either of these two types of analyses?

    5. (Advanced) What are fixed costs? What are variable costs? Is labor a fixed cost or a variable cost? Why? In what situations could it be either or both? How can a company structure its hiring to help the business in these types of economic conditions?

    6. (Introductory) What is operating leverage? How is degree of operating leverage calculated? How is degree of operating leverage used in management decision-making? How are companies using it in the article?

    7. (Advanced) Why are companies reluctant to increase hiring? How does hiring figure into business risk? What will have to happen before companies will feel confident to hire freely again?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Cost Cutting Boosts Profits," by: Paul Vigna and John Shipman, The Wall Street Journal, February 5, 2010 ---
    http://online.wsj.com/article/SB10001424052748704041504575045373947332854.html?mod=djem_jiewr_AC_domainid

    Fourth-quarter earnings for U.S. companies so far have rocked compared with a year ago. The question for this year: How much more can earnings improve?

    Among those posting results thus far, the melody has been sweet. Financial-services companies Visa Inc. and MasterCard Inc., for instance, reported profits rose 33% and 23%, respectively, over a year ago. Earnings overall are running well ahead of last year's dreadful fourth quarter.

    Through Wednesday, with 280 members of the Standard & Poor's 500 index reporting, operating earnings rising sharply, but the year-ago quarter was the first time the group as a whole ever lost money. Excluding financial companies, earnings are up about 47%. Sales gains are more muted, up only 5.9% for S&P 500 companies thus far, and expected to rise about 0.9% from the year-earlier quarter. That doesn't even match the current inflation rate.

    Perhaps most heartening about the quarter's results is that sales are on track to break a string of four consecutive double-digit-percentage declines. Still, the projected increase is well below the average 3.95% gain since 1994, according to S&P.

    Despite modest sales growth, corporations have managed to craft their profit growth mainly through massive cost cutting. For the beat to continue, companies will need to drive the top line, and that looks to be a key challenge for an economy where demand is depressed, with at least 10% of the work force unemployed and another large swath underemployed.

    "Until nonfinancials [corporations] see sustained sales growth, they will not be hiring, and that is the whole ballgame," said Howard Silverblatt, S&P's senior index analyst.

    For 2009, S&P 500 members should see sales down about $1.1 trillion, or 13% from the prior year. For the fourth quarter, sales are expected to total about $2.05 trillion, which gets the group back to the level of the first quarter of 2006. In other words, the intense recession has set sales of the nation's 500-largest companies back nearly four years.

    The S&P 500 companies are just breaking a string of nine-straight quarters of profit declines. Many are going to be reluctant to eat into that newfound earnings growth by ramping up the work force, given that compensation is one of the largest costs for any company. Automated Data Processing Inc. said it is hiring new sales staff, even though it expects that to be a drag on earnings for at least a year.

    Cisco Systems Inc. came out with the boldest outlook this earnings season, pegging sales growth around 25% and announcing it will hire 2,000 to 3,000 new people to help it handle its growing business. Not many companies have outlined such a bullish near-term view.

    Unfortunately, more companies, including Verizon Communications Inc., Wal-Mart Stores Inc. and Diebold Inc., continue to pare workers. And Bristol-Myers Squibb Co. this week froze employee salaries world-wide for 2010.

    And beyond just the profit motive, questions remain about the strength and durability of any recovery. It's telling that both MasterCard and Visa are taking a guarded approach to 2010.

    "We continue to be cautious about the health of the consumer," MasterCard Chief Executive Robert Selander said on Thursday. Agreed Visa Chief Executive Joseph Saunders: "Any recovery will take time and we'll likely have a few bumps along the way," and added, "A complete turnaround in the U.S. will arguably take even longer."


    "Beware Misguided Accountants," by Gary Cokins, Big Fat Finance Blog, December 1st, 2009 ---
    http://bigfatfinanceblog.com/2009/12/01/beware-misguided-accountants/

    . . .

    Imagine that several centuries ago there was a navigator who served on a wooden sailing ship that regularly sailed through dangerous waters. It was the navigator’s job to make sure the captain safely and efficiently sailed the ship from one point to another. In the performance of his duties, the navigator relied on a set of sophisticated instruments. Without the effective functioning of these instruments, it would be impossible for him to chart the ship’s safest and most efficient course.

    One day the navigator realized that one of his most important instruments was calibrated incorrectly. As a result, he provided the captain inaccurate navigational information. No one but the navigator knew of this calibration problem, and the navigator decided not to inform the captain. He was afraid that the captain would blame him for not detecting the problem sooner and then require him to find a way to report the measurements more accurately. That would require a lot of work.

    As a result, the navigator always made sure he slept near a lifeboat so that if the erroneous navigational information led to a disaster, he wouldn’t go down with the ship. Eventually, the ship hit a reef that the captain believed to be miles away. The ship was lost, the cargo was lost, and many sailors lost their lives. The navigator, always in close proximity to the lifeboats, survived the sinking and later became the navigator on another ship.

    Perils of poor managerial accounting

    Can a similar story be told in today’s times? Centuries later, there was a management accountant who worked for a company in which a great deal of money was invested. It was this management accountant’s job to provide information on how the company had performed, its current financial position, and the likely consequences of decisions being considered by the company’s president and managers. In the performance of his duties, the management accountant relied on a managerial cost accounting system that was believed to represent the economics of the company. Without the effective functioning of the costing practices reported from this system, it would be impossible for the accountant to provide the president with the accurate and relevant cost and profit margin information he needed to make economically sound decisions.

    One day the management accountant realized that the calculations and practices on which the cost system was based were incorrect. It did not reflect the economic realities of the company. The input data was correct, but the reported information was flawed. A broadly averaged cost allocation factor was used with no causal relationship to the outputs being costed. As a result, the current and forward-looking information he provided to support the president’s decision making was incorrect. No one but the management accountant knew this problem existed. He decided not to inform the president. He was afraid that the president would blame him for not detecting the problem sooner and then require him to go through the agonizing effort of developing and implementing a new, more accurate and relevant cost system using activity based costing (ABC) principles. That would require a lot of work. Wouldn’t it?

    Meanwhile, the management accountant always made sure he kept his network with other professionals intact in case he had to find another position. Not surprisingly, the president’s poorly informed pricing, investment, and other decisions led the company into bankruptcy. The company went out of business, the owners lost their investment, creditors incurred financial losses, and many hard-working employees lost their jobs. However, the management accountant easily found a job at another company.

    The accountant as a bad navigator

    Why do so many accountants behave so irresponsibly? The list of answers is long. Some believe the costing error is not that big. Some think that extra administrative effort required to collect and calculate the new information will not offset the benefits of better decision making. Some think costs don’t matter because the focus should be on sales growth. Whatever reasons are cited, accountants’ resistance to change is based less on ignorance and more on misconceptions about what determines and influences accurate costing.

    Today commercial ABC software and their associated analytics have dramatically reduced the effort to report good managerial accounting information, and the benefits are widely heralded. Furthermore, the preferred ABC implementation method is rapid prototyping with iteratively scaled modeling, which has destroyed myths about implementing ABC as being too complicated and lengthy. An ABC system can be implemented in a few weeks, not months.

    Reasonably accurate cost and profit information is one of the pillars of performance management’s portfolio of integrated methodologies. Accountants unwilling to adopt logical costing methods, and managers who tolerate the perpetuation of flawed reporting, should change their ways. Stay on the ship or get off the ship before real damage is done.


    "ICMA Announces Reorganization of Certified Management Accountant (CMA) Exam," SmartPros, December 2, 2009 ---
    http://accounting.smartpros.com/x68295.xml

    The Institute of Certified Management Accountants (ICMA), the certification division of the Institute of Management Accountants (IMA), today announced a significant reorganization of its renowned Certified Management Accountant (CMA) curriculum and examination format.

    The CMA exam, which continues to be a career-enhancing credential valued and sought by employers, will be updated next spring to align even more closely with the critical knowledge and skills accountants and financial professionals use every day.

    By focusing specifically on a body of advanced accounting and financial knowledge, the program will now consist of two exam parts rather than four. The updated exam’s subject matter places greater emphasis on the issues most critical to accountants and financial professionals in business, including financial planning, analysis, control and decision support.

    “The new CMA program will maintain the rigor and relevance for which the CMA is highly regarded. At the same time, we have made changes to the program to adapt to the changing profession and the needs of today’s business professionals,” said ICMA Senior Vice President Dennis Whitney.

    With more than 30,000 CMA certificates awarded to date, the CMA program continues to demonstrate its value to professionals. In fact, according to IMA’s 2008 Annual Salary Survey, members holding the CMA designation earned an average of 24 percent more in salary than their non-certified peers.

    “We are confident the enhancements to the CMA program will ensure the credential’s continued relevance and value in organizations around the world as the most appropriate designation for accountants and financial professionals working in business,” said Joseph A. Vincent, CMA, ICMA Board of Regents Chair.

    In tandem with the introduction of the new CMA program, the association also introduced new IMA and CMA brand logos.

    Enrollment in the new CMA program will begin in spring 2010. Candidates may take the new CMA examinations starting May 1, 2010. For more information about the CMA certification program, please visit www.imanet.org/certification 

    December 15, 2009 reply from Jagdish Gangolly [gangolly@GMAIL.COM]

    I think CMA ceased to be the premier certification in Management Accounting decases ago. Compare the CMA stuff with the syllabus of CIMA, which I would guess, has been the premier certification for quite a while.

    http://www1.cimaglobal.com/cps/rde/xchg/SID-0AE7C4D1-AC0D32F8/live/root.xsl/1282.htm 

    If you are looking for breadth, look at the syllabus of the Indian Institute (AICWA)

    http://www.icwai.org/icwai/docs/syllabus-2002.pdf 

    IMA is probably more interested in being popular and populous than in being the hallmark of quality.

    They probably hold the exams inn Canada, but I am not sure. They hold them probably in many commonwealth countries.

    In the US, management accounting has been decimated over the past 35 years or so, in my humble opinion, due to the privileging of "descriptive" research and de-privileging of normative research. And over the years, most normative tools have become foreign to management accountants.

    The fact that the flagship journal of CMAs is called "Strategic Finance" tells it all.

    Jagdish S. Gangolly Department of Informatics College of Computing & Information State University of New York at Albany Harriman Campus, Building 7A, Suite 220 Albany, NY 12222 Phone: 518-956-8251, Fax: 518-956-8247

    December 16, 2009 reply from Bob Jensen

    I will be brief at this point and quibble mostly with respect to terminology.

    Much of the management accounting research, especially ABC and ABM research, has been case method research for which Cooper and Kaplan are probably best known in their Harvard cases. The seminal contributions (such as the ABC idea at John Deere) were usually rooted in industry rather than academe, but academe played a lot of kick-the-can forward with these ideas.

    Case method research is generally more than normative research. When applied to real world settings, case method is also a form of empiricism but usually based on small samples (e.g., one application). Case method is a curious combination of normative, empirical, field research, and anecdotal methodology. It’s key advantage over large-sample studies lies in its ability to deal with variables that are impossible or impractical to quantify in mathematical/statistical models. The drawback of case method is that it almost never casts off our doubts about being anecdotal.

    Sometimes academics keep kicking a can too far. For example, ABC costing lost a lot of its initial hype in industry but not in academe. It appears that ABC costing just did not pass the benefit cost tests in many proposed applications in the real world. Perhaps it was just a formalized and expensive way of telling managers what they already knew in many such instances.

    Another example of an idea that just does not seem to pass the benefit-cost test in practice is the idea of Real Options capital budgeting. I was in Stanford’s doctoral program with a finance student, Stu Meyers, who subsequently had the seminal ideal for Real Options capital budgeting.

    The term "real options" can be attributed to the Stewart Myers ("Determinants of Capital Borrowing", Journal of Financial Economics, Vol..5, 1977). The theory of real options extends the concept of financial options (in particular call options) into the realm of capital budgeting under uncertainty and valuation of corporate assets or entire corporations.

    The real options approach is dynamic in the sense that includes the effect of uncertainty along the time, and what/how/when the relevant real options shall be exercised. Some argue that real options do little more than can be done with dynamic programming of investment states under uncertainty, real options add a rich economic theory to capital investing under uncertainty.

    The real options problem can be viewed as a problem of optimization under uncertainty of a real asset (project, firm, land, etc.) given the available options. Since I was once asked to teach a bit about real options theory while I was lecturing years ago at Monterrey Tech, I thought I might share a bit of my source material that I discovered on the Web. http://faculty.trinity.edu/rjensen/realopt.htm 

    I think that in many possible applications in real world capital budgeting situations, real options just do not pass the benefit-cost tests or deep market tests. My work in the above document is very dated at this point in time, and readers should note that I have not attempted to keep this document up to date.

    Academics want the CMA examination to be an academic examination even for ideas that seemingly fail the benefits-costs test in practice. The IMA is leaning, in my viewpoint, toward a more professional and less academic exam.

    As for me, I’m too out of this loop to pass judgment on the changes being made in the CMA examination. I think in the early days, the CMA was more of an academic examination.

    Bob Jensen

    December 16, 2009 reply from Ron Huefner [rhuefner@ACSU.BUFFALO.EDU]

    As the holder of CMA certificate number 2, let me weigh in on this discussion.

    In my view, the CMA has never caught on among students and young professionals, because it does not convey an image of any particular skill set or employment role, relative to other non-CPA certifications. The Certified Internal Auditor (CIA), Certified Fraud Examiner (CFE) and Chartered Financial Analyst (CFA) all convey the image of a particular set of skills and a fairly well defined job function. But I'd find it hard to define the skill set suggested by the CMA. As to job function, "management accountant" is not a common job title. Thus it's hard for students to get any feel for this field.

    The IMA has had the same problem of conveying an image. They have toyed with "finance" as their image. They gave a CMA-parallel exam -- the CFM, Certified in Financial Management -- for a while, but eventually dropped it. The flagship journal, "Management Accounting", was long ago renamed "Strategic Finance." But it's not clear this has solved their image problem. Nor does it seem they are viewed seriously as a finance organization.

    Part of the problem is that there is an extremely wide range of job functions under the notion of "management accounting," so it is hard for a clear image to come through.

    Until a sense of the implied skill set and the job function(s) of the CMA can be developed, I don't think it's going to get much traction among students.

    Ron Huefner

    Ronald J. Huefner
    Distinguished Teaching Professor
    University at Buffalo

    posted 11:58am by James R. Martin

     December 19, 2009 message from James Martin

    Comment:

    I placed a couple of the more convincing responses to my comments about the CMA format change on MAAW's Blog and MAAW's Home Page. These responses are from two members of the ICMA board who I know and respect. So, I recommend them to those of you who are concerned about the change.

    In response to Bob's comment above, I agree that the area of management accounting is very broad. I include sections and bibliographies for over 100 topics on the MAAW web site and I believe they are all related to management accounting. From my perspective, anyone who passed the old CMA (Five 3.5-hour) exams showed that they had the ability and background to learn how to perform just about anything corporate accounting could require. They might need more traning and experience, but they had the foundation. The old exams were available to those who wanted to study for the CMA, to those of us who teach management accounting, and to those who just wanted to evaluate the quality of the exams.

    After the ICMA changed the exam format to four exams (I think 13 hours) and the old exams were no longer made available, I was never sure about it's quality and value. I would like to get that old feeling back. So now I am going to take a wait and see approach to the CMA format change.

     


    Fraudulent Revenue Accounting
    "Detecting Circular Cash Flow:  Healthy doses of skepticism and due care can help uncover schemes to inflate sales," by John F. Monhemius and Kevin P. Durkin, Journal of Accountancy, December 2009 --- 
    http://www.journalofaccountancy.com/Issues/2009/Dec/20091793.htm

    Following an initial customer confirmation request with no response, a first-year auditor mails a second and third request, all under the supervision of the auditor-in-charge assigned to the account. Field work begins on the audit, but there is still no response from the customer. Another auditor scanning the cash journal from the beginning of the year through the current date notes that all outstanding invoices have subsequently been paid from this customer during this period. Customer check copies are provided, and remittances indicate that payment has been received in settlement of all outstanding invoices at fiscal year-end for this customer. But has the existence of accounts receivable from this customer at fiscal year-end really been established?

    Fraudsters have been creating increasingly complex and sophisticated schemes designed to rely on potential weaknesses in the execution of audit procedures surrounding key assertions such as existence. A financial statement auditor can use his or her professional judgment while carrying out audit procedures to detect such a scheme.

    Given the difficult economic times of the past year, special care should be given to consider fraud while performing audit engagements. One fraud scheme that has been encountered with increasing frequency involves the inflation of accounts receivable and sales through the creation of a circular flow of cash through a company to give the appearance of increasing revenue and existence of accounts receivable. This article addresses this fraud technique when used to materially overstate assets and inflate borrowing capacity under an asset-based revolving line of credit. This article also points out red flags that may help uncover such a scheme.

    BACKGROUND

    A typical asset-based revolving line of credit allows a company to borrow funds for working capital. The borrowing limit is based on a formula that takes into account various working capital assets and related advance rates. A typical availability formula allows for loan advances equal to a set percentage of asset balances.

    This article focuses on an accounts receivable- backed line of credit, an asset that is prone to manipulation in this specific fraud scheme. Typical advances against accounts receivable range from 75% to 85% of eligible accounts receivable. Items excluded from eligible collateral would include invoices aged over 90 days, affiliate receivables or any other invoice that would create a nonprime receivable from the lender’s perspective. The loan agreement in an asset-based loan facility requires management to submit an availability calculation periodically. This allows the lender to monitor collateral levels and exposure. A generic accounts receivable availability calculation is illustrated in Exhibit 1.

    Continued in article

    Bob Jensen's threads on revenue accounting frauds
    Revenue Reporting Frauds --- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Thank you for the heads up Francine!
    "Fifteen Risk Factors for Poor Governance A self-diagnostic to identify risk factors for poor governance and reporting," by Walter Smiechewicz (who at one time worked for the scandalous Countrywide), Directorship, September 8, 2009 ---
    http://www.directorship.com/fifteen-risk-factors-for-poor-governance/

    Some of the best indicators of our overall physical health come from blood tests. Unfortunately, too often we don’t begin to watch and manage these numbers until later on in life. Of course, it’s never too late to improve your diet and exercise, but we’re always left thinking, “if only I’d paid attention to this earlier.”

    With so many recent corporate crises, it is plain it’s suffice to say that a great many corporate board members and executives are experiencing similar regret right now. Perhaps this could have been avoided if they too had practiced routine diagnostic check ups. Like an individual blood test, board members need to know the risks their company is facing, and as with any health risk, they also need to be able to mitigate those exposures.

    Sounds great, but the devils in the details, right? Perhaps not.

    As chief consultant for governance and risk at Audit Integrity, I’ve examined the worst U.S. companies from an “integrity” standpoint in order to help board members and general auditors see how their company’s health stacks up. Audit Integrity’s metrics have shown which companies are 10 times more likely to face SEC Actions; five times more likely to face class action litigation; and four times more likely to face bankruptcy.

    Using Audit Integrity’s proprietary AGR (Accounting, Governance, and Risk) score, 196 companies were identified as laggards or high-risk companies. These companies have been proven to have higher odds of SEC actions and class action litigation, loss of shareholder value, and increased odds of material financial restatement and bankruptcy. All are North American, non-financial, publicly traded companies with over $2 billion in market capitalization with an average-to-weak financial condition.

    Next, I tested the 119 metrics that Audit Integrity flags and discovered that 15 of those metrics appeared consistently as identifiers of problematic companies; the first metric was prevalent in 65 percent of the 196 high-risk companies and the 11th evident in 40 percent. The other 8,000 companies tested had low incidences of these same metrics. A list – dubbed the Risky Business Catalogue – details the common metrics within high-risk companies. Board members, the C-suite, and general auditors should note if their company is a candidate for the RBC. The evidence is not saying that significant issues are imminent if a company has one of the RBCs, but a combination of RBC metrics indicate risk factors to the entity’s business model and strategy.

    RBC’s metrics include:

    1. The company has entered into a merger within the last 12 months. While there is certainly nothing wrong with corporate M&A activity, it’s common for policies to be revised and system integrations to be rushed. Company directors need to caution general auditors to be extra vigilant post merger and increase testing of balance sheet accounts.

    2. The CEO and CFO’s compensation is more highly weighted toward incentive compensation than base compensation. This situation can cause negative motivations and earnings to be increased more creatively to ensure a larger portion of executive pay packages. Close attention should be paid to revenue recognition.

    3. The Board Chairman is also the CEO. An age-old debate, but indispuditedly conflicts of interest invariably result when a company CEO is also its Chairman. Separate the roles to improve governance and reduce compromised oversight.Compromised reliability exists because the very architecture of governance has a built in conflict when the Chairman is also CEO.

    4. The company has undergone a restructuring in the last 12 months. Restructuring may be completely valid, but also can be employed to conceal the lack of sustainable earnings growth. Directors, by role definition, should be intimately involved in restructuring procedures decisions and promised outcomes.

    5. The company has encountered a public regulatory action in the last 12 months. Many corporate stakeholders hold true to the statement that where there’s smoke, there’s fire. Directors should no longer accept “no worries” explanations on regulatory matters. Compliance tests should be employed routinely and if regulatory action does occur, management needs to take action.

    6. The amount of goodwill carried on the balance sheet, when compared to total assets, is high. When intangible assets such as goodwill grow, boards should ask more probing questions about how the business model generated these assets and about concomitant valuation protocols. General Auditors should confirm that models are comprehensively back tested and impairment procedures are adhered to assiduously.

    7. The ratio of the CEO’s total compensation to that of the CFO is high. If a CEO is awarded a much larger paycheck than anyone else (particularly particularally the CFO), it increases governance risk and leads to a top-directed culture, thus limiting collaboration. Boards need to be involved in all executive compensation issues including that which drives pay packages for the CFO, Chief Risk Officer, as well as internal auditors,. etc.

    8. Operating revenue is high when compared to operating expenses. Riskier companies have revenue recognition in excess of what is expected based on operating revenues. Directors should fully understand revenue recognition policies and instruct management to test them to be sure they are not aggressive.

    9. A Divestiture(s) has occurred in the last 12 months. Data shows that riskier companies have more divestures, usually because it is an opportunity for more aggressive accounting activity. Board members should inquire as to how this action fits the strategy.

    10. Debt to equity ratio is high. When a business relies too heavily on debt it reveals that markets are not independently funding the business model or strategy. Boards should know why the markets are not investing in their entity and therefore why debt is so heavily relied upon. Board members should also be knowledgeable on the quality of their equity and not just the amount. Lastly, they should understand management’s funding overall funding strategy and the strength of contingent funding plans.

    11. A repurchase of company stock has taken place in the last 12 months. A repurchase of stock is usually presented to investors as an avenue to increase market demand for the stock, thereby elevating overall shareholder value. Management must provide reasoning for why there are no other ways to invest excess funds. Boards should also request the general auditor to review insider sales during the period of share repurchase programs.

    12. Inventory valuations to total revenue is increasing. When inventory increases in relation to revenue it should raise control questions about inventory valuation. It could indicate changing consumer preferences, which should spur an analysis of a corporation’s business model.

    13. Accounts receivables to sales is increasing. This situation can typically be indicative of relaxed credit standards. Directors should ask whether sales are decreasing due to market conditions and instruct the general auditor to probe receivables to determine their viability.

    14. Asset turnover has slowed when compared to industry peers. If assets are increasing and sales are not flowing it could indicate less productive assets are being brought, or retained, on the balance sheet. Conversely, if sales are decreasing, executives and auditors will again want to analyze changing customer preferences.

    15. Assets driven by financial models make up a larger portion of balance sheet. A collection of other accounting metrics indicates that boards, the C-suite, and general auditors should pay special attention to the controls, assumptions, and governance surrounding assets whose valuations are model driven. This is particularly true if assets that are valued by financial models make up a larger portion of the entities balance sheet.

    To be sure, any one of these in isolation as an indicator of accounting and governance risk can be debated. Company divestitures and M&A can be a healthy indicator. But if a corporation fails more than a few of these metrics, board members need to take action.

    It is easy to dismiss any one of these metrics when you find it is an issue in your company. Human nature is quick to retort – maybe for others but not for us. However, like time and tide, the numbers too, wait for no one. So, if you have any of these AGR metrics, you need to begin confronting these risk characteristics today to improve your corporate health and avoid the much more drastic financial equivalent of cardiovascular surgery tomorrow.

    Walter Smiechewicz is chief consultant for governance and risk at Audit Integrity, a research firm that provides accounting and governance risk analysis

     December 5, 2009 reply from Bob Jensen

    Here are some added thoughts:

    The risk factors are excerpted from AICPA Statement on Auditing Standards 82, “Consideration of Fraud in a Financial Statement Audit” (1997). That statement was issued to provide guidance to auditors in fulfilling their responsibility “to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” Although there risk factor cover a broad range of situations, they are only examples. In the final analysis, audit committee members should use sound informed judgment when assessing the significance and relevance of fraud risk factors that may exist.
    http://www2.gsu.edu/~wwwseh/Financial Reporting Red Flags.pdf
    There may be an update on this material.

    Reflections on the audit committee's role --- http://www.allbusiness.com/accounting-reporting/auditing/173956-1.html

    You might browse some of the Financial Analysis Lab materials at Georgia Tech (directed by Chuck Mulford) ---
    http://mgt.gatech.edu/fac_research/centers_initiatives/finlab/index.html
    This is one of the best centers of academic study of financial reporting and fraud.

    Mulford and Gene Comiskey some great books on red flags in financial reporting.  These include the following:

    ·         Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance

    ·         The Financial Numbers Game: Detecting Creative Accounting Practices

    ·         Financial Warnings: Detecting Earning Surprises, Avoiding Business Troubles, Implementing Corrective Strategies
    This is a bit dated (1996) but it is a classic that I keep within arms reach.

     

     


    Zero-Based Budgeting --- https://en.wikipedia.org/wiki/Zero-based_budgeting

    "Zero-Based Budgeting Is Not a Wonder Diet for Companies," by Daniel Mahler, Harvard Business Review Blog, June 30, 2016 ---
    https://hbr.org/2016/06/zero-based-budgeting-is-not-a-wonder-diet-for-companies?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Zero-based budgeting (ZBB) is elegantly logical: Expenses must be justified for each new budget period based on demonstrable needs and costs, as opposed to the more common method of using last year’s budget as your starting point, then adjusting up or down. ZBB is a straightforward, intuitively simple way to aggressively strip out costs that cannot be rationally justified. Who would argue that a business should not eliminate unjustifiable costs?

    ZBB has been around for decades, but is currently enjoying a revival driven by powerful investors like 3G Capital Partners, the force behind the 2015 merger of Kraft Foods and H.J. Heinz. Such high-profile exposure has prompted more companies to view ZBB as a fresh “wonder diet” for achieving radical corporate leanness. ZBB’s resurgence is further fueled by the uncertain markets hindering many companies’ efforts to attract fresh capital, as we see venture capital and private equity funds increasingly pushing ZBB on their portfolio companies, in the hope of securing a more rapid and profitable exit on their investments.

    Yet for all the promise of ZBB, many companies that try it soon grow disenchanted. They find that the process is a distraction to their people, that it does not deliver all the cost savings they anticipated, and that many of the costs they do eliminate soon creep back in, making the whole effort feel futile. One might conclude from such failures that implementing zero-based budgeting is simply too ambitious. We believe the exact opposite to be true. Most ZBB implementations are not ambitious enough.

    Traditional ZBB implementations focus almost exclusively on simple SG&A, in part because SG&A benchmark data is far more readily attainable than are relevant data from the core functions of comparable companies. In comparison to other methods (such as Six Sigma or activity-based costing), ZBB typically does not address operational excellence in core processes (marketing, sales, supply chain, procurement, manufacturing) or fundamental cost drivers such as portfolio complexity, organizational complexity, customer complaints, and quality issues. Also, ZBB does not challenge existing process design, which can now be completely re-thought and often drastically improved through digitization. Rather, the most visible outcomes of many ZBB efforts are burdensome policies (such as travel cost restrictions) that fail to address the underlying fundamentals (such as who needs to travel, why, and when). The result is a superficial and simplistic focus on “policing” costs versus substantive cost prevention.

    Continued in article

    From the CFO Journal's Morning Ledger on March 26, 2015

    Zero-based budgeting, an austerity measure that forces corporate managers to justify from scratch their spending plans every year, is getting its moment in the spotlight. The tactic is a critical element to 3G Capital Partners LP’s plan for making good with its roughly $49 billion deal to acquire Kraft Foods Group Inc. through its H.J. Heinz Co. unit, the WSJ reports. Zero-based budgeting has triggered sweeping cost cuts at 3G-related companies, including Heinz, ranging from the elimination of hundreds of management jobs to jettisoning corporate jets—and even requiring employees to get permission to make color photocopies.

    And it isn’t just 3G adopting the cost-cutting measure. The budget tool has attracted a wide following among big food companies and has been used by many public agencies. But it does have its downsides. Employees may perceive it as harsh, especially when it eliminates office perks and leads to layoffs, and it can require staff training and sometimes painful discussions. Some experts also say that it doesn’t make sense for high-growth companies or those expanding into new regions.

     

     


    Creative Earnings Management, Agency Theory, and Accounting Manipulations to Cook the Books
    The Controversy Over Earnings Smoothing and Other Manipulations

    Before reading this, you may want to read about creative accounting and earnings management at http://en.wikipedia.org/wiki/Earnings_management

    Financial Statement Fraud: Prevention and Detection, 2nd Edition Zabihollah Rezaee, Richard Riley ISBN: 978-0-470-45570-8 Hardcover 332 pages September 2009


    Cross Firm Real Earnings Management

    Journal of Accounting Research, Vol. 56, No. 3, 2018

     

    SSRN
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3224509
    Posted: 15 Aug 2018
     

    Eti Einhorn

    Tel Aviv University

    Nisan Langberg

    University of Houston - C.T. Bauer College of Business; Tel Aviv University

    Tsahi Versano

    Tel Aviv University - The Leon Recanati Graduate School of Business Administration

    Multiple version iconThere are 2 versions of this paper

    Date Written: June 1, 2018

    Abstract

    Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.

    Keywords: accounting; financial reporting; earnings management; real earnings management; nonproprietary information; product market competition; managerial myopia


    CalPERS --- https://en.wikipedia.org/wiki/CalPERS

    CalPERS Cooks Its Books ---
    https://www.nakedcapitalism.com/2020/09/calpers-cooks-its-books-grossly-understated-investment-consultant-meketas-expenses-in-annual-financials-made-a-criminal-false-account-by-burying-the-cost.html

    Francine McKenna, an accounting expert and adjunct professor at American University in Washington D.C., confirmed our concerns about the misclassification of the Meketa charges:

    It’s either intentional manipulation of the books or a level of incompetence and sloppiness that is inexcusable for an entity of this size with so many highly paid professionals and consultants involved.

    If this excuse for the inability to track the Meketa payments is accurate, it’s an admission that CalPERS has been making false accounts, which is a violation of the California Penal Code section 424. Given the magnitude of either the omission or the deliberate misclassification in combination with the fact that CalPERS is rated by Moodys, which presumably relies on the information in the CAFR, this abuse could rise to the level of a fraud.1

    This reporting deficiency is troubling since it calls into question the integrity of CalPERS’ accounting and record-keeping. But perhaps this is not surprising. Most of the CAFR, including the “Other Supplementary Information” section in which outside vendor costs and CalPERS’ investment overhead fall, is unaudited. As we have pointed out, the entire investment section of CalPERS’ financials, including the valuation of its assets, is not audited either (see the auditor’s letter starting on page 17 to confirm).

     Continued in article


    Three Times You Should Consider Business Valuation (usually infrequent events) ---
    https://www.accountingweb.com/practice/clients/3-times-you-should-consider-business-valuation

    Jensen Comment
    The three major problems with business valuation is that:

    1. Respectable valuations are costly (not usually cost effective on an annual basis)

    2. Business valuations are highly subjective (due largely varying assumptions) and differ between teams of valuators --- which is the reason mergers and acquisitions often take place when "buyers" are more optimistic than "sellers."  Exhibit A is the widely varying valuation between the Michael Jackson Estate between his family versus the IRS. Exhibit B is the valuation of Tesla based on stock price fluctuations where prices fluctuate greatly both due to news releases about Tesla and ups and downs of the stock market apart from news about Tesla.

    3. Business valuations are unstable and change with not only economic conditions but with such things as scandals.  Exhibit A is the expected 2019 crash in the value of the the Michael Jackson estate as media outlets are now banning the playing of his music and videos following the current release of the HBO documentary leaving the audiences more convinced that he was a serial pedophile who bought off witnesses before court trials. Whether or not he's guilty as implied is not so much an issue as the impact of media outlets to new publicity that he's guilty. Exhibit C is the real estate value in Queens between the Amazon announcement of HQ 2 in Queens and the subsequent crash in valuations following the Amazon announcement that it was reneging on Queens. Value can be fickle indeed.

    Exhibit D is the Non-GAAP Earnings Management at Kraft Heinz Co.
    From the CFO Journal's Morning Ledger on March 6, 2019

     The problems Kraft Heinz Co. disclosed last month are shining a light on a growing concern: the company’s tailored financial metrics that help make its results look better.

    You say tomato, I say $6 billion. Since the 2015 merger that created Kraft Heinz, the packaged-food company has reported adjusted operating earnings totaling more than $24 billion. But reported cash flow from operations under standard accounting rules for that same period was only about $6 billion.

    Mind the GAAP. The gap in cash flow tallies underscores the need for investors to be cautious when relying on nonstandard metrics, rather than those that governed by U.S. Generally Accepted Accounting Principles. The relatively low operating cash flow might have been a tipoff to investors that Kraft Heinz was faltering. Last month it announced a big write-down and a decline in the value of several key brands.

    Caveat emptor. Companies are allowed to report tailored financial metrics, but they must provide detailed disclosures and can’t feature them more prominently than official measures. In recent years, the U.S. Securities and Exchange Commission has criticized many companies over the way they feature adjusted measures. 

    Bob Jensen's threads on pro forma and other non-GAAP reporting ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

     


    Harvard Study: When CEOs’ Equity Is About to Vest, They Cut Investment to Boost the Stock Price ---
    https://hbr.org/2018/02/study-when-ceos-equity-is-about-to-vest-they-cut-investment-to-boost-the-stock-price?utm_medium=email&utm_source=newsletter_daily&utm_campaign=dailyalert&referral=00563&spMailingID=19107171&spUserID=MTkyODM0MDg0MAS2&spJobID=1220042201&spReportId=MTIyMDA0MjIwMQS2


    From the CFO Journal's Morning Ledger on October 4, 2016

    Boeing’s nifty accounting
    Boeing Co. started to make money on each 787 Dreamliner it delivers just this spring, but thanks to a unique accounting strategy, the jet has been fattening the aircraft maker’s bottom line for years. Boeing is one of the few companies that use a technique called program accounting. Rather than booking the huge costs of building aircraft as it pays them, Boeing defers the costs over the number of planes it expects to build in the future, and adds expected future profits in current earnings, which is acceptable under accounting rules.


    GAAP versus Non-GAAP Accounting for IPOs
    From the CFO Journal's Morning Ledger on January 8, 2015

    Forty companies went public last year reporting losses under traditional accounting rules but showing profits under their own tailor-made measures, the WSJ’s Michael Rapoport reports. That is 18% of all U.S. IPOs for the year. Some IPO market observers have raised fears that companies’ increased use of nonstandard earnings measures could confuse or mislead investors.

    Companies that use the non-GAAP measures insist that they give investors a better picture of the company. But that worries some experts, and hasn’t stopped the SEC from demanding that some of the companies revise their filings, saying that they give too much prominence to the specialty calculations over more standard measures.

    Nonstandard metrics give investors “the best measure” of continuing performance, said Jason Morgan, chief financial officer of Zoe’s Kitchen Inc., one of the firms that had to revise its filings at the request of the SEC. Do you feel that you need to look beyond GAAP to tell the full story of your company’s performance? Send us a note to let us know or tell us in the comments

    Bob Jensen's threads on pro forma reporting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ProForma


    Cross-Firm Real Earnings Management

    SSRN
    46 Pages Posted: 20 Sep 2017  
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3039038

    Eti Einhorn

    Tel Aviv University - Faculty of Management

    Nisan Langberg

    University of Houston - C.T. Bauer College of Business; Tel Aviv University

    Tsahi Versano

    Tel Aviv University - The Leon Recanati Graduate School of Business Administration

    Date Written: September 18, 2017

    Abstract

    Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any particular firm from observing the earnings reports of its rivals. We argue that such intra-industry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross-firm real earnings management, and explore its potential consequences and its interrelation with the practice of accounting-based earnings management within an industry setting with imperfect (non-proprietary) accounting information.

    Frequent-flier award accountancy is something akin to voo doo and crystal ball estimation.

    Airlines Make More Money Selling Miles Than Seats The golden goose isn’t your ticket or bag fee—it’s the credit card you use to collect frequent flier miles ---
    https://www.bloomberg.com/news/articles/2017-03-31/airlines-make-more-money-selling-miles-than-seats?cmpid=BBD033117_BIZ&utm_medium=email&utm_source=newsletter&utm_term=170331&utm_campaign=bloombergdaily

     . . .

    Investors have failed to appreciate how crucial these programs are to airline profitability amid the stability consolidation brought, said Joseph DeNardi, a senior airline analyst with Stifel Financial Corp. in Baltimore. Since August, he’s issued a steady stream of client notes arguing that the market has undervalued the five largest airlines.

    DeNardi has repeatedly explained that investors have little insight into the billions of dollars large banks pay for these affiliations. At each airline investor call or conference, DeNardi has steadfastly prodded executives for greater reporting detail.

    In many ways, the Big Three U.S. airlines have organized themselves into two distinct businesses. There’s the traditional activity—the one with jets—which involves pricing seats for as much as possible, collecting a bag fee, and selling some food and drinks while keeping a close eye on costs. The other business is the sale of miles—mostly to the big banks, but also to companies that range from car rental firms to hotels to magazine peddlers.

    The latter has expanded so much that it accounts for more than half of all profits for some airlines, including American Airlines Group Inc., the world’s largest.

     Jensen Comment
    Accounting for "sales of miles" has always been problematic due to time differences between award dates and when customers book flights and uncertainties whether the awards will expire without being used by customers. This entails something akin to voo doo and crystal ball estimation.

    Accounting rules for booking frequent-flier miles recently changed and became very complicated under the revised accounting revenue recognition standard
    Foundations of Airline Finance

    by Bijan Vasigh et al.
    Routledge, Second Edition, 2015
    Beginning on Page 154
    Note the illustrations
    https://books.google.com/books?id=FVRWBQAAQBAJ&pg=PA167&lpg=PA167&dq=GAAP+%22Frequent+Flier+Miles%22&source=bl&ots=EzGeMCTu9n&sig=u90HFsYsQ0mLbmF_k0Xm4bVWlKs&hl=en&sa=X&ved=0ahUKEwil-M7f2IHTAhWW3oMKHeJGASc4ChDoAQgqMAM#v=onepage&q=GAAP%20%22Frequent%20Flier%20Miles%22&f=false

    This is an excellent illustration how accounting is more than counting beans and how specialized airline accountants and auditors must become in extremely technical issues.


    Monsanto to Pay $80 Million to Settle Charge of Improper Accounting (for deferred deductions of rebates) ---
    https://www.sec.gov/news/pressrelease/2016-25.html

    According to the SEC’s order instituting a settled administrative proceeding against Monsanto, accounting executives Sara M. Brunnquell and Anthony P. Hartke, and then-sales executive Jonathan W. Nienas:

    ·         Monsanto’s sales force began telling U.S. retailers in 2009 that if they “maximized” their Roundup purchases in the fourth quarter they could participate in a new rebate program in 2010.

    ·         Hartke developed and Brunnquell approved talking points for Monsanto’s sales force to use when encouraging retailers to take advantage of the new rebate program and purchase significant amounts of Roundup in the fourth quarter of the company’s 2009 fiscal year.  Approximately one-third of its U.S. sales of Roundup for the year occurred during that quarter.

    ·         Brunnquell and Hartke, both certified public accountants, knew or should have known that the sales force used this new rebate program to incentivize sales in 2009 and Generally Accepted Accounting Principles (GAAP) required the company to record in 2009 a portion of Monsanto’s costs related to the rebate program.  But Monsanto improperly delayed recording these costs until 2010.

    ·         Monsanto also offered rebates to distributors who met agreed-upon volume targets.  However, late in the fiscal year, Monsanto reversed approximately $57.3 million of rebate costs that had been accrued under these agreements because certain distributors did not achieve their volume targets (at the urging of Monsanto).

    ·         Monsanto then created a new rebate program to allow distributors to “earn back” the rebates they failed to attain in 2009 by meeting new targets in 2010.  

    ·         Under this new program, Monsanto paid $44.5 million in rebates to its two largest distributors as part of side agreements arranged by Nienas, in which they were promised late in fiscal year 2009 that they would be paid the maximum rebate amounts regardless of target performance.

    ·         Because the side agreements were reached in 2009, Monsanto was required under GAAP to record these rebates in 2009.  But the company improperly deferred recording the rebate costs until 2010

    ·         Monsanto repeated the program the following year and improperly accounted for $48 million in rebate costs in 2011 that should have been recorded in 2010.

    ·         Monsanto also improperly accounted for more than $56 million in rebates in 2010 and 2011 in Canada, France, and Germany.  They were booked as selling, general, and administrative (SG&A) expenses rather than rebates, which boosted gross profits from Roundup in those countries.  


    Scott W. Friestad, Associate Director in the SEC’s Division of Enforcement, said, “Monsanto devised rebate programs that elevated form over substance, which led to the booking of substantial amounts of revenue without the recognition of associated costs.  Public companies need to have robust systems in place to ensure that all of their transactions are recognized in the correct reporting period.”


    Monsanto consented to the SEC’s order without admitting or denying the findings that it violated Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, the reporting provisions of Section 13(a) of the Securities Exchange Act of 1934 and underlying rules 12b-20, 13a-1, 13a-11, and 13a-13; the books-and-records provisions of Exchange Act Section 13(b)(2)(A); and the internal accounting control provisions of Exchange Act Section 13(b)(2)(B). 

    Continued in article

     


    Is this Canadian repatriation decision somewhat or all due to deliberate or all earnings management?

    From the CFO Journal's Morning Ledger on October 1, 2015

    Gas, currency sap Costco’s top line; taxes help
    http://blogs.wsj.com/cfo/2015/09/30/gas-currency-sap-costcos-top-line-taxes-help/?mod=djemCFO_h
    Warehouse retailer Costco Wholesale Corp. would have reported strong sales growth if not for cheap gas and a strong dollar, but a tax windfall helped it report solid earnings growth, Maxwell Murphy reports. Costco reported a lower tax rate, thanks to a tax benefit it received bringing home $560 million from Canada. Repatriating the funds gave the company a 4 cent per-share boost to earnings during the fiscal fourth quarter ended in August.


    "Earnings Management and Derivative Hedging with Fair Valuation: Evidence from the Effects of FAS 133," by  Jongmoo Jay Choi and Connie X. Mao, The Accounting Review, Volume 90, Issue 4 (July 2015) ---
    http://aaajournals.org/doi/abs/10.2308/accr-50972

    Abstract
    Barton (2001) and Pincus and Rajgopal (2002) show that earnings management through discretionary accruals and derivative hedging are partial substitutes in smoothing earnings before 1999. In this study, we investigate whether Financial Accounting Standard (FAS) 133 regarding hedge accounting in 2000 has influenced the relative merit of the two earnings-smoothing methods. Based on a sample of S&P 500 nonfinancial firms during 1996–2006, we find that the substitution relation between derivative hedging and discretionary accrual is significantly attenuated after FAS 133 implementation. We also document a significant increase in earnings volatility associated with derivative hedging post-FAS 133. These results are robust to the use of various model and method specifications, as well as controlling for contemporaneous macroeconomic and regulatory shocks. Overall, our results suggest that a material change in an accounting rule regarding derivatives can influence the level and volatility of reported earnings, as well as the method of income smoothing.


    From the CFO Journal's Morning Ledger on September 5, 2015

    Toshiba slashes earnings for past seven years.
    http://www.wsj.com/articles/toshiba-slashes-earnings-for-past-7-years-1441589473?mod=djemCFO_h
    Toshiba Corp.
    , hoping to close the books on one of Japan’s biggest accounting scandals, said it had overstated its earnings by $1.9 billion over seven years, more than four times the initial estimate. The company said Monday that it was taking steps to avoid a repeat of the scandal, which an independent panel said was caused by managers setting aggressive profit targets that subordinates couldn’t meet without inflating divisional results.

    Ernst & Young trying to figure out how it's auditors missed  a multi-year $1+ billion accounting fraud in Toshiba's financial statements
    "E&Y Japan arm launches internal probe of Toshiba audit," Reuters Technology, July 31, 2015 ---
    http://www.reuters.com/article/2015/08/01/us-toshiba-accounting-e-y-idUSKCN0Q62UD20150801

    The Japanese affiliate of Ernst & Young LLC has launched an in-house investigation (using over 150 investigators) into its audit of Toshiba Corp in the wake of the electronics maker's $1.2 billion accounting scandal, a person with knowledge of the matter said.

    Ernst & Young ShinNihon LLC has established a team of about 20 executives to investigate whether there were any problems with how it conducted its audits of Toshiba, the person said.

    The person spoke on condition of anonymity. No one could be reached at the company's offices in Tokyo on Saturday.

    Continued in article

    Jensen Comment
    Audit firms traditionally defend themselves that they're not hired to be fraud detectors unless the frauds materially affect financial statements. The Toshiba accounting fraud had a monumental impact on financial statements.

    From the CFO Journal's Morning Ledger on July 15, 2015

    Toshiba executives likely to step down over accounting scandal
    http://www.wsj.com/articles/toshiba-executives-expected-to-step-down-over-accounting-scandal-1436870307?mod=djemCFO_h
    Toshiba Corp.
    President Hisao Tanaka and several other executives are likely to step down soon over an accounting scandal at the Japanese company involving profit inflated by more than $1 billion. The other executives that people familiar with the situation expect to leave Toshiba include Norio Sasaki, a former president who is currently vice chairman. The board is also likely to undergo significant membership changes.

    . . .

    Toshiba has detailed a number of cases in which business units failed to book adequate costs for executing contracts, causing the company to overstate profit. Toshiba said in June that it would need to reduce operating profit for the 2009 through 2013 fiscal years by a total of ¥54.8 billion. People familiar with the matter said the figure has now ballooned to at least ¥150 billion ($1.2 billion). Toshiba declined to comment.

    During those years, the company’s combined operating profit totaled ¥1.05 trillion, so even at the higher level, the reduction would amount to less than 15% of the company’s operating profit over the five years.

    Continued in WSJ article

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on EY ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Earnings Management --- https://en.wikipedia.org/wiki/Earnings_management

    The Effects of Creative Culture on Real Earnings Management
    SSRN, August 4, 2016
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2818499

    Author

    Ryan D. Guggenmos
    Cornell University - Samuel Curtis Johnson Graduate School of Management

    Abstract

    Chief Executive Officers identify creativity as one of the most desired business leadership competencies. Accordingly, managers are increasingly looking to build creative and innovative cultures within their organizations. However, research in psychology suggests that these attempts may have unintended negative consequences. In this study, I predict and find that an innovative company culture leads to higher levels of real earnings management (REM). To reduce REM in innovative cultures, I design and test interventions based on lower-level and higher-level construals. As I predict, an intervention based on lower-level construal reduces REM, but a higher-level construal intervention reduces REM to a greater extent. I also provide evidence that these interventions reduce the desirability of self-interested behavior that is a consequence of innovation-focused culture. My findings contribute to the emerging accounting literature regarding REM. In addition, I extend the psychology literature investigating the link between self-interested behavior and creativity, as well as expand research on the effects of mental construal on decision making

     


    Earnings Management --- https://en.wikipedia.org/wiki/Earnings_management

    Impact of Assurance Level and Tax Status on the Tendency of Relatively Small Manufacturers to Manage Production and Earnings
    SSRN. July 25, 2016
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2814314

     

    Authors

    Benjamin P. Foster University of Louisville - College of Business and Public Administration

    John M. Mueller California State University, Fresno; Western Michigan University

    Trimbak Shastri University of Louisville - Department of Accountancy

    Abstract

    The number and importance of private companies in the United States indicates that reliable quality of financial accounting reports (QFAR) of private companies that are useful for decision making is likely to be important for economic growth. Most previous research examining QFAR addressed earnings management among publicly-traded companies. This study extends prior literature by examining whether abnormal production of public and private companies is impacted by (i) assurance type (PCAOB-audit, GAAS-audit, and SSARS-Review), (ii) tax status (separately taxed versus pass-through entity) of private companies, and (iii) relative size. An audit of financial statements provides a high degree of assurance, whereas a review provides limited assurance. Due to data limitations with our private company sample, this study focuses on earnings management through abnormal production by manufacturing companies. When examining companies that just met the benchmark of prior years' earnings or zero earnings we found positive abnormal production for publicly traded companies and privately held audited-taxable companies, but not for other privately held companies. Not identified in previous studies, we find that abnormal production of similarly sized public companies and private companies differ. Our findings provide evidence relevant to the Big GAAP/Little GAAP debate and that one set of accounting standards may not satisfy all public and private company financial statement users. Also, results of this study support the recommendations of the Financial Accounting Foundation’s Blue Ribbon Panel’s Report for establishing a separate private company standards board to help ensure appropriate modifications to GAAP.

     


    Teaching Case on Channel Stuffing
    From The Wall Street Journal Accounting Weekly Review on July 31, 2015

    SEC Investigating Smirnoff Maker Diageo
    by: Tripp Mickle and Saabira Chaudhuri
    Jul 24, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Revenue Recognition

    SUMMARY: The Securities and Exchange Commission is investigating whether Diageo PLC has been shipping excess inventory to distributors in an effort to boost the liquor company's results. By sending more cases to distributors than wanted, the British-based owner of Smirnoff and Johnnie Walker would be able to report increased sales and shipments. That allows Diageo to report shipments as sales, leaving distributors with a bitter taste as sales of the company's brands have waned. The company has already changed the way it accounts for those shipments, and that will almost certainly lead to lower inventory levels even as Diageo responds to securities investigators. In the U.S., liquor producers follow a three-tier system to market. Producers like Diageo ship to wholesalers, who then ship to retailers. Liquor companies can record shipments as sales when they ship them to the wholesaler.

    CLASSROOM APPLICATION: This is a great article for a discussion regarding when to recognize sales. The Securities and Exchange Commission probe raises important questions over not only who owns inventory as it moves through distribution channels but who makes decisions about supply.

    QUESTIONS: 
    1. (Introductory) What is the SEC? What is its area of authority?

    2. (Advanced) Why is the SEC investigating Diageo PLC? How does this investigation relate to the SEC's responsibilities?

    3. (Advanced) What are the accounting rules regarding revenue recognition? What are possible times sales can be recognized in the business transaction described in the article? When should the sales be recognized?

    4. (Advanced) What is cash basis accounting? What is accrual basis accounting? How does revenue recognition differ when a company is cash basis vs. accrual basis?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "SEC Investigating Smirnoff Maker Diageo." by Tripp Mickle and Saabira Chaudhuri, The Wall Street Journal, July 24, 2015 ---
    http://www.wsj.com/articles/sec-investigating-smirnoff-maker-diageo-1437678975?mod=djem_jiewr_AC_domainid

    Agency probing whether Diageo has shipped excess inventories to distributors.

    The Securities and Exchange Commission is investigating whether Diageo PLC has been shipping excess inventory to distributors in an effort to boost the liquor company’s results, according to people familiar with the inquiry.

    By sending more cases to distributors than wanted, the British-based owner of Smirnoff and Johnnie Walker would be able to report increased sales and shipments, according to these people.

    Diageo confirmed Thursday to The Wall Street Journal that it received an inquiry from the SEC regarding its distribution in the U.S.

    “Diageo is working to respond fully to the SEC’s requests for information in this matter,” a company spokeswoman said.

    Diageo’s American depositary receipts fell 5% Thursday afternoon, following the Journal’s report on the inquiry, and ended the day down $4.99, or 4.2%, to $114.67.

    The inquiry coincides with a period of tumult in Diageo’s executive ranks. The company announced in June that North American President Larry Schwartz would be retiring by the end of the year. Since then, the company has also announced the departures of its chief marketing officer for North America and a president of national accounts in the U.S.

    Continued in article

    Bob Jensen's threads on channel stuffing scandals ---
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#ChannelStuffing


    From the CFO Journal's Morning Ledger on July 15, 2015

    Toshiba executives likely to step down over accounting scandal
    http://www.wsj.com/articles/toshiba-executives-expected-to-step-down-over-accounting-scandal-1436870307?mod=djemCFO_h
    Toshiba Corp.
    President Hisao Tanaka and several other executives are likely to step down soon over an accounting scandal at the Japanese company involving profit inflated by more than $1 billion. The other executives that people familiar with the situation expect to leave Toshiba include Norio Sasaki, a former president who is currently vice chairman. The board is also likely to undergo significant membership changes.

    . . .

    Toshiba has detailed a number of cases in which business units failed to book adequate costs for executing contracts, causing the company to overstate profit. Toshiba said in June that it would need to reduce operating profit for the 2009 through 2013 fiscal years by a total of ¥54.8 billion. People familiar with the matter said the figure has now ballooned to at least ¥150 billion ($1.2 billion). Toshiba declined to comment.

    During those years, the company’s combined operating profit totaled ¥1.05 trillion, so even at the higher level, the reduction would amount to less than 15% of the company’s operating profit over the five years.

    Continued in WSJ article

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    "Hollywood Creative Accounting: The Success Rate of Major Motion Pictures," by Sergio Sparviero (University of Salzburg), SSRN, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2617170

    Abstract:     
     
    Academic, trade, and popular publications commonly assert that 80 percent of motion pictures fail to make a net profit, suggesting also that the main players of the motion picture industry operate in highly volatile market conditions. More importantly, major film companies use this argument to negotiate for better terms with their production and distribution partners, to lobby for stricter copyright protections, and to argue in favor of media conglomeration as a hedge against adverse market conditions. This article disputes these assertions by calculating the full range of income that major motion pictures derive from their primary and secondary markets. It demonstrates that a large share of studio films are ultimately profitable, therefore challenging the arguments that conglomerates make with industry partners and government policy makers.

    "Intangible Assets in Germany," by Andreas Oehler (Bamberg University) and Hannes Frey (Bamberg University), SSRN, 2014 ---
     http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2615862

  • Abstract:
    Purpose – Intangible assets are regarded as the future value drivers of company performance. However, hardly anything is known about the actual importance and influence of intangible assets. The purpose of this paper is to fill this gap, so the authors analyse the German stock market index DAX and accomplish a survey among the German Certified Public Accountants (CPAs) concerning intangible assets.

    Design/Methodology/Approach – In a first step, the authors analyse the balance sheet data and the corresponding notes of the companies with regard to reported values of intangible assets and applied valuation methods. The sample period covers the years from 2005 to 2008. In a second step, the authors analyse the statements of the German CPAs with regard to intangible assets. The authors sent a standardised questionnaire to all 180 offices of the top ten German auditing firms.

    Findings – The results indicate that intangible assets have gained in importance, while information on valuation methods is still scarce. According to the German CPAs, the current influence of intangible assets on company performance is on a high level and even will increase during the next few years. The mostly used valuation approach for the fair value measurement of patented technologies is the income approach. Furthermore, the accounting standards leave room for accounting policy – a result which casts doubt on the reliability of financial statements.

    Originality/Value – For the first time not only annual balance sheet data but also corresponding notes regarding intangible assets are analysed. The findings are connected with a survey of an expert group for the valuation of intangibles.

  • Bob Jensen's threads on intangibles and contingencies accounting ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    Teaching Case on Controversial Tailored Accounting at IPOs
    From The Wall Street Journal Accounting Weekly Review on January 16, 2015

    Tailored Accounting at IPOs Raises Flags
    by: Michael Rapoport
    Jan 08, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Reporting, Initial Public Offerings, IPOs

    SUMMARY: Forty companies went public in 2014 reporting losses under traditional accounting rules but showing profits under their own tailor-made measures. That is 18% of all U.S. initial public offerings for the year the highest level since at least 2009. Of 2014's 10 biggest IPOs, nine used nonstandard earnings measures alongside the official accounting treatment to some degree. Many companies prefer highlighting their own customized measures, saying they give investors a better picture of the company. That worries some experts, and the Securities and Exchange Commission has written letters to Zoe's and other companies telling them the bespoke figures they use are given too much prominence in regulatory filings and asking for revisions.

    CLASSROOM APPLICATION: This is very interesting information to add to the topics of financial accounting and IPOs.

    QUESTIONS: 
    1. (Introductory) What is an IPO? Who is involved? Why have the numbers of IPOs grown in recent years?

    2. (Advanced) Why is financial reporting needed as a part of an IPO? Who would be using the financial information? Why is accuracy and full disclose important?

    3. (Introductory) What is the issue presented in the article? Who is concerned by these activities? Why are they concerned?

    4. (Advanced) Why do companies wish to use their own customized measures? What do they say in support of using them? Is their defense of their actions reasonable? Why or why not?

    5. (Advanced) What are some examples of changes companies have made in their financial reporting? What problems or misunderstandings could this "tailored accounting" cause?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    What Companies Strip Out of 'Non-GAAP' Earnings: Fines, Exec Bonuses, Severance, Rebranding Costs...
    by Michael Rapoport
    Jan 08, 2015
    Online Exclusive

    "Tailored Accounting at IPOs Raises Flags," by Michael Rapoport, The Wall Street Journal, January 7, 2015 ---
    http://www.wsj.com/articles/tailored-accounting-at-ipos-raises-flags-1420677431?mod=djem_jiewr_AC_domainid&autologin=y

    Critics Say Companies’ Increased Use of Customized Earnings Measures Could Confuse Investors

    Zoe’s Kitchen Inc. is serving up profits—but only after leaving some of its expenses off the menu.

    Zoe’s, a chain of 125-plus Mediterranean-theme restaurants that went public in April, reported an adjusted profit of $13.2 million for the first nine months of 2014 under its own accounting treatments that strip out a variety of expenses.

    Including those expenses, as is required under standard accounting rules, Zoe’s reported a loss of $8.4 million.

    It is far from an isolated example. Forty companies went public in 2014 reporting losses under traditional accounting rules but showing profits under their own tailor-made measures. That is 18% of all U.S. initial public offerings for the year, according to consulting firm Audit Analytics, the highest level since at least 2009. Of 2014’s 10 biggest IPOs, nine used nonstandard earnings measures alongside the official accounting treatment to some degree.

    Many companies prefer highlighting their own customized measures, saying they give investors a better picture of the company. That worries some experts, and the Securities and Exchange Commission has written letters to Zoe’s and other companies telling them the bespoke figures they use are given too much prominence in regulatory filings and asking for revisions.

    Nonstandard metrics give investors “the best measure” of continuing performance, said Jason Morgan, chief financial officer of Zoe’s, who added that the SEC’s concerns were addressed in the company’s case by revising its prospectus.

    But as the IPO market heated up last year, observers have raised fears that companies’ increased use of these nonstandard measures could confuse or mislead investors at a time when they are forming their first impression of a company.

    “I think it’s a sign of frothiness” in the IPO market, said Brandon Rees, deputy director of the AFL-CIO’s Office of Investment. “Why investors tolerate it, I don’t know.”

    Some say the costs that companies strip out of their nonstandard measures are increasingly things that should be counted in earnings calculations, such as executive bonuses, fees for stock offerings and acquisition expenses.

    “I was just astounded at the wide variety of elements that people thought were appropriate to exclude,” said Curtis Verschoor, a DePaul University emeritus professor of accountancy. Investors should be aware that a company’s nonstandard numbers “are more likely to be slanted rather than balanced,” he said.

    Companies must still prominently disclose their earnings under generally accepted accounting principles, the standard set of U.S. accounting rules, even if they also spotlight their earnings under “non-GAAP” measures.

    “It’s knee-jerk to say that’s a place where companies put bad stuff,” said Mike Guthrie, chief financial officer of TrueCar Inc., an auto-buying-and-selling platform that went public in May.

    For the first nine months of 2014, TrueCar had a $38.6 million loss under standard rules but a $6.6 million profit under “adjusted Ebitda”—earnings before interest, taxes, depreciation and amortization, modified further to exclude other costs, such as an $803,000 expense to acquire rights to the company’s stock symbol.

    Mr. Guthrie said it would be more misleading for the companies not to present adjusted measures; the stock-symbol cost, for instance, was a one-time expense that won’t affect TrueCar’s future results. TrueCar closed Wednesday at $20.94 a share, up 133% from its IPO price of $9.

    According to Audit Analytics data, 59% of the companies that filed for an IPO since 2012 have used nonstandard metrics, compared with 48% in 2010 and 2011.

    Many go beyond the items that companies most frequently strip out of their preferred measures, such as employee stock compensation and foreign-exchange gains and losses. A PricewaterhouseCoopers LLP survey found 80% of IPO companies that made adjustments to their Ebitda from 2010 to 2013 had at least one adjustment beyond the more-common strip-outs, though PwC said it couldn’t comment on individual companies.

    The growth in such reporting by IPO companies comes in part because more technology and service-based companies are coming public. Those companies are more likely to use accounting estimates and subjective measures when compared with traditional bricks-and-mortar companies, said Jay Ritter, a University of Florida finance professor who tracks IPOs.

    The SEC has expressed concern in the past about companies’ non-GAAP metrics, notably with regard to daily-deals company Groupon Inc. Before Groupon’s 2011 IPO, the SEC raised questions about its use of “adjusted consolidated segment operating income,” a metric that excluded Groupon’s marketing costs to land new subscribers. Groupon scaled back its use of the metric in response to the SEC concerns. Groupon couldn’t be reached for comment.

    In the past two years, the commission has sent comment letters to more than 30 companies, both pre-IPO companies and those already public, criticizing them for giving nonstandard earnings measures “undue prominence” in their securities filings.

    Zoe’s received such a letter in January 2014.

    Zoe’s had mentioned its adjusted Ebitda first in the “management’s discussion and analysis” section of its prospectus, four pages before providing an earnings table that followed standard accounting rules. The SEC also questioned Zoe’s exclusion of some cash expenses from its adjusted Ebitda, such as the costs of opening new restaurants and management and consulting fees.

    Zoe’s prospectus had been filed under seal with the SEC at the time, and the company revised its filings to address the “undue prominence” criticism before it filed a public prospectus in March, the company’s finance chief, Mr. Morgan, said. Whether the expenses should be excluded “came down to an interpretation” of regulations, and the company didn’t change its methodology, he added.

    Zoe’s stock closed Wednesday at $31.63 a share, more than twice its IPO price of $15.

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on pro forma reporting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ProForma


    Usually With the Blessings of Their Audit Firms:  The PCAOB concludes that all large audit firms frequently conduct deficient audits)
    "Big Companies Can’t Stop Cooking Their Books," The Economist, December 13, 2014 ---
    http://www.businessinsider.com/why-big-companies-cant-stop-cooking-their-books-2014-12

    No endorsement carries more weight than an investment by Warren Buffett. He became the world's second-richest man by buying safe, reliable businesses and holding them for ever. So when his company increased its stake in Tesco to 5% in 2012, it sent a strong message that the giant British grocer would rebound from its disastrous attempt to compete in America.

    But it turned out that even the Oracle of Omaha can fall victim to dodgy accounting. On September 22nd Tesco announced that its profit guidance for the first half of 2014 was £250m ($408m) too high, because it had overstated the rebate income it would receive from suppliers. Britain's Serious Fraud Office has begun a criminal investigation into the errors. The company's fortunes have worsened since then: on December 9th it cut its profit forecast by 30%, partly because its new boss said it would stop "artificially" improving results by reducing service near the end of a quarter. Mr Buffett, whose firm has lost $750m on Tesco, now calls the trade a "huge mistake".

    No sooner did the news break than the spotlight fell on PricewaterhouseCoopers (PwC), one of the "Big Four" global accounting networks (the others are Deloitte, Ernst & Young (EY) and KPMG). Tesco had paid the firm £10.4m to sign off on its 2013 financial statements. PwC mentioned the suspect rebates as an area of heightened scrutiny, but still gave a clean audit.

    PwC's failure to detect the problem is hardly an isolated case. If accounting scandals no longer dominate headlines as they did when Enron and WorldCom imploded in 2001-02, that is not because they have vanished but because they have become routine. On December 4th a Spanish court reported that Bankia had mis-stated its finances when it went public in 2011, ten months before it was nationalised. In 2012 Hewlett-Packard wrote off 80% of its $10.3 billion purchase of Autonomy, a software company, after accusing the firm of counting forecast subscriptions as current sales (Autonomy pleads innocence). The previous year Olympus, a Japanese optical-device maker, revealed it had hidden billions of dollars in losses. In each case, Big Four auditors had given their blessing.

    And although accountants have largely avoided blame for the financial crisis of 2008, at the very least they failed to raise the alarm. America's Federal Deposit Insurance Corporation is suing PwC for $1 billion for not detecting fraud at Colonial Bank, which failed in 2009. (PwC denies wrongdoing and says the bank deceived the firm.) This June two KPMG auditors received suspensions for failing to scrutinise loan-loss reserves at TierOne, another failed bank. Just eight months before Lehman Brothers' demise, EY's audit kept mum about the repurchase transactions that disguised the bank's leverage.

    The situation is graver still in emerging markets. In 2009 Satyam, an Indian technology company, admitted it had faked over $1 billion of cash on its books. North American exchanges have de-listed more than 100 Chinese firms in recent years because of accounting problems. In 2010 Jon Carnes, a short seller, sent a cameraman to a biodiesel factory that China Integrated Energy (a KPMG client) said was producing at full blast, and found it had been dormant for months. The next year Muddy Waters, a research firm, discovered that much of the timber Sino-Forest (audited by EY) claimed to own did not exist. Both companies lost over 95% of their value.

    Of course, no police force can hope to prevent every crime. But such frequent scandals call into question whether this is the best the Big Four can do--and if so, whether their efforts are worth the $50 billion a year they collect in audit fees. In popular imagination, auditors are there to sniff out fraud. But because the profession was historically allowed to self-regulate despite enjoying a government-guaranteed franchise, it has set the bar so low--formally, auditors merely opine on whether financial statements meet accounting standards--that it is all but impossible for them to fail at their jobs, as they define them. In recent years this yawning "expectations gap" has led to a pattern in which investors disregard auditors and make little effort to learn about their work, value securities as if audited financial statements were the gospel truth, and then erupt in righteous fury when the inevitable downward revisions cost them their shirts.

    The stakes are high. If investors stop trusting financial statements, they will charge a higher cost of capital to honest and deceitful companies alike, reducing funds available for investment and slowing growth. Only substantial reform of the auditors' perverse business model can end this cycle of disappointment. Born with the railways

    Auditors perform a central role in modern capitalism. Ever since the invention of the joint-stock corporation, shareholders have been plagued by the mismatch between the interests of a firm's owners and those of its managers. Because a company's executives know far more about its operations than its investors do, they have every incentive to line their pockets and hide its true condition. In turn, the markets will withhold capital from firms whose managers they distrust. Auditors arose to resolve this "information asymmetry".

    Early joint-stock firms like the Dutch East India Company designated a handful of investors to make sure the books added up, though these primitive auditors generally lacked the time or expertise to provide an effective check on management. By the mid-1800s, British lenders to capital-hungry American railway companies deployed chartered accountants--the first modern auditors--to investigate every aspect of the railroads' businesses. These Anglophone roots have proved durable: 150 years later, the Big Four global networks are still essentially controlled by their branches in the United States and Britain. Their current bosses are all American.

    As the number of investors in companies grew, so did the inefficiency of each of them sending separate sleuths to keep management in line. Moreover, companies hoping to cut financing costs realised they could extract better terms by getting an auditor to vouch for them. Those accountants in turn had an incentive to evaluate their clients fairly, in order to command the trust of the markets. By the 1920s, 80% of companies on the New York Stock Exchange voluntarily hired an auditor.

    Unfortunately, Jazz Age investors did not distinguish between audited companies and their less scrupulous peers. Among the miscreants was Swedish Match, a European firm whose skill at securing state-sanctioned monopolies was surpassed only by the aggression of its accounting. After its boss, Ivar Kreuger, died in 1932 the company collapsed, costing American investors the equivalent of $4.33 billion in current dollars. Soon after this the Democratic Congress, cleaning up the markets after the Great Depression, instituted a rule that all publicly held firms had to issue audited financial statements. Britain had already brought in a similar policy.

    Read more: http://www.businessinsider.com/why-big-companies-cant-stop-cooking-their-books-2014-12#ixzz3LsJuCymz

    Bob Jensen's Recipes for Book Cooking ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation


    BDO (the fifth largest multinational accounting firm) --- http://en.wikipedia.org/wiki/BDO_International

    PCAOB --- http://en.wikipedia.org/wiki/Public_Company_Accounting_Oversight_Board

    From the CFO Journal's Morning Ledger on December 4, 2014

    (PCAOB) Regulator finds deficiencies in 65% of BDO USA’s audits
    http://blogs.wsj.com/cfo/2014/12/03/regulator-finds-deficiencies-in-65-of-bdo-usas-audits/?mod=djemCFO_h
    The government’s audit watchdog on Wednesday released annual inspection reports for 37 audit firms, and found more deficiencies in audits by BDO USA LLP and fewer problems in those by Crowe Horwath LLP, CFO Journal’s Noelle Knox reports. Weaknesses in BDO’s audits according to the Public Company Accounting Oversight board included a failure to test controls over goodwill, reserves and receivables, as well as a failure to test a client’s method for calculating the revenue and value of certain financial assets.

    Bob Jensen's threads on the woes of BDO ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm

    Jensen Comment
    There's little evidence that PCAOB inspection reports have done much to improve financial auditing in large firms. It seems like the audit firms pretty much ignore the reports if improvements are expensive such as the expense of more detailed testing. Those reports do destroy the myth that expensive audits from the largest auditing firms are superior audits.

    Clients seemingly are more concerned with reducing audit costs than improving audit quality. My hypothesis is that audit firms cut corners on clients that they are relatively certain will not lead to auditing lawsuits. When firms audit troubled clients perhaps those audits have more due diligence. A bad inspection report can destroy a small audit firm, but a negative inspection report seems to not hurt the huge global auditing firms seeking new clients.
    PCAOB Inspection Reports --- http://pcaobus.org/Inspections/Pages/default.aspx

    Teaching Case on Audit Inspections
    From The Wall Street Journal Weekly Accounting Review on October 31, 2014

    KPMG Audits Had 46% Deficiency Rate in PCAOB Inspection

    by: Michael Rapoport
    Oct 24, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Firms, Auditing, Deficiencies, PCAOB

    SUMMARY: The 23 deficient audits the Public Company Accounting Oversight Board found in its 2013 inspection of the firm, were out of 50 audits or partial audits conducted by KPMG that the PCAOB evaluated - a deficiency rate of 46%. In the previous year's inspection, the PCAOB found deficiencies in 17 of 50 KPMG audits inspected, or 34%. The report spotlights the PCAOB's continuing concerns about audit quality. Overall, 39% of audits inspected in the latest evaluations of the Big Four firms - KPMG, PricewaterhouseCoopers LLP, Deloitte & Touche LLP and Ernst & Young LLP - were found to have deficiencies, compared with 37% the previous year.

    CLASSROOM APPLICATION: This is useful for an auditing class to present recent results of PCAOB inspections.

    QUESTIONS: 
    1. (Introductory) What is the PCAOB? What is its function?

    2. (Advanced) What are the "Big Four" accounting firms? What are the results of the annual inspections of the Big Four accounting firms? Did one firm perform better than others?

    3. (Advanced) What is the purpose of these inspections? What do the inspectors do? What is a deficiency? What do the firms do with the inspection results?

    4. (Advanced) What happens once these results are determined? Are the financial statements changed as a result of these inspections? Are the firms sanctioned?

    5. (Advanced) The article notes that the PCAOB has made public what was previously secret criticism of the firms. Why were those previous results secret? Should this information be secret? Why or why not?

    6. (Advanced) Should these results impact the reputations of the Big Four firms? Why or why not? How should the firms handle these public revelations?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Inspection Finds Defects in 19 PricewaterhouseCoopers Audits
    by Michael Rapoport
    Jun 30, 2014
    Online Exclusive

    Regulator Finds Deficiencies in 15 Deloitte & Touche Audits
    by Michael Rapoport
    Jun 02, 2014
    Online Exclusive

    Ernst & Young 2013 Audit Deficiency Rate 49%, Regulators Say
    by Michael Rapoport
    Aug 28, 2014
    Online Exclusive

    "KPMG Audits Had 46% Deficiency Rate in PCAOB Inspection," Michael Rapoport, The Wall Street Journal, October 24, 2014 ---
    http://online.wsj.com/articles/kpmg-audits-had-46-deficiency-rate-in-pcaob-inspection-1414093002?mod=djem_jiewr_AC_domainid

    Audit regulators found deficiencies in 23 of the KPMG LLP audits they evaluated in their latest annual inspection of the Big Four accounting firm’s work.

    The 23 deficient audits the Public Company Accounting Oversight Board found in its 2013 inspection of the firm, released Thursday, were out of 50 audits or partial audits conducted by KPMG that the PCAOB evaluated—a deficiency rate of 46%. In the previous year’s inspection, the PCAOB found deficiencies in 17 of 50 KPMG audits inspected, or 34%.

    In a statement responding to the PCAOB inspection, KPMG said, “We are always mindful of our responsibility to the capital markets, and we are committed to continually improving our firm and to working constructively with the PCAOB to improve audit quality.”

    The 23 deficiencies were significant enough that it appeared KPMG hadn’t obtained sufficient evidence to support its audit opinions that a company’s financial statements were accurate or that it had effective internal controls, the PCAOB said. A deficiency in the audit doesn’t mean a company’s financial statements were wrong, however, or that the problems found haven’t since been addressed.

    Still, the report spotlights the PCAOB’s continuing concerns about audit quality. Overall, 39% of audits inspected in the latest evaluations of the Big Four firms—KPMG, PricewaterhouseCoopers LLP, Deloitte & Touche LLP and Ernst & Young LLP—were found to have deficiencies, compared with 37% the previous year.

    In addition, all of the Big Four have now seen the PCAOB make public some of its previously secret criticisms of the firms. Separately from the latest report, the PCAOB on Thursday unsealed previously confidential criticisms of KPMG’s quality controls it had made in 2011 and 2012, mirroring previous moves the board had made with regard to PwC, E&Y and Deloitte. The unsealing amounts to a public rebuke to KPMG for not acting quickly enough to fix quality-control problems, in the regulator’s view.

    In the unsealed passages, the board said some of the firm’s personnel had failed to sufficiently evaluate “contrary evidence” that seemed to contradict its audit conclusions.

    In the latest inspection report, among the areas in which the PCAOB found audit deficiencies at KPMG were failure to sufficiently test companies’ loan-loss reserves, testing of companies’ valuations of hard-to-value securities, and audits of certain kinds of derivatives transactions.

    The PCAOB didn’t identify the clients involved in the deficient audits, in accordance with its usual practice.

    PCAOB inspectors evaluate a sample of audits every year at each of the major accounting firms—focused on those the board believes are at highest risk for problems. Because of that focus, the PCAOB says the inspection results may not reflect how frequently a firm’s overall audit work is deficient. The inspections are intended only to evaluate the firms’ performance and highlight areas for potential improvement, so the firms aren’t subject to any penalties.

    Only part of the inspection reports typically becomes public. A separate portion, with the PCAOB’s criticisms of the firm’s quality controls, is kept confidential to give the firm an opportunity to address any concerns. If the firm does so, that portion of the report stays sealed permanently.

    If the firm doesn’t do enough to satisfy the PCAOB within a year, however, the board makes the concerns public. Again, though, the unsealing doesn’t carry any formal penalties for the firms.

    Bob Jensen's threads on the two faces of KPMG ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm

    Bob Jensen's threads on professionalism in auditing ---
    http://faculty.trinity.edu/rjensen/Fraud001c.htm

     


    What can be done to make reports easier for everyone to understand?
    Cut through the financial reporting clutter ---
    http://intheblack.com/articles/2014/11/11/cut-through-the-financial-reporting-clutter

    Jensen Comment
    This is useful, especially for students in accounting and finance classes who are not accounting majors.

    I would stress how financial analysis and investing entails a whole lot more than comparing earnings numbers such as eps trends and P/E ratios. Those indices are potentially very misleading since the FASB and IASB cannot even define earnings, and earnings indices may not be comparable over time or for different companies at a point in time.

     


    Question
    In accounitng, what is the difference between "cooking the books" and "misrepresenting the books"?

    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on August 8, 2014

    SEC Charges QSGI Executives of Misrepresenting Books
    by: Maria Arnental
    Jul 30, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Fraud, Internal Controls, Misrepresentation

    SUMMARY: Top executives of Florida computer-equipment company QSGI Inc. have been charged with misrepresenting the company's books to increase the amount of money they could borrow. The authorities allege that co-founders Messrs. Sherman and Cummings misled the company's external auditors and had poor internal controls. The deficiencies continued until the company filed for bankruptcy in July 2009.

    CLASSROOM APPLICATION: This article is good to use for coverage of both internal controls and also misrepresentation. The case is a good illustration of the implications of having weak internal controls that lead to intentional or unintentional misstatements in the financial statements.

    QUESTIONS: 
    1. (Introductory) What are the facts of the case in the article? What agency was involved? Why was it involved in the case?

    2. (Advanced) What were the inventory control problems detailed in the article? Do those problems seem to be a result of negligence or intentional actions? Why? What responsibilities do CEOs and CFOs have to insure that financial records properly record the situation in the company?

    3. (Advanced) What sanctions did Mr. Cummings agree to accept? Do these seem appropriate sanctions for his actions?

    4. (Advanced) The article states that Mr. Cummings did not admit or deny wrongdoing. Why would the SEC not require an admission of wrongdoing? Why did he agree to sanctions if the SEC did not prove he participated in wrongdoing?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "SEC Charges QSGI Executives of Misrepresenting Books," by Maria Arnental, The Wall Street Journal, July 30, 2014 ---
    http://online.wsj.com/articles/sec-charges-florida-computer-company-executives-1406751620?mod=djem_jiewr_AC_domainid

    Top executives of Florida computer-equipment company QSGI Inc. QSGI -42.50% have been charged with misrepresenting the company's books to increase the amount of money they could borrow, the Securities and Exchange Commission said Wednesday.

    QSGI Inc.'s Co-Founder and former Chief Financial Officer Edward L. Cummings has agreed to pay a $23,000 a penalty to settle the charges, the agency said. Under the terms of the settlement, Mr. Cummings, who didn't admit or deny wrongdoing, agreed to a five-year ban from practicing as an accountant of any entity regulated by the SEC and from serving as an officer or director of a publicly traded company, the agency said.

    The case against Co-Founder and Chief Executive Marc Sherman is pending. Mr. Sherman is to file an answer within 20 days, according to the SEC.

    Attempts to reach Mr. Sherman and the company for comment were unsuccessful.

    The authorities charge Messrs. Sherman and Cummings misled the company's external auditors, withholding, for example, that inventory controls at the company's Minnesota operations were inadequate.

    The authorities charge the West Palm Beach, Fla., company failed to design inventory-control procedures that took into account such things as employees' qualifications and experience levels. Sales and warehouse employees often failed to document the removal of items from inventories and when they did, accounting personnel often failed to process the paperwork and adjust inventory in the company's financial reporting system, the SEC said.

    The inventory control problems emerged at the Minnesota facility beginning in 2007, when key personnel left, according to the SEC. Workers assigned to replace the accounting staff, however, lacked the necessary accounting background, the authorities said, adding, training either didn't take place or was inadequate, the SEC says.

    The deficiencies continued until the company filed for bankruptcy in July 2009, the SEC added.

    Also, the authorities alleged, Mr. Sherman directed Mr. Cummings to accelerate the recognition of certain inventory and accounts receivables by as much as a week at a time, improperly increasing revenue, to maximize how much money the company could borrow from its chief creditor.

     


    Hertz Restatements due to Inadequate Internal Controls and Faulty Audit by PricewaterhouseCoopers
    "
    Ethics and Compliance Failures Underlie Hertz’s Restatement of Financial Statements," by Steven Mintz, Ethics Sage, November 26, 2014 ---
    http://www.ethicssage.com/2014/11/ethics-and-compliance-failures-underlie-hertzs-restatement-of-financial-statements-.html

     Teaching Case
    From The Wall Street Journal Accounting Weekly Review on November 21, 2014

    Hertz to Restate More Results
    by: Michael Calia
    Nov 15, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Errors, Materiality, Restatements

    SUMMARY: Hertz Global Holdings Inc. confirmed concerns that its accounting issues run even deeper, saying it would restate its results for 2012 and 2013 as the company continues an investigation into its financial statements dating back to 2011. The company said it would take longer to complete the auditing process. "Hertz does not currently expect to complete the process and file updated financial statements before mid-2015, and there can be no assurance that the process will be completed at that time, or that no additional adjustments will be identified," the company said in a filing.

    CLASSROOM APPLICATION: This article is appropriate for a financial accounting class for the topics of restatements and accounting errors, or could be used in an auditing class.

    QUESTIONS: 
    1. (Introductory) What are the facts of the Hertz restatements discussed in the article?

    2. (Advanced) What are the reasons for the delays in releasing financial statements? What additional work must occur? Why?

    3. (Advanced) How have these announcements affected Hertz's stock price? Why? How could the company's stock price be impacted going into the future?

    4. (Advanced) What should the company do in the future to prevent problems like this?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Hertz's Accounting Woes Wider Than Thought
    by Michael Calia
    Jun 09, 2014
    Online Exclusive

    Hertz Restates Some Results Citing Errors
    by Michael Calia
    Mar 20, 2014
    Online Exclusive

    Hertz Withdraws Guidance Citing Ongoing Audit Costs
    by Maria Armental
    Aug 19, 2014
    Online Exclusive

    Carl Icahn Takes 8.5% Stake in Hertz
    by Maria Armental
    Aug 20, 2014
    Online Exclusive

    "Hertz to Restate More Results," by Michael Calia, The Wall Street Journal, November 15, 2014 ---
    http://online.wsj.com/articles/hertz-to-restate-more-results-1415969212?mod=djem_jiewr_AC_domainid

    Hertz Global Holdings Inc. on Friday confirmed concerns that its accounting issues ran even deeper, saying it would restate its results for 2012 and 2013 as the company continues an investigation into its financial statements dating back to 2011.

    Previously, the company had said it would only restate results for 2011, while saying that it would revise the results for 2012 and 2013.

    Hertz shares, down 23% over the past three months through Thursday, fell as much as 14% Friday, before closing down about 5%.

    The company also disclosed changes to its rental-car fleet strategy and a plan to cut $100 million in costs over the next year.

    The company said its audit committee and management have “concluded that the additional proposed adjustments arising out of the review are material to the company’s 2012 and 2013 financial statements,” Hertz said in a filing Friday.

    As a result, the company said it would take longer to complete the auditing process. “Hertz does not currently expect to complete the process and file updated financial statements before mid-2015, and there can be no assurance that the process will be completed at that time, or that no additional adjustments will be identified,” the company said in a filing.

    Hertz revealed its detection of accounting errors in March, which followed its naming of a new chief financial officer at the end of last year. In June, the company said it would restate its 2011 results, while warning it may do the same for 2012 and 2013. It withdrew its guidance in August, citing the continuing challenges and costs associated with the audit.

    The company has since fallen under scrutiny by activists investors such as Jana Partners LLC and Carl Icahn . Jana, which owns a 7% stake in Hertz, earlier this month pressed the company to move ahead with its succession planning as the company seeks a new chief executive. Mark Frissora stepped down from that role early in September as the company contended with weak results and accounting issues.

    Mr. Icahn, who disclosed an 8.5% stake in Hertz in August, has said he believes the company’s shares are undervalued, and that he lacked confidence in management amid the accounting strife.

    Hertz on Friday also unveiled a new strategy for its U.S. rental car fleet, with an emphasis on buying more 2015 model-year cars than 2014 models.

    The company said it has implemented a cost-cutting program expected to result in $100 million in savings by the end of next year, as well.

    Hertz said its total revenue for the period ended Sept. 30 rose about 2% to $3.12 billion. U.S. car-rental revenue was down slightly to $1.76 billion, while international car-rental rose about 3% to $795 million.

    The company’s equipment-rental business posted a 3% revenue increase to $415 million.

    Continued in article

    Bob Jensen's threads on PwC ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm

    Bob Jensen's threads on audit firm professionalism and ethics ---
    http://faculty.trinity.edu/rjensen/Fraud001c.htm

     


    Teaching Case from The Wall Street Journal Weekly Accounting Review on October 31, 2014

    Buybacks Can Juice Per-Share Profit, Pad Executive Pay
    by: Maxwell Murphy and John Kester
    Oct 28, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Earnings Per Share, Stock Buybacks

    SUMMARY: In the most recent quarter, one in four companies in the S&P 500 index is expected to have juiced its earnings per share by 4% or more by snapping up its own stock. That is up from one in five at the beginning of 2014. Corporations have long bought their own shares as a way of returning excess cash to shareholders. Reducing the number of shares outstanding gives the remaining investors a larger stake in the company. Buybacks also are often a sign of a company's confidence in its future. The other side of the blade: Some shareholders and analysts are questioning why companies aren't instead plowing more money back into their business, and they say that buybacks may serve the interests of top management more than those of average shareholders.

    CLASSROOM APPLICATION: This article is appropriate to use when covering stock buybacks and the effect they have on the financial statements.

    QUESTIONS: 
    1. (Introductory) What is a stock buyback? What companies have participated in this activity in recent months?

    2. (Advanced) Why would a company do a stock buyback? What are the advantages of a stock buyback? What are the potential problems with a stock buyback?

    3. (Advanced) What is the impact of a stock buyback on the financial statements? How would the transaction be recorded? What account balances are impacted?

    4. (Advanced) What is earnings per share? How is EPS used in financial statement analysis? How would a stock buyback affect EPS?

    5. (Advanced) What areas of financial statement analysis, other than EPS, are impacted by a stock buyback? For each of those aspects, would the impact be positive, negative, or could be either, depending on the situation?

    6. (Advanced) When are conditions positive for a company to consider a stock buyback? What conditions make a buyback a poor idea?

    7. (Advanced) How should investors view buybacks? What factors should investors consider when evaluating the value of the buyback?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    The Downside to Stock Buybacks
    by Jonathan Clements
    Oct 26, 2014
    Online Exclusive

    Putting IBM's $5 Billion Buyback in Perspective
    by Kevin Kingsbury
    Oct 28, 2014
    Online Exclusive

    Companies Reduced Stock Buybacks in 2nd Quarter
    by Tess Stynes
    Sep 24, 2014
    Online Exclusive

    Companies' Stock Buybacks Help Buoy the Market
    by Dan Strumpf
    Sep 15, 2014
    Online Exclusive

    H-P to Resume Stock Buybacks
    by Dana Cimilluca and Joann S. Lublin 
    Oct 16, 2014
    Online Exclusive

    Trying to Beat the Market by Predicting the Next Buyback
    by Daisy Maxey
    Aug 11, 2014
    Online Exclusive

    Icahn Letter Pushes Apple to Buy Back More Shares
    by Erin McCarthy
    Oct 10, 2014
    Online Exclusive

    "Buybacks Can Juice Per-Share Profit, Pad Executive Pay," by Maxwell Murphy and John Kester, The Wall Street Journal, October 28, 2014 ---
    http://blogs.wsj.com/cfo/2014/10/28/buybacks-can-juice-per-share-profit-pad-executive-pay/?mod=djem_jiewr_AC_domainid

    Buying earnings growth cuts both ways.

    In the most recent quarter, one in four companies in the S&P 500 index is expected to have juiced its earnings per share by 4% or more by snapping up its own stock, according to S&P Dow Jones Indices. That is up from one in five at the beginning of the year.

    Corporations have long bought their own shares as a way of returning excess cash to shareholders. Reducing the number of shares outstanding gives the remaining investors a larger stake in the company. Buybacks also are often a sign of a company’s confidence in its future.

    The other side of the blade: Some shareholders and analysts are questioning why companies aren’t instead plowing more money back into their business, and they say that buybacks may serve the interests of top management more than those of average shareholders.

    “Executives are compensated [based] on EPS,” said Warren Chiang, a managing director at investment firm Mellon Capital Management Corp. EPS growth, he added, is “the primary reason they do buybacks.”

    After a dip in the second quarter, companies have been buying back their shares at the quickest clip since the recession, and the pace is expected to accelerate through year-end.

    Among those that have invested most aggressively in their own stock are Ingersoll-Rand PLC, Illinois Tool Works Inc., and FedEx Corp. , which all have reported year-to-year EPS growth in the latest quarter at least 13 percentage points higher than their gains in overall profit.

    Ingersoll-Rand and Illinois Tool spokeswomen said one-time events were partially responsible for the discrepancy between net income and EPS growth.

    FedEx Corp. said its board recently authorized a new stock-repurchase program that will be used primarily to offset dilution from employee stock grants. Separately, after the article’s publication, FedEx said that long-term incentive compensation calculations exclude earnings per share as a result of share buybacks.

    While the economy has crawled back to life, many businesses remain reluctant to buy new equipment, build factories or hire workers. They blame the uneven recovery that has left many Americans behind and foreign markets that are stumbling.

    Repurchases, meanwhile, can boost a company’s curb appeal. Illinois Tool Works used buybacks to post an EPS surge of 33%, nearly twice the latest quarter’s bottom-line profit growth. Bed Bath & Beyond Inc. ’s stock purchases turned a 10% drop from a year earlier in overall profit into a penny improvement in EPS. The housewares retailer didn’t provide comment.

    Flouting Wall Street’s conventional wisdom of “buy low, sell high,” companies tend to vacuum up their stock as prices rise, and dial back purchases when prices swoon, said Gregory Milano, chief executive of business consulting firm Fortuna Advisors LLC. Plus, he said, companies that avoid buybacks usually outperform those that embrace them over the long term.

    “It’s kind of like a kid in school. A lot of kids are motivated by getting the best grades they can; other kids are focused on learning as much as they can,” he said. While the child with better marks might have a leg up entering the workforce, “the kid who understands it better has a better career.”

    Of course, there are times when companies are awash in cash. Home Depot Inc. has bought back almost $50 billion of its shares since 2002. And CFO Carol Tomé says she is content to pursue this strategy as long as the home-improvement retailer’s stock price is below what she believes is its intrinsic value.

    “If you’re cash rich, and you have no better place to put it,” she said. “We’re such a cash cow. The last thing we’re going to do is sit on cash. That is value-destroying to our shareholders.”

    In addition, a well-executed buyback can charm money managers. Northrop Grumman Corp. has “done an A-plus job in our mind,” because it has been buying shares at an attractive valuation, and Lockheed Martin Corp. has “done a similarly good job,” said Matt Lamphier, a portfolio manager at First Eagle Investment Management, a major shareholder in both defense companies.

    Finance chiefs bristle at the idea that buybacks are just a mechanism to burnish EPS numbers or pad their bonuses.

    “If you’re doing the top-line growth, buying back stock is just a means of returning capital to shareholders,” said John Geller Jr., CFO of Marriott Vacations Worldwide Corp. , which announced this month it would buy back 10% of its shares. Plus, he added, “most investors are fairly sophisticated,” and can tell the difference between real and fabricated growth.

    Still, investors should expect a year-end spending spree. While about 8% of a year’s buybacks historically take place October, the peak is in November, with 14% of repurchases, and another 10% come in December, according to David Kostin, senior U.S. equity strategist at Goldman Sachs Group Inc.GS -0.29%

    Late last year, Stanley Black & Decker Inc. said it would buy back as much as $1 billion of its stock, or 7% of its current market value, by the end of 2015. But, CFO Donald Allan Jr. acknowledges that the tonic effects of such deals are temporary.

    Buybacks alone “might help your stock price performance and your company’s performance for a two- to three-year period,” he said, “but it’s not going to help the performance of the company over a decade.”

    Correction: The original version of this blog incorrectly stated that FedEx Corp. didn’t provide a comment. The blog post was prematurely updated Wednesday and then restored to its original form. Above is the corrected version.

    "When Stock Buybacks Are Not a Waste of Money," by Justin Fox, Harvard Business Review Blog, November 4, 2014 --- Click Here
    http://blogs.hbr.org/2014/11/when-stock-buybacks-are-not-a-waste-of-money/?utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date&cm_ite=DailyAlert-110514+%281%29&cm_lm=rjensen%40trinity.edu&referral=00563&cm_ven=Spop-Email&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date

    Buying back stock, pretty much corporate America’s favorite thing to do with its money over the past decade, has come in for a lot of criticism this fall. In an epic September 2014 HBR article, “Profits Without Prosperity,” economist William Lazonick blamed buybacks for much of what ails the U.S. economy. His arguments have begun to catch on, in the media at least.

    Two years ago, though, HBR Press published a book that cast buybacks in a much different light. In The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, Will Thorndike described how share buybacks had helped drive several of the most remarkable corporate successes of the past half century. The Outsiders has been described by The Wall Street Journal as the “playbook” for many of the activist investors currently pushing companies to buy back more shares.

    So I asked Thorndike, a managing director at the private equity firm Housatonic Partners, what gives: Are buybacks a travesty, or smart capital allocation? What follows is an edited and condensed version of our conversation. But first, I should probably define a few things that come up: A tender offer is when a company publicly offers to buy a large number of shares, at a set price, over a limited time period. P/E means price-to-earnings ratio. And John Malone is a cable-TV billionaire who figures prominently in Thorndike’s book.

    I guess I’ll start where your book starts, with Henry Singleton, who is really the father of the modern stock buyback. What did he do?

    The way to think about Henry Singleton is that he demonstrated kind of unique range as a capital allocator. He built Teledyne [in the 1960s] largely by using his very high P/E  to acquire a wide range of businesses. He bought 130 companies, all but two of them in stock deals. Throughout that decade his stock traded at an average P/E north of 20, and he was buying businesses at a typical P/E of 12. So it was a highly accretive activity for his shareholders.

    That was Phase One. Then he abruptly stops acquiring when the P/E on his stock falls at the very end of the decade, 1969, and focuses on optimizing operations. He pokes his head up in the early ‘70s and all of a sudden his stock is trading in the mid single digits on a P/E basis, and he begins a series of significant stock repurchases. Starting in ‘72, going to ’84, across eight significant tender offers, he buys in 90% of his shares. So he’s sort of the unparalleled repurchase champion.

    When he started doing that in ‘72, and across that entire period, buybacks were very unconventional. They were viewed by Wall Street as a sign of weakness. Singleton sort of resolutely ignored the conventional wisdom and the related noise from the media and the sell side. He was an aggressive issuer when his stock was highly priced, and an aggressive purchaser when it was priced at a discount to the market.

    The other seven companies in the book, buybacks were a big part of their success too, right?

    Yes, that’s correct. Of the eight companies in the book, all but Berkshire Hathaway — kind of a special case, Warren Buffett’s company — bought in 30% or more of shares outstanding over the course of the CEO’s tenure.

    Is part of it the era? Most of these stories you tell, the bear market of the ‘70s and early ‘80s is right in the middle of them.

    Continued in article

     


    "Were Nook's Books Cooked? Barnes & Noble's Accounting Investigated By SEC," by Brian Solomon, Forbes, December 6, 2013 ---
    http://www.forbes.com/sites/briansolomon/2013/12/06/were-nooks-books-cooked-barnes-nobles-accounting-investigated-by-sec/

    Bad news for Barnes & Noble this Christmas: the SEC thinks the bookseller’s accounting practices may have been naughty.

    In Barnes & Noble’s quarterly report filed Thursday, the company noted that the SEC “notified the Company that it had commenced an investigation into: (1) the Company’s restatement of earnings announced on July 29, 2013, and (2) a separate matter related to a former non-executive employee’s allegation that the Company improperly allocated certain Information Technology expenses between its NOOK and Retail segments for purposes of segment reporting.” The company announced that it is cooperating with the SEC on this matter.

    Barnes & Noble stock fell with the news. At 1:15pm EST, it was down 7.69%.

    Analysts at Stifel issued a note Friday expressing uncertainty about how the SEC investigation will affect Barnes & Noble. “While we have no way to judge the allegations, the risk is towards the viability of a sale of NOOK,” they said. “The announcement certainly suggests NOOK questions are not yet behind the company.”

    The analysts also indicated more downward movement for the stock: “We’ve long discussed a $10-$23 range for this sum-of-the-parts, and this news could push BKS toward the lower end.”

    Prior to today, Barnes & Noble stock was up 8.61% on the year. It opened Friday at $16.39 per share.

     Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    Net Earnings Functional Fixation?

    From the 24/7 Wall Street newsletter on October 28, 2013

    Earnings season is in full swing and this coming week will bring many key earnings reports. This will also be the last week of major on-calendar earnings for the third quarter, even if important earnings will still be coming out in the next two weeks or three weeks. 24/7 Wall St. has decided to publish previews for what it feels are the ten most important earnings reports on the calendar for the week ahead. While these may be market movers in their own right, they are definitely all sector movers. These are the 10 most important earnings in the week ahead.

    Alas!
    Net earnings is the most important number reported in financial statements and sadly accounting standard setters like the IASB and FASB can no longer even define what net earnings or any derivatives of  mean ---
    http://www.fasri.net/index.php/2009/10/the-asset-liability-approach-primacy-does-not-mean-priority/

    Accounting theorists who sometimes argue that earnings numbers between firms or even over time with within a firm are misleading and should not be compared. Why then do earnings numbers and derivatives like earnings-per-share and P/E ratios dominate the analyses of both investors and financial analysts?

    Accounting theorists scramble to explain why business firms that cook the books often do so to creatively manage their earnings numbers ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    "Accounting Alchemy," by Robert E. Verrecchia, Accounting Horizons, September 2013, pp. 603-618.
    Verrecchia alleges that it's not that managers have a functional fixation for earnings metrics as it is that they believe that other managers and investors are so fixated with earnings that it because of monumental importance not because it is inherently a great metric but because they believe deeply that the market itself makes this index of vital importance.

    . . .

    In summary, my thesis is that managers project that others are fixated on earnings—independent of any evidence in support of, or contrary to, this phenomenon. This leads to managers resisting the inclusion in earnings items that fail to enhance performance, such as the amortization of Goodwill, or measures that make future performance more volatile, such as those based on fair value. In the absence of acknowledging PEF and attempting to grapple with it, I continue to see confrontations over accounting regulation along the lines of recent debates about fair value accounting, in addition to further impediments along the path to greater transparency in financial statements.


    Recall when "agency theory" assumed that CEO's had personal incentives to make accounting transparent without the need for outside regulation requirements? This is probably still being taught in accounting theory courses where instructors rely on old textbooks and journal articles.
    In the latest twist in the stock options game, some executives may have changed the so-called exercise date — the date options can be converted to stock — to avoid paying hundreds of thousands of dollars in income tax, federal investigators say . . . As those cases have progressed, at least 46 executives and directors have been ousted from their positions. Companies have taken charges totaling $5.3 billion to account for the impact of improper grants, according to Glass Lewis & Company, a research firm that advises big investors on shareholder issues. And further investigations, indictments and restatements are expected. Securities regulators are now focusing on several cases where it appears the exercise dates of the options were backdated, according to a senior S.E.C. enforcement official, who asked not to be identified because of the agency’s policy of not commenting on active cases. Besides raising disclosure and accounting problems, backdating an exercise date can result in tax fraud.
    Eric Dash, "Dodging Taxes Is a New Stock Options Scheme," The New York Times, October 30, 2006 --- http://www.nytimes.com/2006/10/30/business/30option.html?_r=1&oref=slogin

    You can read about agency theory at http://en.wikipedia.org/wiki/Agency_Theory

    You can read the following at http://en.wikipedia.org/wiki/Agency_Theory#Incentive-Intensity_Principle

    Incentive-Intensity Principle

    However, setting incentives as intense as possible is not necessarily optimal from the point of view of the employer. The Incentive-Intensity Principle states that the optimal intensity of incentives depends on four factors: the incremental profits created by additional effort, the precision with which the desired activities are assessed, the agent’s risk tolerance, and the agent’s responsiveness to incentives. According to Prendergast (1999, 8), “the primary constraint on [performance-related pay] is that [its] provision imposes additional risk on workers…” A typical result of the early principal-agent literature was that piece rates tend to 100% (of the compensation package) as the worker becomes more able to handle risk, as this ensures that workers fully internalize the consequences of their costly actions. In incentive terms, where we conceive of workers as self-interested rational individuals who provide costly effort (in the most general sense of the worker’s input to the firm’s production function), the more compensation varies with effort, the better the incentives for the worker to produce.

    Monitoring Intensity Principle

    The third principle – the Monitoring Intensity Principle – is complementary to the second, in that situations in which the optimal intensity of incentives is high correspond to situations in which the optimal level of monitoring is also high. Thus employers effectively choose from a “menu” of monitoring/incentive intensities. This is because monitoring is a costly means of reducing the variance of employee performance, which makes more difference to profits in the kinds of situations where it is also optimal to make incentives intense.


    Book Cooking at the Highest Levels of USA Government

    Why all this controversy over new lease accounting standard revisions to show more debt on the books.
    The best way to not show more debt is to simply stop booking more debt when you borrow more money to pay your bills.

    "Jack Lew’s “Extraordinary Measures” on Debt Just 'Cooking the Books”'," by Morgan Brittany, Townhall, August 19, 2013 --- Click Here
    http://finance.townhall.com/columnists/morganbrittany/2013/08/19/jack-lews-extraordinary-measures-on-debt-just-cooking-the-books-n1667607?utm_source=thdaily&utm_medium=email&utm_campaign=nl

    . . .

    When you delve deeper into what the Treasury Department did, you see that there is a magic number of $16,699,421,000,000 to reach the debt limit set in a law passed by Congress and signed by the King himself.  Isn’t it odd that the number reached when the clock stopped ticking was about $25 million below the limit?

    If the clock had continued to click, by the end of July it would have gone over the legal debt limit and would have been in violation of the law.  However, according to the Monthly Treasury Statement for July, even though money was spent, their reports didn’t show a change in the debt by even one penny.  Isn’t that the definition of “cooking the books”?

    When it became apparent that the debt was going to exceed the limit, Jack Lew sent a “cover my behind” letter to Speaker John Boehner explaining that he was going to take “extraordinary measures” to prevent the Treasury from exceeding the legal limit on the Federal debt. This massaging of the numbers has been going on for months now.

    Jensen Comment
    The GAO declared the Pentagon and the IRS are impossible to audit. Why should it come as a surprise that the Treasury Department of the U.S. Government is incapable of being audited? Why all this debate about whether QE is tantamount to printing money. Our Treasury Secretary has a better idea. Borrow all you want and just don't book it into the accounts. Why didn't I think of that?

    The Bureau of Economic Analysis numbers can no longer be believed. Honesty in reporting is no longer a policy of our Government leaders ---
    http://finance.townhall.com/columnists/peterschiff/2013/08/11/the-half-full-economy-n1661450?utm_source=thdaily&utm_medium=email&utm_campaign=nl

    Welcome to Zimbabwe of North America.

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Ebix is a leading international supplier of software and e-commerce solutions to the insurance industry ---
    http://www.ebix.com/#
    Global Offices --- http://www.ebix.com/locations.aspx

    "Ebix: Did Bad Writing Signal Bad Accounting?" by Anthony H. Catanach Jr., Grumpy Old Accountants Blog July 5, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/7/5/ebix-did-bad-writing-signal-bad-accounting

    Poor Ebix…the Company and its flamboyant, turnaround expert CEO have had a challenging ten months.  First, on September 28, 2012, an Atlanta U.S. district court ruled that an investor lawsuit alleging false statements by the Company in its financial reports could proceed (see 2012 10-K, page 15). Next, came the revelation in November 2012 that the U.S. Securities and Exchange Commission (SEC) was investigating the Company for its accounting practices: revenue recognition and financial reporting internal controls. This was followed by news on June 14, 2013 that the U.S. Attorney in Atlanta is investigating the Company for intentional misconduct.  And this last bit of news not only scuttled an offer by Goldman Sachs Group, Inc. to buy the Company for $780 million, but also wiped out almost $300 million in market capitalization. At least for the time being, Robin Raina’s dream of owning 29 percent in the “new” company, and silencing the short-sellers who have been hounding the Company for the past two years, is dead.  But is bad accounting really to blame for Ebix’s recent misfortunes?  Or could it be something else?

    What you ask? Well, a recent column by Jean Eaglesham titled Accounting Fraud Targetedmight just offer a clue.  This article mentions the SEC’s use of new software to analyze the 10-K’s management discussion and analysis (MD&A) section looking for signs of possible earnings manipulation and other financial reporting fraud behaviors.  So, could “bad writing” have tripped up the Company?  After all, on the surface, the Company’s numbers seem just fine: increasing revenue, operating income, earnings per share, and assets.  As you might expect, this grumpy old accountant just had to conduct his own “textual analysis.”

    Without any fancy fraud detection software at my disposal, I decided to arm myself with the latest MBA jargon as an “enabler,” so that I might “drill down” into Ebix’s MD&A.  I was not disappointed at all.  On page two of the Company’s 2012 10-K alone, I was rewarded with such confusing and incomprehensible phrases as “powerhouse of backend insurance transactions; complimentary accretive acquisitions; carrying data from one end to another seamlessly; best of breed functionality; integrates seamlessly; best of breed solution; resources and infrastructure are leveraged; and acquisitive growth vs. organic revenue growth becomes rather obscure.”

    Continued in article

    Bob Jensen's threads on creative accounting and earnings management ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    From the CFO Journal's Morning Ledger on June 21, 2013

    Insurance-accounting overhaul moves toward final phase
    The IASB just issued its latest draft of proposed new rules for accounting for insurance contracts,
    Emily Chasan reports. The proposal this week revises a 2010 exposure draft to reduce the impact of artificial, noneconomic volatility in insurance accounting and would change the way companies present insurance-contract revenue in their financial statements. New rules on insurance accounting are expected to make fundamental changes to the way companies account for insurance contracts, and add more principle-based rules to one of the most industry-specific areas of accounting. Read the exposure draft here (PDF).

    "Insurers Inflating Books, New York Regulator Says," by Mary Williams Walsh, The New York Times, June 11, 2013 ---

    New York State regulators are calling for a nationwide moratorium on transactions that life insurers are using to alter their books by billions of dollars, saying that the deals put policyholders at risk and could lead to another taxpayer bailout.

    Insurers’ use of the secretive transactions has become widespread, nearly doubling over the last five years. The deals now affect life insurance policies worth trillions of dollars, according to an analysis done for The New York Times by SNL Financial, a research and data firm.

    These complex private deals allow the companies to describe themselves as richer and stronger than they otherwise could in their communications with regulators, stockholders, the ratings agencies and customers, who often rely on ratings to buy insurance.

    Benjamin M. Lawsky, New York’s superintendent of financial services, said that life insurers based in New York had alone burnished their books by $48 billion, using what he called “shadow insurance,” according to an investigation conducted by his department. He issued a report about the investigation late Tuesday.

    The transactions are so opaque that Mr. Lawsky said it took his team of investigators nearly a year to follow the paper trail, even though they had the power to subpoena documents.

    Insurance is regulated by the states, and Mr. Lawsky said his investigators found that life insurers in New York were seeking out states with looser regulations and setting up shell companies there for the deals. They then used those states’ tight secrecy laws to avoid scrutiny by the New York State regulators.

    Insurance regulation is based squarely on the concept of solvency — the idea that future claims can be predicted fairly accurately and that each insurer should track them and keep enough reserves on hand to pay all of them. The states have detailed rules for what types of assets reserves can be invested in. Companies are also expected to keep a little more than they really expect to need — called their surplus — as a buffer against unexpected events. State regulators monitor the reserves and surpluses of companies and make sure none fall short.

    Mr. Lawsky said that because the transactions made companies look richer than they otherwise would, some were diverting reserves to other uses, like executive compensation or stockholder dividends.

    The most frequent use, he said, was to artificially increase companies’ risk-based capital ratios, an important measurement of solvency that was instituted after a series of life-insurance failures and near misses in the 1980s.

    Mr. Lawsky said he was struck by similarities between what the life insurers were doing now and the issuing of structured mortgage securities in the run-up to the financial crisis of 2008.

    “Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices,” Mr. Lawsky said. “And ultimately, those practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multitrillion-dollar taxpayer bailout.”

    The transactions at issue are modeled after reinsurance, a business in which an insurance company pays another company, a reinsurer, to take over some of its obligations to pay claims. Reinsurance is widely used and is considered beneficial because it allows insurers to spread their risks and remain stable as they grow. Conventional reinsurance deals are negotiated at arm’s length by independent companies; both sides understand the risk and can agree on a fair price for covering it. The obligations drop off the original insurer’s books because the reinsurer has picked them up.

    Mr. Lawsky’s investigators found, though, that life insurance groups, including some of the best known, were creating their own shell companies in other states or countries — outside the regulators’ view — and saying that these so-called captives were selling them reinsurance. The value of policies reinsured through all affiliates, including captives, rose to $5.46 trillion in 2012, from $2.82 trillion in 2007.

    Continued in article

    Also see
    "World Needs More Hardheads Like Benjamin Lawsky," by Jonathan Weil, Bloomberg News, June 13, 2013 ---
    http://www.bloomberg.com/news/2013-06-13/world-needs-more-hardheads-like-benjamin-lawsky.html

    Bob Jensen's threads on creative accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation


    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.


    "The Many Ways That Cities Cook Their Bond Books:  The $3 trillion municipal debt market is rife with creative accounting," by Steve Malanga, The Wall Street Journal, May 31, 2013 ---
    http://online.wsj.com/article/SB10001424127887324659404578501241181682894.html?mod=djemEditorialPage_h

    It has been a busy few weeks for the Securities and Exchange Commission. In May, the SEC charged two cities—Harrisburg, Pa., and South Miami, Fla.—with securities fraud for allegedly deceiving investors in their municipal bonds.

    This follows similar fraud charges against states, New Jersey in 2010 and Illinois in March, after SEC investigators uncovered what they called "material omissions" and "false statements" in bond documents related to those state's pension funds.

    With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."

    The Harrisburg charges are part of a broader SEC effort to scrutinize state and local government issuers in the nation's $3 trillion municipal-bond market. "Anyone who follows municipal finance knows that budgets can sometimes be a work of fiction," says Anthony Figliola, a vice president at Empire Government Strategies, a Long Island-based consulting firm to local governments. "Harrisburg is the tip of the iceberg."

    And a mighty iceberg it is. The 2012 State of the States report, released in November by Harvard's Institute of Politics, the University of Pennsylvania's Fels Institute of Government and the American Education Foundation, found state and local governments are carrying more than $7 trillion in debt, an amount equal to nearly half the federal debt. Often, the report said, "States do not account to citizens in ways that are transparent, timely or accessible."

    Consider the practices of Stockton, Calif., which last June became the nation's biggest city to file for bankruptcy. In 2011, Stockton's new financial managers issued a blistering critique of past accounting practices and acknowledged that the city's previous financials had hidden significant costs, including the real cost of employee compensation and retirement obligations. Bob Deis, the new city manager, declared that Stockton's financials bore "eerie similarities to a Ponzi scheme."

    If so, the city's bondholders have been taken for a ride. In bankruptcy court earlier this year, a judge ruled that Stockton could suspend payments on its bonds even while continuing to fund its employee retirement system.

    Similarly, when another California city, San Bernardino, went bust last year, some city officials alleged that it had been filing inaccurate financial records for nearly 16 years. At best, officials said, the city's bookkeeping had been "unprofessional." The SEC began an investigation last fall. Meanwhile, the city has defaulted on bond payments, leaving investors in the lurch.

    One area that has come under special scrutiny is pension-fund accounting, because states have latitude in choosing how to value their retirement debts. The SEC noted that Illinois used accounting that funds a larger percentage of an employee's pension costs near the end of his career, a method that increases the risks that the system could go bust. The SEC said Illinois didn't properly reveal the risks posed by this sophisticated accounting wrinkle.

    The SEC accused New Jersey of failing to disclose to investors that it wasn't sticking to a plan to adequately fund its pension system. In this, the Garden State isn't alone. Many states underfund their pension systems, even by their own accounting standards.

    A June 2012 study by the Pew Center on the States found that 29 states didn't make their annual required contribution for pensions in 2010, the last year for which data were available. It isn't clear how many of the more than 3,000 local government pension systems follow the same practice, although a survey this January by Pew of 61 large cities found nearly half didn't make their full contributions.

    In the South Miami case the SEC zeroed in on a complex bond deal that changed over time in a way that threatened the tax-free status of the securities. The SEC essentially warned South Miami that municipalities that employ such schemes need to fully understand the consequences for investors. In this particular case, South Miami paid $260,000 to the Internal Revenue Service to preserve the tax-free status of the bonds for investors.

    Municipal investors have often ignored such questionable practices thanks to a generation of low default rates. Many also assume that even when a local government gets into financial trouble, bondholders are always first in line to be paid.

    But officials in some troubled cities are pushing back against the notion that investors should get the best deal among creditors. Harrisburg City Council members have balked at a state-proposed bailout plan because they claim it places much of the burden on taxpayers without penalizing investors. Last year, City Councilman Brad Koplinski called the plan's 1% increase in the state-imposed income tax on Harrisburg residents "a bad decision for the people of Harrisburg, people who did nothing to get our city into our fiscal crisis.''

    Investors will hear more of this talk as municipalities face growing budget pressures. Recently, former New York Lt. Gov. Richard Ravitch warned the municipal bond industry that the promises governments have made to repay investors may not take precedent over other obligations. States and cities face "a unique challenge," he said, "in trying to maintain services and meet their retirement commitments to workers," emphasizing that this was "not necessarily a good message" for investors.

    Continued in article

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    Tom Selling takes on what he claims is a "self-serving" Ernst & Young
    "Do Survey Results Mean that External Audits Don’t Protect Against Earnings Manipulation? (What a Surprise!)," by Tom Selling, The Accounting Onion, May 10, 2013 --- Click Here
    http://accountingonion.com/2013/05/do-survey-results-mean-that-external-audits-dont-protect-against-earnings-manipulation-what-a-surprise.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

    Jensen Comment
    This time I think Tom is on to something. It would be great if E&Y would reply to his blog post, but I doubt that this is going to happen. The usual reply is that external auditors are not paid to detect fraud unless the fraud is material to the audited financial statement outcomes. It would seem that the survey results in this instance would mostly affect financial statements in great gobs.

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on Ernst & Young are at
    http://faculty.trinity.edu/rjensen/Fraud001.htm


    One of the major concerns of the IASB is that some nations at some points in time will simply not enforce the IASB standards that these nations adopted. The biggest problem that the IASB is now having with European Banks is that the IASB feels many of many (actually most) EU banks are not conforming to standards for marking financial instruments to market (fair value). But the IASB thus far has been helpless in appealing to IFRS enforcement in this regard.

    European Union officials knew this and let Spain proceed with its own brand of accounting anyway.
    "The EU Smiled While Spain’s Banks Cooked the Books," by Jonathan Weil, Bloomberg, June 14, 2012 ---
    http://www.bloomberg.com/news/2012-06-14/the-eu-smiled-while-spain-s-banks-cooked-the-books.html

    Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

    But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

    By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

    This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

    What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia (BKIA) group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

    Name Calling

    Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

    “Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”

    The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

    One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

    “They didn’t implement IFRS, and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS,” McCreevy said, according to a transcript of the meeting on the monitoring board’s website. “The Spanish regulator did not do that, and he survived this. His banks have survived this crisis better than anybody else to date.”

    Ignoring Rules

    McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, went on: “The rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them.”

    Why didn’t he take action? McCreevy said he was a fan of dynamic provisioning. “Why am I like that? Well, I’m old enough to remember when I was a young student that in my country that I know best, banks weren’t allowed to publish their results in detail,” he said. “Why? Because we felt if everybody saw the reserves, etc., it would create maybe a run on the banks.”

    So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

    Continued in article

     

    Jensen Comment
    Thus it is one thing to promote the advantages of international accounting standards and quite another to own up to the major problems of international accounting standards enforcement.

    Bob Jensen's threads on cookie jar accounting deceptions ---
    http://faculty.trinity.edu/rjensen/theory01.htm#CookieJar

    Bob Jensen's threads on cookie jar accounting are at
    See below

    February 19, 2010 reply from Bob Jensen

    Hi Francine,

    The Sandrew article is really terrific (thanks for the heads up) ---
    http://sandrew.tumblr.com/post/397168410/on-the-impossibility-of-measuring-model-risk

    As to the cookie jar question, I think it reduces to an issue of whether the bad quant reserves are used primarily to smooth income in the same sense as cookie jar reserves are traditionally used to smooth income. Or are the bad quant reserves more like bad debt reserves that are used for better matching under the matching concept where timing of cost write offs better matches revenues with expenses incurred to generate those revenues.

    To me, the Allowance for Bad Quants seems to me to be a bit more like the Allowance for Bad Debts, but I’ve not really taken time to study this question in detail.

    A great example of cookie jar accounting, aside from the classic examples allowed in Switzerland, is Tom Selling’s General Motors example ---
    See below

    Bob Jensen

     


    "FAS 106: Will the SEC Allow GM to Have the Largest Earnings Cookie Jar in History?" by Tom Selling, The Accounting Onion, March 13, 2008 --- http://accountingonion.typepad.com/theaccountingonion/2008/03/gm-holding-work.html

    Bob Jensen's thread on creative accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation


    "Accounting Option Facilitates Multinational Earnings Manipulation," by Michael Cohn, Accounting Today, October 12, 2012 ---
    http://www.accountingtoday.com/news/accounting-option-facilitates-multinational-earnings-manipulation-64298-1.html

    An accounting construct known as permanently reinvested earnings is helping U.S.-based multinational corporations keep tens of billions of dollars in profits overseas, according to a new study.

    Not only does it greatly reduce earnings repatriation, but it appears to be used extensively to manipulate corporate earnings and thereby mislead investors. A tax director of a Fortune 500 company has compared permanently reinvested earnings to crack cocaine, explaining that "once you start using it, it's hard to stop."

    The accounting tool, known as PRE for short, goes one better than IRS rules that each year permit companies to defer paying U.S. taxes on tens of billions of dollars' worth of earnings by their foreign subsidiaries. PRE gives the multinationals the additional option of omitting from their financial statements entirely, except in footnotes, an admission that any taxes at all are owed to Washington on those profits, which they are able to do by declaring their intention to indefinitely reinvest them abroad. PRE have accumulated over time, and by the end of last year they amounted to more than $1.5 trillion, about 42 percent above their level of two years earlier.

    While accounting scholars have for some time agreed that the PRE option lowers the repatriation of foreign earnings, it has remained unclear by how much. New research offers an answer.

    A study in the current issue of the journal The Accounting Review, published by American Accounting Association, concludes that the PRE option reduces multinational firms' repatriation of foreign affiliates' earnings (through dividends paid to U.S. parent firms) by approximately 20 percent a year. While acknowledging that high U.S corporate tax rates and the ability to defer payment play a major role in keeping earnings abroad, it finds that "repatriation is more sensitive to the repatriation tax rate in the presence of reporting incentives," so much so that "firms with high reporting incentives repatriate, on average, 16.6 to 21.4 percent less per year than firms with low reporting incentives."

    "Our study suggests that companies would repatriate about 20 percent more than they currently do if they didn't have this accounting tool that enables them to put a gloss on their financial statements," said Leslie A. Robinson, an accounting professor at Dartmouth College, who conducted the study with professors Linda Krull of the University of Oregon and Jennifer Blouin of the University of Pennsylvania.

    Even though U.S. tax law permits multinationals to defer payment of U.S. taxes due on earnings abroad, Robinson explained, mere deferral does not exempt these firms from recording a tax liability on their financial statements. In contrast, declaring profits to be PRE provides this exemption, which has the effect of enhancing firms' bottom lines.

    The accounting standard responsible for PRE, known as APB 23, came under attack last month during a one-day Senate hearing, chaired by Carl Levin, D-Mich., which probed offshore corporate profit-shifting (see Senate Probes Offshore Profit Shifting by Microsoft and HP). Indeed, one expert witness called for abolishing APB 23 entirely, describing it as "provid[ing] enormous potential to call up earnings as needed —or postpone them —in a large multinational operation."

    Foreign affiliates' permanently invested earnings, he added, can be “sliced as finely as needed to meet earnings estimates with pinpoint precision.”

    Levin commented: "On the one hand these companies assert that they intend to indefinitely or permanently invest that money offshore. Yet, they promise on the other hand to bring it home as soon as it is granted a tax holiday. That's not any definition of' 'permanent'' that I understand. While this may seem like an obscure matter, it is a major issue for U.S. multinational corporations."

    While the authors of the new Accounting Review paper do not offer specific policy prescriptions, their findings make clear the special appeal PRE have for U.S. parent companies that, in the study's words, "face reporting incentives to consistently report strong earnings numbers." The study’s authors find that public firms are likely to declare a considerably greater proportion of their assets as PRE than private firms do, since "capital-market pressures vary between public and private firms due to differences in the constituents to which the two types of firms report...Public-firm managers typically have a strong focus on reported earnings because of its effect on both firm value and managerial compensation. In contrast, private firms have high levels of insider ownership and encounter...less incentive to focus on reported earnings."

    Among public multinationals, the study suggests, PRE are especially favored by firms highly sensitive to the capital markets, including those whose stock prices have above-average responsiveness to company earnings, those with a consistent record of matching or narrowly beating earnings forecasts, and those with relatively few dedicated investors—that is, institutional investors whose focus is on companies' long-term performance.

    In addition, the more PRE that firms accumulate over time, the lower their repatriation of current foreign earnings. The study explains that, if companies designate high levels of undistributed foreign earnings as PRE, they may find themselves in a bind in repatriating current earnings, since their financial statements will have to recognize both higher tax expenses and lower earnings than were recorded for previous periods.

    The study's findings derive from a sample of 577 U.S.-based multinational corporations, including 479 public companies with 23,669 foreign affiliates and 98 private firms with 1,790 foreign affiliates. The professors combine data from the U.S. Bureau of Economic Analysis with information from other sources to construct measures of tax-reporting incentives over a six-year period. To isolate the effect on repatriation of tax-reporting incentives, as distinguished from incentives to avoid actual tax payments, the professors "identify and measure firm attributes across which reporting incentives vary while holding the cash payment for repatriation taxes constant." The reporting incentives include whether a company is public or private, how sensitive it is to capital markets, and how much PRE it has accumulated.

    Continued in article


    "Curse of Arthur Andersen Lives On (in Huron Consulting)," by Jonathan Weil, Bloomberg, July 19, 2012 ---
    http://www.bloomberg.com/news/2012-07-19/curse-of-arthur-andersen-lives-on.html

    Huron Consulting Group Inc., a Chicago-based consulting company founded by a group of former Arthur Andersen LLP partners after the accounting firm's 2002 demise, has agreed to pay $1 million to settle Securities and Exchange Commission allegations that it cooked its books.

    The deal caps a remarkable act of corporate self-immolation. One of Huron's main businesses had been providing forensic-accounting advice to other companies, including those under SEC investigation for accounting fraud. Then in 2009 Huron restated more than three years of its financial reports to correct accounting violations, which reduced its earnings by $56 million. The company sold part of its disputes-and-investigations practice in 2010 and shuttered the rest.

    The SEC, which disclosed the accord in a press release late Thursday, also reached settlement deals with Huron's former chief financial officer, Gary Burge, and its former chief accounting officer, Wayne Lipski. They agreed to pay almost $300,000 to resolve the SEC's claims against them.

    Per the usual formalities, the defendants neither admitted nor denied anything. Unlike the conviction against Arthur Andersen for obstructing the government's investigation of Enron Corp., the SEC's order against Huron in this case won't be overturned.

    PS
    This is an illustration of an Audit Committee doing an excellent job. Huron's Audit Committee sniffed out the book cooking.

    Bob Jensen's threads on the Huron Consulting Group's book cooking scandals ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm#Cooking

    Bob Jensen's threads on book cooking ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     

     

     


    Creative Accounting Inflation of Reported Cash from Operations

    I have long argued that if cash flow statements were not accompanied by accrual accounting financial statements, managers would manipulate the timings of cash flows in cash collections and terms of contracts. Here's some empirical evidence that this happens in spite of being accompanied by accrual accounting financial statements.

    "Incentives to Inflate Reported Cash from Operations Using Classification and Timing," by  Lian Fen Lee, The Accounting Review, January 2012, pp. 1-34

    ABSTRACT:

    This study examines when firms inflate reported cash from operations in the statement of cash flows (CFO) and the mechanisms through which firms manage CFO. CFO management is distinct from earnings management. Unlike the manipulation of accruals, firms cannot manage CFO with biased estimates, but must resort to classification and timing. I identify four firm characteristics associated with incentives to inflate reported CFO: (1) financial distress, (2) a long-term credit rating near the investment/non-investment grade cutoff, (3) the existence of analyst cash flow forecasts, and (4) higher associations between stock returns and CFO. Results indicate that, even after controlling for the level of earnings, firms upward manage reported CFO when the incentives to do so are particularly high. Specifically, firms manage CFO by shifting items between th estatement of cash flows categories both within and outside the boundaries of generally accepted accounting principles (GAAP), and by timing certain transactions such as delaying payments to suppliers or accelerating collections from customers.

    Data Availability: Data are available from public sources identified in the study.

    Keywords:  classification shifting, real activities manipulation, cash flow reporting

     


    "Financial Reporting Quality in U.S. Private Firms," Ole-Kristian Hope, Wayne B. Thomas, and Dushyantkumar Vyas, SSRN, January 29, 2012 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1995124

    Abstract:     
    We provide a large-scale investigation of financial reporting quality (FRQ) among U.S. private firms. Private firms are vital to the economy but have received limited attention from researchers due to a lack of available data. Using a new database that contains accounting data for a large sample of U.S. private firms, we provide interesting new evidence on their FRQ. Relative to publicly traded companies, we find that private firms have lower FRQ as proxied for by several commonly used FRQ measures and are less conservative. Further, we provide the first exploration of cross-sectional variations in the FRQ of private firms. Specifically, we show that private firms with greater external financing needs and a greater presence of long-term debt have higher FRQ and greater conservatism. Private firms with greater owner-manager separation (i.e., C corporations) tend to exhibit lower FRQ but more conservatism.

     

    Number of Pages in PDF File: 45

    Keywords: Private firms, financial reporting quality, public versus private, within private examination, demand, opportunism

    Bob Jensen's threads on accounting theory and practice are at
    http://faculty.trinity.edu/rjensen/Theory01.htm


    The SEC is getting soft in its old age.  We suggest that it get grumpy instead.
    "JCOM: WHEN WILL THE SEC CALL AN ERROR AN ERROR?," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, March 8, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/557

    The business enterprise j2 Global Communications (JCOM) in its first quarter 2011 filing made an accounting change and called it a change in estimate.  As several observers have noted, what the Company called a change in estimate is really an accounting error.  What we would like to know is when will the SEC take JCOM’s managers to the woodshed and call an error an error.

    Gradient Analytics may have been the first to report this anomaly.  In its November 21, 2011 report, it gave JCOM an earnings quality grade of “F” (boy, were they grumpy or what?).  In part, this failing grade was due to the Company’s mislabeling an error as a change in estimate.  Basically, JCOM through transparency right out the window.

    Sam Antar pointed out this discrepancy in his blog “White Collar Fraud.”  Tracy Coenen likewise raised questions about this sleight of hand in her post “[JCOM] …Trying to Hide Accounting Errors.”  Both of them referred to the research by Gradient Analytics, and both of them agreed that this change was an accounting error.

    Here are the details.  In footnote 1 of the 10-Q (Q1 2011), JCOM writes:

    In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax® subscribers.  As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers.  As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenues of $10.3 million with an equal offset to revenues.  This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended March 31, 2011 by $0.17 and $0.16, respectively.

    This description is baffling.  Estimates are for unobservables, generally items that are future-oriented.  For example, depreciation requires an estimate of the remaining life of the asset and an estimate of its salvage value at some unknown future date.  As time goes by, managers may be in a better position to assess these unknowns, and any revisions will be changes in estimates.  Similar statements can be made about depletion, amortization, bad debts, sales returns, and a variety of items.  In every case, the estimates are for future items, be they the asset’s life, the amount of future cash collections from customers, the amount of future returns, etc.

    It seems natural to base revenue estimates on the “actual remaining service obligations to these customers,” after all, the last time we checked, revenue has to be earned. So, what was JCOM basing it on beforehand?

    Of course, it is possible that the previous accounting information system was inadequate for the job. In that case, the auditor SingerLewak LLP should not have blessed the internal control system in the 10-K. An accounting information system that cannot produce accurate data for such a basic process does not deserve an unqualified opinion. Such a system is pathetic.

    The SEC sent a letter to JCOM on December 19, 2011. The SEC asked managers to explain why the actual remaining service obligations were not previously known. The firm responded on January 3, 2012 (intertwined with our thoughts):

    Continued in article

     


    A Teaching Case Featuring an Article by NYU Accounting Professor Baruch Lev

    From The Wall Street Journal Accounting Weekly Review on March 2, 2012

    The Case for Guidance
    by: Baruch Lev
    Feb 27, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Earnings Forecasts, Earnings Management

    SUMMARY: This is the first of three articles in the WSJ's Section on Leadership in Corporate Finance published on Monday, February 27, 2012. Baruch Lev, the Philip Bardes Professor of Accounting and Finance at NYU's Stern School of Business offers arguments in favor of publicly traded companies' managements issuing earnings guidance. He has recently published a book entitled "Winning Investors Over."

    CLASSROOM APPLICATION: The article is useful for any financial reporting class to introduce the notions of management earnings guidance, analyst earnings forecasts, and the arguments for and against this information dissemination process. It is as well useful to highlight the usefulness of academic research in finance and accounting.

    QUESTIONS: 
    1. (Introductory) What is management guidance? To whom is it directed?

    2. (Introductory) What is the trend regarding the number of publicly traded U.S. firms providing management guidance?

    3. (Advanced) What is the difference between annual guidance and quarterly guidance? What are the trends in regarding the numbers of companies providing each of these?

    4. (Introductory) What are the arguments often presented against companies providing annual earnings guidance?

    5. (Introductory) What are the author's counterarguments to those points?

    6. (Introductory) What does Dr. Lev say about management's need for the information that is used to develop and present management earnings guidance?

    7. (Advanced) Who is Dr. Baruch Lev?

    8. (Introductory) What is the source for Dr. Lev's information in writing this article for The Wall Street Journal?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "The Case for Guidance," by Baruch Lev, The Wall Street Journal, February 7, 2012 ---
    http://online.wsj.com/article/SB10001424052970203391104577124243623258110.html?mod=djem_jiewr_AC_domainid

    Alot of prominent people don't like the idea of giving the market an early heads-up.

    Critics, who include Warren Buffett, Al Gore and groups like the Chamber of Commerce, have blasted the practice of issuing "guidance"—advance notices about earnings and other matters. They argue that it wastes managers' time and encourages short-term thinking, and may even drive companies to seek capital overseas instead of in the U.S.

    But a host of research—mine and others'—shows that those arguments don't hold up. Guidance benefits investors, companies and managers in a number of ways, such as cutting down shareholder lawsuits and giving the market better data to work with. Indeed, research recently published in the Journal of Accounting and Economics documents a significant stock-price drop for companies that announced they were stopping guidance. Far from a waste of time, guidance is a crucial part of an executive's job.

    That said, companies should do it smartly. For one thing, they should issue guidance only when they can predict performance better than analysts—and they should make it part of a broader practice of disclosure that gives investors insight into the company's plans and progress. A Vital Component

    Let's start with the most basic argument against guidance: It takes too much time. Critics say executives must set up elaborate and costly forecasting processes, and then answer endless rounds of questions about the numbers they issue. And that prevents them from undertaking other productive activities.

    ut guidance requires a negligible investment of time. A CEO who doesn't readily have short- and medium-term performance forecasts shouldn't guide, and shouldn't manage. Guidance also increases the circle of analysts following the firm, since guidance data makes it much easier to do their job. And having lots of analysts on board comes in handy in stock issues and proxy contests.

    More broadly, managers gain credibility when they have a track record of issuing accurate guidance. There's also evidence that guidance helps keep management honest. A study from University of Georgia researchers finds that companies that issue guidance are less likely to put out dishonest earnings reports than companies that don't guide.

    Critics also say that guidance encourages a futile short-term earnings game. Companies, the argument goes, slash R&D or other long-term initiatives to meet earnings estimates—sacrificing future growth.

    But the argument misses a crucial point: Most guidance isn't short-term. It forecasts several quarters ahead, giving companies a chance to fill in details that wouldn't show up in regular financial reports.

    For instance, reported earnings don't reflect the progress of the product-development process of innovative companies, such as in biotech. They also ignore recent business initiatives and new contracts signed or canceled, as well as the impact of economic developments—like the European recession—on future performance.

    In fact, I further argue that critics are wrong even when companies are providing short-term guidance. For one thing, the game of trying to beat expectations plays out with or without guidance. Doesn't Google, the famous nonguider, aim to beat the consensus? Reducing Uncertainty

    More broadly, getting more information out helps everyone involved—shareholders, analysts and companies. By sharing information with the market, companies reduce investor uncertainty and prevent stock prices from swinging wildly upon unexpected bad news. My research shows that managers' quarterly earnings guidance is more accurate than the current analysts' consensus forecast in 70% of cases. Analysts know this and are quick to revise their forecasts upon the release of guidance.

    But warning investors about potential disappointments doesn't just help protect them from losses—it helps protects companies, too. Guidance released prior to weak earnings is considered a mitigating factor in shareholder lawsuits, and was shown in a study published in 1997 to reduce settlement figures. (Most shareholder lawsuits are settled.)

    There's one more argument the critics often make against guidance: It puts so much pressure on companies that they abandon the U.S. equities market and seek out private equity or foreign listings. But I haven't found a single example of a company taken private or listed abroad whose managers claimed that the "pressure to guide" was a major reason. Besides, isn't it easier just to abstain from guidance? Two-thirds of public companies do just that.

    All that said, there are right and wrong ways to do guidance. Here's a look at some basic principles companies should follow.

    • Guide when you are a better prognosticator than analysts. For the past three to five years, compare your internal quarterly earnings forecasts with analysts' public forecasts, relative to the subsequently released earnings. If you beat analysts, chalk one up for guidance. If not, how come outsiders know more about your company's future than you do?

    • If most of your industry peers release guidance regularly, you don't want to stand out as a refusenik. Investors will suspect that you have something to hide or that you aren't on top of things.

    Continued in article

    Jensen Comment
    Baruch has done a considerable amount of previous accountics research on how to measure and report intangibles and contingency items. I'm sorry to say that over the years I've been mostly critical of that research ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    "Banks use (IFRS) accounting loopholes to inflate profits and bolster bonuses: Gordon Kerr former banker and author of the report calls for radical reform to stop banks investing in risky assets," by Jill Treanor, The Guardian, December 13, 2011 ---
    http://www.guardian.co.uk/business/2011/dec/14/banks-accounting-loopholes-profits-bonuses?newsfeed=true

    The cited report is at
    http://www.adamsmith.org/sites/default/files/research/files/ASI_Law_of_opposites.pdf

    "Banks use (IFRS) accounting loopholes to inflate profits and bolster bonuses: Gordon Kerr former banker and author of the report calls for radical reform to stop banks investing in risky assets," by Jill Treanor, The Guardian, December 13, 2011 ---
    http://www.guardian.co.uk/business/2011/dec/14/banks-accounting-loopholes-profits-bonuses?newsfeed=true

    The cited report is at
    http://www.adamsmith.org/sites/default/files/research/files/ASI_Law_of_opposites.pdf

     

    December 14, 2011 reply from Jim Peters

    I looked at the article in detail, the term “loophole” isn’t quite accurate. The issue is fair value accounting and marking derivatives to market, which I wouldn’t call a loophole. It seems the author considers fair value accounting a loophole because banks record profits in their income statements before there is a hard transaction, which is just fair value accounting. He also complained that mark to market accounting allows banks to record assets at market value even if they can’t be sold for that value. I found that a bit confusing because a market value is, by definition, what the market is currently paying for assets. I could imagine a situation where a bank held enough securities that, if sold all at once, might depress the prices. But other than that, the market is supposed to be the arbiter of asset values in free markets. My summary conclusion is that the title of the article and issue raised is intentionally inflammatory to gain readership and really, the underlying issue is old news.

    December 15, 2011 reply from Bob Jensen

    Hi Jim and Pat,

    I think you're both correct in theory, but the problem in Europe is that companies, especially banks, are not being symmetric in the implementation of the fair value rules --- fair values are moved fully upward but not necessarily fully downward. The IASB has objected to a degree (Tweedie sent a ranting protest letter), but eventually the IASB caved in to pressures from the EU to allow over-estimations of tanking bond values and also delayed IFRS 9 implementation until 2015. We might allege, therefore, that the IASB is being somewhat complicit with corporate overstatements of earnings under fair value accounting in an effort to keep the EU in the fold regarding the IASB standards and interpretations.

    In the U.S., FAS 157 is somewhat loose about fair value estimation. For a variety of reasons that sound good on paper companies can depart from mark-to-market adjustments and use fair value (Level 3) models that are not clearly defined. The devil is in the details, and I think companies and their auditors can abuse the subjectivity in the rules. Of course Lehman Brothers derivatives value estimates showed us that this could never happen (wink, wink)!
     

    "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 onethirtieth 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.

     


  • "Executive Overconfidence and the Slippery Slope to Financial Misreporting," Catherine Schrand, Professor of Accounting at the University of Pennsylvania, and Sarah Zechman of the accounting group at the University of Chicago Booth School of Business, The Harvard Law School Forum on Corporate Governance and Financial Regulation, October 14, 2011 ---
    http://blogs.law.harvard.edu/corpgov/2011/10/14/executive-overconfidence-and-the-slippery-slope-to-financial-misreporting/

    In the paper, Executive Overconfidence and the Slippery Slope to Financial Misreporting, forthcoming in the Journal of Accounting and Economics as published by Elsevier, our detailed analysis of a sample of 49 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) suggests two distinct explanations for the misstatements. Just over one quarter of the cases represent many of the well-publicized examples of corporate fraud including Adelphia, Enron, Healthsouth, and Tyco. The nature of the misstatements, their timing, and an analysis of the executives suggest that the activities are consistent with a strong inference of intent on the part of the respondent and consistent with the legal standards necessary to establish fraud.

    However, perhaps more surprising, we find that the actions by the executives in the remaining three quarters of the cases are not consistent with the pleading standards required to establish an intent to defraud. Rather, our analysis of the 49 AAER firms suggests that optimistic bias on the part of executives can explain these AAERs. We show that the misstatement amount in the initial period of alleged misreporting is relatively small, and possibly unintentional. Subsequent period earnings realizations are poor, however, and the misstatements escalate. Using a matched sample of non-AAER firms, we show that the misreporting firms did not simply get a bad draw on earnings. Nor does it appear that weaker monitoring relative to the matched sample explains why the misreporting manager’s optimistic bias affects the financial statements.

    We further examine whether the optimistic bias for the misreporting firms is associated with the character trait of overconfidence. The evidence from the analysis of the 49 AAER sample is mixed on this question. However, we find evidence of a positive association between proxies for overconfidence and the propensity for AAERs in two larger samples that use alternative measures of overconfidence. The association between overconfidence and AAERs is consistent with the slippery slope explanation in which greater optimistic bias makes it more likely that a manager is in the position that significant misreporting is an optimal choice.

    An interesting question raised by the analysis is the importance of monitoring the optimistic bias of executives. Various models predict that overconfidence has desirable effects on the executive’s performance (Goel and Thakor, 2000; Gervais and Goldstein, 2007; Gervais et al., 2010). Our analysis indicates overconfidence can be associated with financial reporting concerns and prior work has documented an association between overconfidence and distorted investment and financing decisions (e.g., Malmendier and Tate, 2005 and 2008 among others). For firms who value the positive aspects of overconfidence, a plausible response is to put mechanisms in place to monitor the executive’s decision-making biases associated with this trait. This response is feasible only if the Board recognizes executive overconfidence. Our evidence indicating that the misreporting firms and matched sample of non-AAER firms have different compensation arrangements suggests that the Board is able to do so at some level. However, our corresponding analysis of monitoring does not indicate that the overconfident managers were better monitored, which explains why they were more likely to end up misreporting. The potential for monitoring to moderate the optimistic bias that characterizes executives remains an interesting open question. Is it that our analysis does not adequately capture the specific mechanisms that would control optimistic bias? Or, is the cost of better monitoring higher than the expected benefits from mitigating the risk of misreporting, which is a significant but unusual event?

    The full paper is available for download at
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1919729
    Download it while it's free.

    Bob Jensen's threads on creative accounting and earnings management are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on Enron are at
    http://faculty.trinity.edu/rjensen/FraudEnron.htm

    Bob Jensen's threads on accounting theory are at
    http://faculty.trinity.edu/rjensen/Theory01.htm

    Jensen Comment
    Once again this illustrates how the IASB and FASB are overly focused on assets and liabilities without even being able to define net income on anything other than a residual leftover basis. As a result, things like unrealized fair value changes get blended in with realized operational earnings in eps and P/E ratio calculations that are the major focal points of company management and investors. This supports my previous appeal for multi-column financial statements that vary according to degree of realization and attestation by CPA auditors.

     


    An example where regulation worked to detect and correct a huge accounting fraud

     

    The Largest Earnings Management Fraud in History
    and Congressional Efforts to Cover it Up

    Without trying to place the blame on Democrats or Republicans, here are some of the facts that led to the eventual fining of Fannie Mae executives for accounting fraud and the firing of KPMG as the auditor on one of the largest and most lucrative audit clients in the history of KPMG. The restated earnings purportedly took upwards of a million journal entries, many of which were re-valuations of derivatives being manipulated by Fannie Mae accountants and auditors (Deloitte was charged with overseeing the financial statement revisions. 

     

    Fannie Mae may have conducted the largest earnings management scheme in the history of accounting.
     
    You can read the following at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
     
    . . . flexibility also gave Fannie the ability to manipulate earnings to hit -- within pennies -- target numbers for executive bonuses. Ofheo details an example from 1998, the year the Russian financial crisis sent interest rates tumbling. Lower rates caused a lot of mortgage holders to prepay their existing home mortgages. And Fannie was suddenly facing an estimated expense of $400 million.

    Well, in its wisdom, Fannie decided to recognize only $200 million, deferring the other half. That allowed Fannie's executives -- whose bonus plan is linked to earnings-per-share -- to meet the target for maximum bonus payouts. The target EPS for maximum payout was $3.23 and Fannie reported exactly . . . $3.2309. This bull's-eye was worth $1.932 million to then-CEO James Johnson, $1.19 million to then-CEO-designate Franklin Raines, and $779,625 to then-Vice Chairman Jamie Gorelick.

    That same year Fannie installed software that allowed management to produce multiple scenarios under different assumptions that, according to a Fannie executive, "strengthens the earnings management that is necessary when dealing with a volatile book of business." Over the years, Fannie designed and added software that allowed it to assess the impact of recognizing income or expense on securities and loans. This practice fits with a Fannie corporate culture that the report says considered volatility "artificial" and measures of precision "spurious."

    This disturbing culture was apparent in Fannie's manipulation of its derivative accounting. Fannie runs a giant derivative book in an attempt to hedge its massive exposure to interest-rate risk. Derivatives must be marked-to-market, carried on the balance sheet at fair value. The problem is that changes in fair-value can cause some nasty volatility in earnings.

    So, Fannie decided to classify a huge amount of its derivatives as hedging transactions, thereby avoiding any impact on earnings. (And we mean huge: In December 2003, Fan's derivatives had a notional value of $1.04 trillion of which only a notional $43 million was not classified in hedging relationships.) This misapplication continued when Fannie closed out positions. The company did not record the fair-value changes in earnings, but only in Accumulated Other Comprehensive Income (AOCI) where losses can be amortized over a long period.

    Fannie had some $12.2 billion in deferred losses in the AOCI balance at year-end 2003. If this amount must be reclassified into retained earnings, it might punish Fannie's earnings for various periods over the past three years, leaving its capital well below what is required by regulators.

    In all, the Ofheo report notes, "The misapplications of GAAP are not limited occurrences, but appear to be pervasive . . . [and] raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision and overall safety and soundness. . . ." In an agreement reached with Ofheo last week, Fannie promised to change the methods involved in both the cookie-jar and derivative accounting and to change its compensation "to avoid any inappropriate incentives."

    But we don't think this goes nearly far enough for a company whose executives have for years derided anyone who raised a doubt about either its accounting or its growing risk profile. At a minimum these executives are not the sort anyone would want running the U.S. Treasury under John Kerry. With the Justice Department already starting a criminal probe, we find it hard to comprehend that the Fannie board still believes that investors can trust its management team.

    Fannie Mae isn't an ordinary company and this isn't a run-of-the-mill accounting scandal. The U.S. government had no financial stake in the failure of Enron or WorldCom. But because of Fannie's implicit subsidy from the federal government, taxpayers are on the hook if its capital cushion is insufficient to absorb big losses. Private profit, public risk. That's quite a confidence game -- and it's time to call it.

     

    **********************************

    :"Sometimes the Wrong 'Notion':   Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio," by Michael MacKenzie, The Wall Street Journal, October 5, 2004, Page C3 

    Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio

    What exactly did Fannie Mae do wrong?

    Much has been made of the accounting improprieties alleged by Fannie's regulator, the Office of Federal Housing Enterprise Oversight.

    Some investors may even be aware the matter centers on the mortgage giant's $1 trillion "notional" portfolio of derivatives -- notional being the Wall Street way of saying that that is how much those options and other derivatives are worth on paper.

    But understanding exactly what is supposed to be wrong with Fannie's handling of these instruments takes some doing. Herewith, an effort to touch on what's what -- a notion of the problems with that notional amount, if you will.

    Ofheo alleges that, in order to keep its earnings steady, Fannie used the wrong accounting standards for these derivatives, classifying them under complex (to put it mildly) requirements laid out by the Financial Accounting Standards Board's rule 133, or FAS 133.

    For most companies using derivatives, FAS 133 has clear advantages, helping to smooth out reported income. However, accounting experts say FAS 133 works best for companies that follow relatively simple hedging programs, whereas Fannie Mae's huge cash needs and giant portfolio requires constant fine-tuning as market rates change.

    A Fannie spokesman last week declined to comment on the issue of hedge accounting for derivatives, but Fannie Mae has maintained that it uses derivatives to manage its balance sheet of debt and mortgage assets and doesn't take outright speculative positions. It also uses swaps -- derivatives that generally are agreements to exchange fixed- and floating-rate payments -- to protect its mortgage assets against large swings in rates.

    Under FAS 133, if a swap is being used to hedge risk against another item on the balance sheet, special hedge accounting is applied to any gains and losses that result from the use of the swap. Within the application of this accounting there are two separate classifications: fair-value hedges and cash-flow hedges.

    Fannie's fair-value hedges generally aim to get fixed-rate payments by agreeing to pay a counterparty floating interest rates, the idea being to offset the risk of homeowners refinancing their mortgages for lower rates. Any gain or loss, along with that of the asset or liability being hedged, is supposed to go straight into earnings as income. In other words, if the swap loses money but is being applied against a mortgage that has risen in value, the gain and loss cancel each other out, which actually smoothes the company's income.

    Cash-flow hedges, on the other hand, generally involve Fannie entering an agreement to pay fixed rates in order to get floating-rates. The profit or loss on these hedges don't immediately flow to earnings. Instead, they go into the balance sheet under a line called accumulated other comprehensive income, or AOCI, and are allocated into earnings over time, a process known as amortization.

    Ofheo claims that instead of terminating swaps and amortizing gains and losses over the life of the original asset or liability that the swap was used to hedge, Fannie Mae had been entering swap transactions that offset each other and keeping both the swaps under the hedge classifications. That was a no-go, the regulator says.

    "The major risk facing Fannie is that by tainting a certain portion of the portfolio with redesignations and improper documentation, it may well lose hedge accounting for the whole derivatives portfolio," said Gerald Lucas, a bond strategist at Banc of America Securities in New York.

    The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities.  The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts.  How the SEC acts may well override the FASB.  How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

     

    Video on the efforts of some members of Congress seeking to cover up accounting fraud at Fannie Mae ---
    http://www.youtube.com/watch?v=1RZVw3no2A4

     

    May 31, 2011 message from Roger Collins

    Of possible interest...

    http://www.nytimes.com/2011/05/29/books/review/book-review-reckless-endangerment-by-gretchen-morgenson-and-joshua-rosner.html?ref=books

    "It’s hardly news that the near meltdown of America’s financial system enriched a few at the expense of the rest of us. Who’s responsible? The recent report of the Financial Crisis Inquiry Commission blamed all the usual suspects — Wall Street banks, financial regulators, the mortgage giants Fannie Mae and Freddie Mac,
    and subprime lenders — which is tantamount to blaming no one. “Reckless Endangerment” concentrates on particular individuals who played key roles.

    The authors, Gretchen Morgenson, a Pulitzer Prize-winning business reporter and columnist at The New York Times, and Joshua Rosner, an expert on housing finance, deftly trace the beginnings of the collapse to the mid-1990s, when the Clinton administration called for a partnership between the private sector and Fannie and Freddie to encourage home buying. The mortgage agencies’ government backing was, in effect, a valuable subsidy, which was used by Fannie’s C.E.O.,
    James A. Johnson, to increase home ownership while enriching himself and other executives. A 1996 study by the Congressional Budget Office found that Fannie pocketed about a third of the subsidy rather than passing it on to homeowners. Over his nine years heading Fannie, Johnson personally took home roughly $100 million. His successor, Franklin D. Raines, was treated no less lavishly...."

    continued in article...

    Roger

    Bob Jensen's threads on earnings management fraud at Fanny Mae ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on slease in thesubprime scandals ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze

    Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts of Private Companies ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm


    PCAOB Snags KPMG Yet Another Time (this time for a client named Motorola with dubious revenue recognition to meet an earnings target)

    The oversight board said a significant portion of the company’s earnings for the 2006 third quarter came from two licensing agreements that were recorded during the last three days of the quarter. One was the Qualcomm deal that wasn’t signed until the fourth quarter. The board also cited other deficiencies in KPMG’s review of Motorola’s accounting for the transactions.
    "Dirty Secrets Fester in 50-Year Relationships," byJonathan Weil, Bloomberg News, June 9, 2011 ---
    http://www.bloomberg.com/news/2011-06-09/dirty-secrets-fester-in-50-year-relationships-jonathan-weil.html

    Another financial scandal. Another cover-up by regulators. Four years ago, inspectors for the auditing industry's chief watchdog discovered that KPMG LLP had let Motorola Inc. record revenue during the third quarter of 2006 from a transaction with Qualcomm Inc. (QCOM), even though the final contract wasn’t signed until the early hours of the fourth quarter. That’s no small technicality. Without the deal, Motorola would have missed its third-quarter earnings target.

    The regulator, the Public Company Accounting Oversight Board, later criticized KPMG for letting Motorola book the revenue when it did. Although KPMG had discussed the transaction’s timing with both Motorola and Qualcomm, the board said the firm “failed to obtain persuasive evidence of an arrangement for revenue-recognition purposes in the third quarter.” In other words, KPMG had no good reason to believe the deal shouldn’t have been recorded in the fourth quarter.

    The oversight board didn’t tell the public that this happened at Motorola, though. The maker of wireless- communications equipment, now known as Motorola Solutions Inc., didn’t restate its earnings for the period in question. And there’s no sign the Securities and Exchange Commission ever followed up with an investigation of Motorola’s accounting, even though it oversees the board and had access to its findings.

    All of this is business as usual for America’s numbers cops. Since the board’s creation by the Sarbanes-Oxley Act in 2002, its inspectors have found audit failures by large accounting firms at hundreds of U.S.-listed companies. Yet its policy is to keep the identities of those clients secret.

    ‘Issuer C’

    Likewise, in August 2008 when the board released its annual inspection report on KPMG, it referred to Motorola as “Issuer C” in the section on the auditor’s work for the company. For what it’s worth, Motorola paid the firm $244.2 million from 2000 to 2010.

    This is the third column I’ve written revealing the name of a client whose accounting practices were a subject of a major auditing firm’s inspection report. Motorola is the biggest yet. I hope a whistleblower comes forward someday to leak many more. This is information investors need to know.

    The Sarbanes-Oxley Act authorizes the oversight board to disclose “such confidential and proprietary information as the board may determine to be appropriate” in the public portions of its inspection reports. So it’s the board’s call whether to disclose clients’ names, although the SEC could overrule it. The board never does, bowing to the wishes of the accounting firms.

    Identity Revealed

    Motorola’s identity was disclosed in public records last month as part of a class-action shareholder lawsuit against the company in a federal district court in Chicago. The plaintiffs in the case, led by the Macomb County Employees’ Retirement System in Michigan, filed a transcript of a September 2010 deposition of a KPMG auditor, David Pratt, who testified that Issuer C was Motorola. KPMG isn’t a defendant in the lawsuit.

    Pratt also identified the Motorola customers cited in the board’s inspection report. It’s his deposition that allows me to describe the report’s findings using real names.

    The oversight board said a significant portion of the company’s earnings for the 2006 third quarter came from two licensing agreements that were recorded during the last three days of the quarter. One was the Qualcomm deal that wasn’t signed until the fourth quarter. The board also cited other deficiencies in KPMG’s review of Motorola’s accounting for the transactions.

    Making the Numbers

    Motorola booked $275 million of earnings during the 2006 third quarter as a result of the Qualcomm deal, according to estimates by the plaintiffs in the shareholder suit. The plaintiffs allege that all of it was recorded in violation of generally accepted accounting principles. That’s 28 percent of the net income Motorola reported for the quarter.

    A Motorola spokesman, Nicholas Sweers, said the company’s accounting complied with GAAP, and that the financial statements for the periods covered in the inspection report have never been the subject of an SEC investigation. He declined to discuss details of Motorola’s accounting, citing the litigation. A KPMG spokesman, George Ledwith, declined to comment. So did an oversight board spokeswoman, Colleen Brennan, and an SEC spokesman, John Nester.

    The story doesn’t end there. Last week the board’s new chairman, James Doty, gave a speech in which he said the board should consider setting mandatory term limits for auditors at public companies. To prove his point, he cited two instances that were “galling in their simplicity” where auditors “have failed to exercise the required skepticism and have accepted evidence that is less than persuasive.”

    Making a Match

    One of his examples matched the fact pattern of KPMG’s 2006 review at Motorola exactly. “PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract was not signed until the early hours of the fourth quarter,” Doty said. “Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target.”

    Continued in article

    Jensen Comment
    Recall that KPMG was fired from the big Fannie Mae audit because of alleged cooperation in helping Fannie's top executives creatively meet earnings targets for their personal bonuses ---
    http://faculty.trinity.edu/rjensen/Theory02.htm

    Bob Jensen's threads on revenue recognition and Hypothetical Future Value are at
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

    Bob Jensen's threads about the two faces of KPMG are at
    http://faculty.trinity.edu/rjensen/Fraud001.htm


    Financial Statement Fraud Casebook: Baking the Ledgers and Cooking the Books
    Joseph T. Wells (Editor) ISBN: 978-0-470-93441-8 Hardcover 360 pages June 2011
    Wiley --- http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470934417.html


    Probably the best illustration of earnings management is the saga of Enron --- http://faculty.trinity.edu/rjensen/FraudEnron.htm#Quotations 


    "Dell Is the Latest to Go the SEC’s Woodshed; Settlement of $100 million for Fraudulent Accounting, Disclosure Violations," by Caleb Newquist, Going Concern, July 22, 2010 --- http://goingconcern.com/2010/07/michael-dell-is-the-latest-to-go-the-secs-woodshed/

    Also see http://www.crn.com/it-channel/201800702;jsessionid=5YIC355EBYCZNQE1GHPSKHWATMY32JVN

    Bob Jensen's threads on Deloitte are at
    http://faculty.trinity.edu/rjensen/Fraud001.htm


    Book --- Click Here
    http://www.amazon.com/gp/product/0071703071?ie=UTF8&tag=worbet-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0071703071
    Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition [Hardcover]
    Howard Schilit (Author), Jeremy Perler (Author)
    Also available as an eBook


    Wow:  A Must Read for Sure

    "Cooking the Books Why do firms issue financial misstatements? Based on the Research of Jap Efendi, Anup Srivastava And Edward P. Swanson," Kellog Insight, February 2011 ---
    http://insight.kellogg.northwestern.edu/index.php/Kellogg/article/cooking_the_books/#When:18:17:07Z

    When the dot-com bubble of the late 1990s sent stock prices soaring, something else soared, too: CEOs’ perceptions of their net wealth. That theory alone may explain a large part of the psychology and behavior of why some corporate managers allowed their accounting books to get cooked.

    On March 10, 2000, the dot-com bubble burst abruptly and as a result many firms had to issue accounting restatements well into the next decade. Let’s face it, a lot of people lost a lot of money, and not just the CEOs who watched large portions of their own stock holdings in their own companies vaporize. Let’s also not forget the chasm of broken trust that opened between the business community and the public.

    So what happened? Did the CEOs transmogrify into greed-poisoned crooks? That answer may satisfy our human desire for a villain, but that is not exactly how things played out, says Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School of Management.

    While most firms were not guilty of accounting irregularities or criminal activity, a few were. Srivastava and Jap Efendi, an assistant professor at University of Texas at Arlington, and Edward P. Swanson, a professor at Texas A&M, dug into the problem of overvaluation of firms’ equity, and they developed several reasons why CEOs may have overseen the release of false or misleading financial statements. At the heart of the matter was a confluence of CEO compensation structuring with a little idea (holding large implications) about how very large incentives can cause normally law-abiding citizens to step outside the law’s bounds.

    Taking Risks Srivastava explains that in 2005, Harvard professor emeritus and noted financial economist Michael C. Jensen wrote a paper titled “Agency costs of overvalued equity,” which was published in the journal Financial Management. “In this paper, Jensen argues that managers are normal human beings but when the stakes are very high, normal human beings begin making extremely risky decisions,” Srivastava says. “Our paper examining the overvaluation of a firm’s equity during the dot-com years is the only paper that has tested his theory.”

    When Srivastava says a firm is overvalued, he is referring to extreme situations where the stock may be worth 100 to 1,000 percent of its fundamental value. When this happens, the firm’s fundamentals cannot justify the stock price and so managers begin to “do things.”

    “They start taking extreme risks. They make acquisitions and play with their accounting numbers,” Srivastava explains. “This is very destructive to society. Decisions based on overvalued equity are not good for society because they lead to a loss of wealth.”

    Srivastava says that an important trend in CEO compensation over the past two decades has been an increasing emphasis placed on company stock options. When this collides with market overvaluation, CEOs may find that their in-the-money stock options balloon into the stratosphere to nearly one hundred times the value of their salary.

    “Let’s say their in-the-money stock options are worth a billion dollars now,” Srivastava says. “They may start to think, ‘I’m a billionaire.’” By confusing their overinflated stock options with their net wealth, these CEOs begin to make riskier and riskier decisions, perhaps to preserve their perceived wealth. It is a fragile zone to live within; a 10 percent decline in their company’s stock price could spell out a 50 percent decline in their net wealth.

    “In this scenario, they will do anything and everything to keep the stock values high,” Srivastava says. But this motivation may also extend beyond their own personal gain; they may want to maintain the status quo by not liquidating their holdings as to avoid attention from the Securities and Exchange Commission or their investors regarding the overvaluation problem.

    “What we highlight in our paper is the fact that when equity is overvalued, and overvaluation in equity results in large in-the-money options for managers, then managers have incentives to take very risky accounting decisions,” Srivastava says.

    Show Me the Money The researchers used ninety-five sample firms—pinpointed from a Government Accountability Office (GAO) database of companies that restated a previously issued financial statement—and compared these to ninety-five control firms that had not issued restatements but were matched in terms of size, industry, and asset values. They then examined the firms that announced a restatement between January 1, 2001, and June 30, 2002, for accounting errors in prior years, extending back to April 1995. (Firms often announce a restatement one to two years after the year being restated, e.g., a restatement announced in January 2001 could be for the accounting year 1999 or 2000.) The team used press releases and annual reports to discover the exact year of the misstatement, a detail the GAO database lacks.

    For example, say an Internet company called WidgetTechs tanked in the 2000 bust and announced a restatement of its accounts later. Srivastava and his team basically poked through records to find WidgetTechs’ historic stock prices and its compensation package. Then they dissected this data to look for trends that associated aspects of compensation to time points right before, during, and after accounting irregularities, or criminal activity, was said to have occurred.

    By doing this, Srivastava and his colleagues found that the best predictors of accounting misstatements turned out to be in-the-money values of stock options held by CEOs. To illuminate the magnitude of in-the-money option holdings, they found the average holdings for CEOs at restating firms was approximately $50 million, which greatly exceeded the average of $9 million at matched firms that did not announce a restatement. Stated another way, the CEOs of restating firms held options with in-the-money value that was forty-six times their salary, compared with options six times the salary of CEOs in control firms.

    The team then parsed the restating firms into two main categories based on accounting issue classifications assigned by the GAO—non-malfeasance and malfeasance—that describe the degree of seriousness of the firm’s accounting error. (A malfeasance category correlates to fraudulent behavior or an SEC-induced restatement, while a non-malfeasance category correlates to a non-criminal, less serious issue or irregularity.)

    The researchers found that the in-the-money value of options for CEOs at restating firms with evidence of accounting malfeasance was even higher, averaging approximately $130 million (compared to an average of $50 million for all restating firms).

    One of the study’s key insights centered on the degree to which options were in-the-money. The analysis detected no difference between the value or number of options issued by restatement and control firms to their CEOs. In other words, the larger in-the-money values of restatement firms were not due to the number of options held but the degree to which the firm’s stock options were in-the-money. Within both the restating firms and the control firms, the research team analyzed CEO compensation to look for predictors that a firm would issue a restatement. They tested the base salary, bonus, options grant, in-the-money stock options, restricted stock grants, and restricted stock holdings. The only statistically significant variable turned out to be in-the-money options.

    Continued in article

    Jim Martin wrote the following in his MAAW Blog on May 20,2016
    http://maaw.blogspot.com/2016/05/financial-shenanigans-update.html

    Financial Shenanigans update
    I added the following note to my summary of Schilit, H. 2002. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. 2nd edition. McGraw Hill.

    Schilit includes seven main shenanigans that include 30 accounting tricks and techniques. See
    http://maaw.info/ArticleSummaries/ArtSumSchilit2002.htm

    The third edition of this book was published in 2010. See Schilit, H. and J. Perler. 2010. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd edition. McGraw-Hill Education.

    Part three includes four chapters on cash flow shenanigans:

    Chapter 10: Shifting financing cash flows to the operating section.

    Chapter 11: Shifting normal operating cash flows to the investing section.

    Chapter 12: Inflating operating cash flows using acquisitions or disposals.

    Chapter 13: Boosting operating cash flows using unsustainable activities.

     

    Part four includes two chapters on key metrics shenanigans:

    Chapter 14: Showcasing misleading metrics that overstate performance.

    Chapter 15: Distorting balance sheet metrics to avoid showing deterioration

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     

    Bob Jensen's recipes for cooking the books ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation


    International Accountant 57 is now available in digital format. In particular this issue has an interesting article on creative accounting case studies --- http://www.aiaworldwide.com/content/InternationalAccountant/Issue57.htm

    Jensen Comment
    I'm generally frustrated by the difficulty of navigating and searching issues of this journal. It seems to be technology run amuck.


    "Groupon: Comedy or Drama?"  by Grumpy Old Accountants  Anthony H. Catanach Jr. and J. Edward Ketz, SmartPros, July 2011 ---
    http://accounting.smartpros.com/x72233.xml 

    "Trust No one, Particularly Not Groupon's Accountantns," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, August 24, 2011 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/ 

    "Is Groupon "Cooking Its Books?"  by Grumpy Old Accountants  Anthony H. Catanach Jr. and J. Edward Ketz, SmartPros, September  2011 ---
    http://accounting.smartpros.com/x72233.xml 

     

    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

    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

    Bob Jensen's threads about cooking the books ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     


    "Why Do CFOs Become Involved in Material Accounting Manipulations?" Harvard Law School Forum, December 20, 2010 ---
    http://blogs.law.harvard.edu/corpgov/2010/12/20/why-do-cfos-become-involved-in-material-accounting-manipulations/

    In the paper, Why Do CFOs Become Involved in Material Accounting Manipulations? we investigate why CFOs become involved in material accounting manipulations. To address this research question, we examine two possible explanations. CFOs might instigate accounting manipulations for immediate personal financial gain, as reflected in their equity compensation. Alternatively, CFOs could manipulate the financial reports under pressure from CEOs.

    Using a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005, we investigate the costs and benefits associated with intentional financial misreporting for CFOs. We find that CFOs bear substantial legal costs when involved in accounting manipulations. We also document that these CFO equity incentives (measured by pay-for-performance sensitivity) are not significantly different from those of CFOs of control firms. However, CEOs of the manipulation firms have significantly higher equity incentives and power than CEOs of the control firms. Moreover, CFO turnover is significantly higher within three years prior to the occurrences of material accounting manipulations for manipulation firms than control firms, consistent with CFOs facing significant costs (loss of job) for saying no to CEO pressure. Finally, our AAER content analyses suggest that CEOs of manipulation firms are more likely than CFOs to be described as having orchestrated the manipulation and to be requested to disgorge financial gains from the manipulation. Taken together, our findings suggest that CFOs are likely to become involved in material accounting manipulations because they succumb to CEO pressure, rather than because they seek immediate financial benefit.

    Some caveats are in order. First, we assume that CFOs of accounting manipulation firms are aware of or are involved in misreporting. We believe this assumption is reasonable given that one of the main job responsibilities of CFOs is to watch over the financial reporting process and make related decisions. However, in some unusual cases accounting manipulations could occur without the knowledge of CFOs (e.g., CEOs collude with divisional managers to create fictitious sales and hide the manipulation from CFOs). These cases are likely to add noise instead of introducing a systematic bias to our empirical results. Second, we assume that the companies identified by the SEC have indeed manipulated financial statements. This assumption seems reasonable given that the SEC spends effort and resources to establish evidence for the alleged manipulations. However, the SEC likely does not identify all the companies with accounting manipulations; as a result, some of our control firms might have “undetected” manipulations. This issue would be a concern if the SEC systematically pursues companies with characteristics examined and found significant in our empirical tests, but we are not aware of any evidence supporting this possibility.

    While subject to these caveats, our paper contributes to the understanding of CFOs’ incentives when they face accounting manipulation decisions. Our findings suggest that CFOs are typically not the instigator of accounting manipulations. Instead, it appears that CEOs, especially powerful CEOs with high equity incentives, exert significant influence over CFOs’ financial reporting decisions. In other words, CFOs’ role as watchdog over financial reports is compromised by the pressure from CEOs. Overall, the findings of this study suggest a corporate governance failure for the accounting manipulation firms, and have important implications for current corporate governance reform. While researchers, practitioners, and regulators have generally concluded that stock-based compensation has provided managers with incentives to misstate accounting numbers, our results indicate that re-designing compensation packages for CFOs is not necessarily the only remedy. Improving CFO independence by alleviating the pressure of CEOs on CFOs could be critical to improving financial reporting quality. One possible way to achieve this would be to have boards or audit committees more involved in CFO performance evaluation and in hiring and retention decisions (Matejka, 2007).

    The full paper is available for download here.---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1260368 

    Bob Jensen's threads on creative accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#Manipulation

    Also see
    http://faculty.trinity.edu/rjensen//theory/00overview/AccountingTricks.htm


    Mr. Buffett, who has interests in both companies, claimed there was another agenda (aside from hedging with derivatives). “The reason many of them do it (invest in derivative contracts) is that they want to smooth earnings,” he said, referring to the idea of trying to make quarterly numbers less volatile. “And I’m not saying there’s anything wrong with that, but that is the motivation.”
    "Derivatives, as Accused by Buffett," by Andrew Ross Sorkin, The New York Times, March 14, 2011 ---
    http://dealbook.nytimes.com/2011/03/14/derivatives-as-accused-by-buffett/?ref=business

    Mr. Buffett once described derivatives as “financial weapons of mass destruction.” Yet some of his most ardent fans have quietly raised eyebrows at his pontifications, given that he plays in the opaque market. In the fourth quarter alone, Berkshire made $222 million on derivatives. TheStreet.com published a column last spring with the headline: “Warren Buffett Is a Hypocrite.”

    ¶His comments, which were released last month by the financial crisis commission, come as the government is writing rules for derivatives as part of the Dodd-Frank financial regulatory overhaul. And the statements could influence the debate.

    ¶Mr. Buffett appeared to backpedal from his oft-quoted line, explaining: “I don’t think they’re evil per se. It’s just, they, I mean there’s nothing wrong with having a futures contract or something of the sort. But they do let people engage in massive mischief.”

    ¶The problems arise, Mr. Buffett said, when a bank’s exposure to derivatives balloons to grand proportions and uninformed investors start using them.

    ¶It “doesn’t make much difference if it’s, you know, one guy rolling dice against another, and they’re doing $5 a throw. But it makes a lot of difference when you get into big numbers.”

    ¶What worries him most is the big financial institutions that have millions of contracts. “If I look at JPMorgan, I see two trillion in receivables, two trillion in payables, a trillion and seven netted off on each side and $300 billion remaining, maybe $200 billion collateralized,” he said, walking through his thinking. “That’s all fine. But I don’t know what discontinuities are going to do to those numbers overnight if there’s a major nuclear, chemical or biological terrorist action that really is disruptive to the whole financial system.”

    ¶“Who the hell knows what happens to those numbers?” he asked. “I think it’s virtually unmanageable.”

    ¶Mr. Buffett defended Berkshire Hathaway’s use of derivatives, arguing that the company maintains a limited amount. At the time of the interview, the company had only about 250 derivative contracts. (It’s now down to 203.) “I want to know every contract, and I can do that with the way we’ve done it. But I can’t do it with 23,000 that a bunch of traders are putting on.”

    ¶He noted that when Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” he said to the government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.

    ¶Mr. Buffett said he used derivatives to capitalize on discrepancies in the market. (That’s what other investors must think they are doing — just not as successfully.)

    ¶Perhaps the most insightful nugget in the interview was Mr. Buffett’s explanation of why corporations use derivatives — and why they probably shouldn’t.

    ¶Many companies, as diverse as Coca-Cola and Burlington Northern, argue that they employ derivatives to hedge their risk.

    ¶The United States-based Coca-Cola tries to protect against fluctuations in currencies since it does business around the world. Burlington Northern, the railroad giant, uses the investments to limit the effect of fuel prices.

    ¶Mr. Buffett, who has interests in both companies, claimed there was another agenda. “The reason many of them do it is that they want to smooth earnings,” he said, referring to the idea of trying to make quarterly numbers less volatile. “And I’m not saying there’s anything wrong with that, but that is the motivation.”

    ¶The numbers all even out eventually, he cautioned, so derivatives don’t really make much difference in the long term.

    ¶“They’re going to lose as much on the diesel fuel contracts over time as they make,” he said of Burlington Northern. “I wouldn’t do it.”

    Continued in article

    Bob Jensen's tutorials on accounting for derivative financial instruments ---
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

     


    Clawback Teaching Case:  Earnings Management and Creative Accounting

    "Clawbacks: Prospective Contract Measures in an Era of Excessive Executive Compensation and Ponzi Schemes," by Miriam A. Cherry and Jarrod Wong, SSRN, August 23, 2009 --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1460104

    Abstract:
    In the spring of 2009, public outcry erupted over the multi-million dollar bonuses paid to AIG executives even as the company was receiving TARP funds. Various measures were proposed in response, including a 90% retroactive tax on the bonuses, which the media described as a "clawback." Separately, the term "clawback" was also used to refer to remedies potentially available to investors defrauded in the multi-billion dollar Ponzi scheme run by Bernard Madoff. While the media and legal commentators have used the term "clawback" reflexively, the concept has yet to be fully analyzed. In this article, we propose a doctrine of clawbacks that accounts for these seemingly variant usages. In the process, we distinguish between retroactive and prospective clawback provisions, and explore the implications of such provisions for contract law in general. Ultimately, we advocate writing prospective clawback terms into contracts directly, or implying them through default rules where possible, including via potential amendments to the law of securities regulation. We believe that such prospective clawbacks will result in more accountability for executive compensation, reduce inequities among investors in certain frauds, and overall have a salutary effect upon corporate governance.

    Clawback in the Context of TARP --- http://en.wikipedia.org/wiki/Troubled_Asset_Relief_Program

    On October 14, 2008, Secretary of the Treasury Paulson and President Bush separately announced revisions in the TARP program. The Treasury announced their intention to buy senior preferred stock and warrants in the nine largest American banks. The shares would qualify as Tier 1 capital and were non-voting shares. To qualify for this program, the Treasury required participating institutions to meet certain criteria, including: "(1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive." The Treasury also bought preferred stock and warrants from hundreds of smaller banks, using the first $250 billion allotted to the program.

    The first allocation of the TARP money was primarily used to buy preferred stock, which is similar to debt in that it gets paid before common equity shareholders. This has led some economists to argue that the plan may be ineffective in inducing banks to lend efficiently.[15][16]

    In the original plan presented by Secretary Paulson, the government would buy troubled (toxic) assets in insolvent banks and then sell them at auction to private investor and/or companies. This plan was scratched when Paulson met with United Kingdom's Prime Minister Gordon Brown who came to the White House for an international summit on the global credit crisis.[citation needed] Prime Minister Brown, in an attempt to mitigate the credit squeeze in England, merely infused capital into banks via preferred stock in order to clean up their balance sheets and, in some economists' view, effectively nationalizing many banks. This plan seemed attractive to Secretary Paulson in that it was relatively easier and seemingly boosted lending more quickly. The first half of the asset purchases may not be effective in getting banks to lend again because they were reluctant to risk lending as before with low lending standards. To make matters worse, overnight lending to other banks came to a relative halt because banks did not trust each other to be prudent with their money.[citation needed]

    On November 12, 2008, Secretary of the Treasury Henry Paulson indicated that reviving the securitization market for consumer credit would be a new priority in the second allotment

    From The Wall Street Journal Accounting Weekly Review on August 13, 2010

    Clawbacks Divide SEC
    by: Kara Scannell
    Aug 07, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Auditing, Executive Compensation, Restatement, Sarbanes-Oxley Act, SEC, Securities and Exchange Commission, Stock Options

    SUMMARY: During the settlement with Dell, Inc. in which founder Michael Dell agreed to pay a $4 million penalty without admitting or denying wrongdoing, Commissioner Luis Aguilar raised the issue of "clawing back" compensation to executives based on inflated earnings. "The SEC alleged Mr. Dell hid payments from Intel Corp. that allowed the company to inflate earnings....Under [Section 304 of the 2002 Sarbanes-Oxley law], the SEC can seek the repayment of bonuses, stock options or profits from stock sales during a 18-month period following the first time the company issues information that has to be restated." The SEC has been working on a formal policy to guide them in cases in which an executive has not been accused of personal wrongdoing, "but hammering out a policy acceptable to the five-member Commission...may be difficult." The related article announced the clawback provision when it was enacted into law in July and compares it to the previous requirements related to executive compensation under Sarbanes-Oxley.

    CLASSROOM APPLICATION: The article covers topics in financial reporting related to restatement, executive compensation topics, the Sarbanes-Oxley law, and the SEC's recent enforcement efforts in general.

    QUESTIONS: 
    1. (Introductory) Based on the main and related article, define and describe a "clawback" policy.

    2. (Introductory) Why will most publicly traded companies implement change as a result of the new law and resultant SEC requirements?

    3. (Advanced) When must a company restate previously reported financial results? Cite the authoritative accounting literature requiring this treatment.

    4. (Advanced) Describe one executive compensation plan impacted by reported financial results. How would such a plan be impacted by a restatement?

    5. (Introductory) What is the difficulty with applying the new clawback provisions to executive stock option plans? Based on the related article, how are companies solving this issue?

    6. (Advanced) Is it possible that executives who are innocent of any wrongdoing could be affected financially by these new clawback provisions? Do you think that such executives should have to repay to their companies compensation amounts received in previous years? Support your answer.

    7. (Advanced) Refer to the main article. Consider the specific case of Dell Inc. founder Michael Dell. Do you believe Mr. Dell should have to return compensation to the company? Support your answer.

    8. (Introductory) How do the new requirements under the financial reform law enacted in July exceed the requirements of Sarbanes-Oxley? In your answer, include one or two statements to define the Sarbanes-Oxley law.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    Law Sharpens 'Clawback' Rules for Improper Pay
    by JoAnn S. Lublin
    Jul 25, 2010
    Online Exclusive

    "Clawbacks Divide SEC," by: Kara Scannell, The Wall Street Journal, August 7, 2010 ---
    http://online.wsj.com/article/SB10001424052748703988304575413671786664134.html?mod=djem_jiewr_AC_domainid

    A dispute over how to claw back pay from executives at companies accused of cooking the books is roiling the Securities and Exchange Commission.

    Commissioner Luis Aguilar, a Democrat, has threatened not to vote on cases where he thinks the agency is too lax, people familiar with the matter said. That prompted the SEC to review its policies for the intermittently used enforcement tool.

    "The SEC ought to use all the tools at its disposal to try to seek funds for deterrence," Mr. Aguilar said in an interview on Tuesday. "It's important for us to the extent possible to try to deter, and part of that means using tools Congress has given us."

    The issue of clawbacks came up during the SEC's recent settlement with Dell Inc. and founder Michael Dell, people familiar with the matter said.

    The SEC alleged Mr. Dell hid payments from Intel Corp. that allowed the company to inflate earnings. He agreed to pay a $4 million penalty to settle the case without admitting or denying wrongdoing, but didn't return any pay.

    Mr. Aguilar initially objected to the Dell settlement, according to people familiar with the matter. It is unclear whether the penalty—considered high by historical standards for an individual—swayed Mr. Aguilar's vote or whether he removed himself from the case.

    In the interview, Mr. Aguilar spoke generally about clawbacks and declined to discuss Dell or other specific cases.

    A spokesman for the SEC declined to comment.

    Section 304 of the 2002 Sarbanes-Oxley law gave the SEC the ability to seek reimbursement of compensation from the chief executive and chief financial officer of a company when it restates its financial statements because of misconduct.

    Under the law, the SEC can seek the repayment of bonuses, stock options or profits from stock sales during a 12-month period following the first time the company issues information that has to be restated.

    Last year, the SEC used the tool for the first time against an executive who wasn't accused of personal wrongdoing.

    In that case the SEC sued Maynard Jenkins, the former chief executive of CSK Auto Corp., for $4 million in bonuses and stock sales. Mr. Jenkins is fighting the allegations.

    SEC attorneys have been working on a more formal policy to guide them in such cases, people familiar with the matter said. They were seeking to tie the amount of the clawback to the period of wrongdoing, these people said.

    Mr. Aguilar felt the emerging new policy wasn't stringent enough and told the SEC staff he would recuse himself from cases when he didn't agree with the enforcement staff's recommendations, the people said.

    Amid the standoff, SEC enforcement chief Robert Khuzami has halted the initial policy and set up a committee to take another look at the matter, the people said.

    Hammering out a policy acceptable to the five-member commission, which has split on recent high-profile cases, may be difficult.

    The divisions worry some within the SEC because the absence of an agreement could affect cases in the pipeline, especially on close calls where Mr. Aguilar's vote might be necessary to go forward.

    Mr. Aguilar's hard line on clawbacks was bolstered by the Dodd-Frank law, signed by President Obama on July 21. It says stock exchanges need to change listing standards to require companies to have clawback policies in place that go further than the Sarbanes-Oxley policy.

    Section 954 of the law says that pay clawbacks should apply to any current or former employee and instructs companies to seek pay earned during the three-year period before a restatement "in excess of what would have been paid to the executive under the accounting restatement."

    Since becoming a commissioner in late 2008, Mr. Aguilar has called for a tougher enforcement approach, including a rework of the agency's policy of seeking penalties against companies.

    In a speech in May, Mr. Aguilar took up the issue of executive pay in the context of the SEC's lawsuit against Bank of America Corp. for failing to disclose to shareholders the size of bonuses paid to Merrill Lynch executives. The bank agreed to pay $150 million to settle the matter.

    Mr. Aguilar said that penalty "pales" in comparison to the $5.8 billion in bonuses paid during the merger.

    "Perhaps what should happen is that, when a corporation pays a penalty, the money should be required to come out of the budget and bonuses for the people or group who were the most responsible," he said.

    Bob Jensen's threads on outrageous executive compensation are at
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Lying CEOs:  Language May Hold Key To Knowing What Chiefs Have Accounting to Hide

    A Teaching Case from the Stanford Rock Center for Corporate Governance

    From The Wall Street Journal Accounting Weekly Review on August 20, 2010

    For Lying CEOs, 'Team,' Not 'I'
    by: Kyle Stock
    Aug 12, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting Changes and Error Corrections, Earning Announcements, Restatement

    SUMMARY: David Larcker and Anastasia Zakolyukina of Stanford Graduate School of Business and the Stanford Rock Center for Corporate Governance examined the psychological and linguistics components of investor conference calls by CEOs and CFOs of companies that later had to revise earnings results. "They fed their filter almost 30,000 transcripts of earnings conference calls from 2003 to 2007 and found that..." they could accurately predict subsequent earnings restatements about 50% to 65% of the time. The research paper is entitled "Detecting Deceptive Discussions in Conference Calls" and is available as paper #1572705 on the Social Science Research Network (SSRN) at http://ssrn.com/abstract=1572705 The paper was last updated on July 29, 2010. The authors note in the abstract that their model is significantly better at detecting subsequent earnings restatements than are models based on discretionary accruals and traditional controls, a point not noted in the WSJ article.

    CLASSROOM APPLICATION: The article is useful to introduce students to the nature of accounting research in any financial reporting class covering earnings release topics.

    QUESTIONS: 
    1. (Advanced) What are earnings restatements? What authoritative accounting literature requires restatements? Under what circumstances are such restatements required?

    2. (Advanced) What are earnings releases? What conference calls are associated with earnings releases?

    3. (Introductory) Summarize the basic points of the accounting research reported on in this newspaper article. Who conducted this research? What did they examine?

    4. (Advanced) Why do you think it is useful to be able to predict likely earnings restatements? Why might this result in the authors of this research "hearing from some hedge funds" as the author of this WSJ article states?

    Reviewed By: Judy Beckman, University of Rhode Island

    "For Lying CEOs, 'Team,' Not 'I," by: Kyle Stock, The Wall Street Journal, August 12, 2010 ---
    http://online.wsj.com/article/SB20001424052748704216804575423683536800418.html?mod=djem_jiewr_AC_domainid

    Conference call Q&As can be a confusing and cryptic dance. Executives try to put the most attractive case before investors, without giving away too much, of course. And in many cases, they are trying to put a good spin on bad results.

    But what if an investor could read right through all of the posturing and careful prose to recognize if they were being strung along?

    A pair of accounting professors at the Stanford Graduate School of Business and the Stanford Rock Center for Corporate Governance recently tried to do just that. The team built a model that tries to flush out executive, well, lies, using psychological and linguistic studies and transcripts of conference calls from companies that later restated earnings.

    They fed their filter almost 30,000 transcripts of earnings conference calls from 2003 to 2007 and found that it worked quite nicely. Executives who later had to revise their books displayed some very consistent clues.

    For one, they seldom referred to themselves or their companies in the first person; "I" and "we" were replaced by terms like "the team" and "the company." Deceitful executives passed up humdrum adjectives such as "solid" and "respectable" in favor of gushing words like "fantastic," and (not surprisingly) they seldom mentioned shareholder value.

    They also tended to buttress their points with references to general knowledge with phrases like "you know" and to make short statements with little hesitation, presumably because they had carefully scripted the untruths in advance and had no interest in lingering on them.

    Though the study doesn't call out particular companies, chiefs across a wide-range of industries raised the censor's red light 14% of the time. Those in the finance business proved slightly more honest than average, tagged for lying only 10% of the time. The study didn't specify the industry with the most dissembling.

    Finance chiefs, it appears, hold their cards a little closer to their chests. They spoke about half as much as their bosses, and, unlike chief executives, they showed no "positive emotions" via "brilliant" and "astounding" adjectives. Maybe they were busy picturing themselves in brilliant orange coveralls.

    The professors' model isn't perfect. It proved accurate enough to make predictions 50% to 65% of the time, in part because individual executives have unique ways of speaking that don't fall neatly into a pattern of deception.

    Still, big money has to like those odds. We bet that the authors of the study, David Larcker and Anastasia Zakolyukina, will be hearing from some hedge funds soon, if they haven't already.

    Bob Jensen's threads on corporate governance are at
    http://faculty.trinity.edu/rjensen/fraud001.htm#Governance

    Paul Ekman video on how to read faces and detect lying --- http://www.youtube.com/watch?v=IA8nYZg4VnI
    This video runs for nearly one hour

    Paul Ekman --- http://en.wikipedia.org/wiki/Paul_Ekman

    Ekman's work on facial expressions had its starting point in the work of psychologist Silvan Tomkins.[Ekman showed that contrary to the belief of some anthropologists including Margaret Mead, facial expressions of emotion are not culturally determined, but universal across human cultures and thus biological in origin. Expressions he found to be universal included those indicating anger, disgust, fear, joy, sadness, and surprise. Findings on contempt are less clear, though there is at least some preliminary evidence that this emotion and its expression are universally recognized.]

    In a research project along with Dr. Maureen O'Sullivan, called the Wizards Project (previously named the Diogenes Project), Ekman reported on facial "microexpressions" which could be used to assist in lie detection. After testing a total of 15,000 [EDIT: This value conflicts with the 20,000 figure given in the article on Microexpressions] people from all walks of life, he found only 50 people that had the ability to spot deception without any formal training. These naturals are also known as "Truth Wizards", or wizards of deception detection from demeanor.

    He developed the Facial Action Coding System (FACS) to taxonomize every conceivable human facial expression. Ekman conducted and published research on a wide variety of topics in the general area of non-verbal behavior. His work on lying, for example, was not limited to the face, but also to observation of the rest of the body.

    In his profession he also uses verbal signs of lying. When interviewed about the Monica Lewinsky scandal, he mentioned that he could detect that former President Bill Clinton was lying because he used distancing language.

    Ekman has contributed much to the study of social aspects of lying, why we lie, and why we are often unconcerned with detecting lies. He is currently on the Editorial Board of Greater Good magazine, published by the Greater Good Science Center of the University of California, Berkeley. His contributions include the interpretation of scientific research into the roots of compassion, altruism, and peaceful human relationships. Ekman is also working with Computer Vision researcher Dimitris Metaxas on designing a visual lie-detector.

    Research Papers Worth Reading On Deceit, Body Language, Influence etc.. (with links to pdfs)
     

    Sixteen Enjoyable Emotions.(2003) Emotion Researcher, 18, 6-7. by Ekman, P

    “Become Versed in Reading Faces”. Entrepreneur, 26 March 2009. Ekman, P. (2009)
    Intoduction: Expression Of Emotion - In RJ Davidson, KR Scherer, & H.H. Goldsmith (Eds.) Handbook of Afective Sciences. Pp. 411-414.Keltner, D. & Ekman, P (2003)

    Facial Expression Of Emotion. – In M.Lewis and J Haviland-Jones (eds) Handbook of emotions, 2nd edition. Pp. 236-249. New York: Guilford Publications, Inc. Keltner, D. & Ekman, P. (2000)

    Emotional And Conversational Nonverbal Signals. – In L.Messing & R. Campbell (eds.) Gesture, Speech and Sign. Pp. 45-55. London: Oxford University Press.

    A Few Can Catch A Liar. - Psychological Science, 10, 263-266. Ekman, P., O’Sullivan, M., Frank, M. (1999)
    Deception, Lying And Demeanor.- In States of Mind: American and Post-Soviet Perspectives on Contemporary Issues in Psychology . D.F. Halpern and A.E.Voiskounsky (Eds.) Pp. 93-105. New York: Oxford University Press.

    Lying And Deception. – In N.L. Stein, P.A. Ornstein, B. Tversky & C. Brainerd (Eds.) Memory for everyday and emotional events. Hillsdale, NJ: Lawrence Erlbaum Associates, 333-347.

    Lies That Fail.- In M. Lewis & C. Saarni (Eds.) Lying and deception in everyday life. Pp. 184-200. New York: Guilford Press.

    Who Can Catch A Liar. -American Psychologist, 1991, 46, 913-120.
    Hazards In Detecting Deceit. In D. Raskin, (Ed.) Psychological Methods for Investigation and Evidence. New York: Springer. 1989. (pp 297-332)

    Self-Deception And Detection Of Misinformation. In J.S. Lockhard & D. L. Paulhus (Eds.) Self-Deception: An Adaptive Mechanism?. Englewood Cliffs, NJ: Prentice-Hall, 1988. Pp. 229- 257.

    Smiles When Lying. – Journal of Personality and Social Psychology, 1988, 54, 414-420.
    Felt- False- And Miserable Smiles.Ekman, P. & Friesen, W.V.

    Mistakes When Deceiving. Annals of the New York Academy of Sciences. 1981, 364, 269-278.

    Nonverbal Leakage And Clues To Deception Psychiatry, 1969, 32, 88-105.

    "You Can't Hide Your Lying Brain (or Can You?), by Tom Bartlett, Chronicle of Higher Education, May 6, 2010 ---
    http://chronicle.com/blogPost/You-Cant-Hide-Your-Lying/23780/

    Earlier this week Wired reported that a Brooklyn lawyer wanted to use fMRI brain scans to prove that his client was telling the truth. The case itself is an average employer-employee dispute, but using brains scans to tell whether someone is lying—which a few, small studies have suggested might be useful—would set a precedent for neuroscience in the courtroom. Plus, I'm pretty sure they did something like this on Star Trek once.

    But why go to all the trouble of scanning someone's brain when you can just count how many times the person blinks? A study published this month in Psychology, Crime & Law found that when people were lying they blinked significantly less than when they were telling the truth. The authors suggest that lying requires more thinking and that this increased cognitive load could account for the reduction in blinking.

    For the study, 13 participants "stole" an exam paper while 13 others did not. All 26 were questioned and the ones who had committed the mock theft blinked less when questioned about it than when questioned about other, unrelated issues. The innocent 13 didn't blink any more or less. Incidentally, the blinking was measured by electrodes, not observation.

    But the authors aren't arguing that the blink method should be used in the courtroom. In fact, they think it might not work. Because the stakes in the study were low--no one was going to get into any trouble--it's unclear whether the results would translate to, say, a murder investigation. Maybe you blink less when being questioned about a murder even if you're innocent, just because you would naturally be nervous. Or maybe you're guilty but your contacts are bothering you. Who knows?

    By the way, the lawyer's request to introduce the brain scanning evidence in court was rejected, but lawyers in another case plan to give it a shot later this month.

    (The abstract of the study, conducted by Sharon Leal and Aldert Vrij, can be found here. The company that administers the lie-detection brain scans is called Cephos and their confident slogan is "The Science Behind the Truth.")

    "The New Face of Emoticons:  Warping photos could help text-based communications become more expressive," by Duncan Graham-Rowe,  MIT's Technology Review, March 27, 2007 --- http://www.technologyreview.com/Infotech/18438/

    Computer scientists at the University of Pittsburgh have developed a way to make e-mails, instant messaging, and texts just a bit more personalized. Their software will allow people to use images of their own faces instead of the more traditional emoticons to communicate their mood. By automatically warping their facial features, people can use a photo to depict any one of a range of different animated emotional expressions, such as happy, sad, angry, or surprised.

    All that is needed is a single photo of the person, preferably with a neutral expression, says Xin Li, who developed the system, called Face Alive Icons. "The user can upload the image from their camera phone," he says. Then, by keying in familiar text symbols, such as ":)" for a smile, the user automatically contorts the face to reflect his or her desired expression.

    "Already, people use avatars on message boards and in other settings," says Sheryl Brahnam, an assistant professor of computer information systems at MissouriStateUniversity, in Springfield. In many respects, she says, this system bridges the gap between emoticons and avatars.

    This is not the first time that someone has tried to use photos in this way, says Li, who now works for Google in New York City. "But the traditional approach is to just send the image itself," he says. "The problem is, the size will be too big, particularly for low-bandwidth applications like PDAs and cell phones." Other approaches involve having to capture a different photo of the person for each unique emoticon, which only further increases the demand for bandwidth.

    Li's solution is not to send the picture each time it is used, but to store a profile of the face on the recipient device. This profile consists of a decomposition of the original photo. Every time the user sends an emoticon, the face is reassembled on the recipient's device in such a way as to show the appropriate expression.

    To make this possible, Li first created generic computational models for each type of expression. Working with Shi-Kuo Chang, a professor of computer science at the University of Pittsburgh, and Chieh-Chih Chang, at the Industrial Technology Research Institute, in Taiwan, Li created the models using a learning program to analyze the expressions in a database of facial expressions and extract features unique to each expression. Each of the resulting models acts like a set of instructions telling the program how to warp, or animate, a neutral face into each particular expression.

    Once the photo has been captured, the user has to click on key areas to help the program identify key features of the face. The program can then decompose the image into sets of features that change and those that will remain unaffected by the warping process.

    Finally, these "pieces" make up a profile that, although it has to be sent to each of a user's contacts, must only be sent once. This approach means that an unlimited number of expressions can be added to the system without increasing the file size or requiring any additional pictures to be taken.

    Li says that preliminary evaluations carried out on eight subjects viewing hundreds of faces showed that the warped expressions are easily identifiable. The results of the evaluations are published in the current edition of the Journal of Visual Languages and Computing.

    Continued in article

    Bob Jensen's threads on visualization are at
    http://faculty.trinity.edu/rjensen/352wpvisual/000datavisualization.htm


    "Fibbing With Numbers," by Steven Strogatz, The New York Times, September 19, 2010 ---
    http://www.nytimes.com/2010/09/19/books/review/Strogatz-t.html?_r=1&hpw

    Charles Seife is steaming mad about all the ways that numbers are being twisted to erode our democracy. We’re used to being lied to with words (“I am not a crook”; “I did not have sexual relations with that woman”). But numbers? They’re supposed to be cold, hard and objective. Numbers don’t lie, and they brook no argument. They’re the best kind of facts we have.

    And that’s precisely why they can be so powerfully, persuasively misleading, as Seife argues in his passionate new book, “Proofiness.” Seife, a veteran science writer who teaches journalism at New York University, examines the many ways that people fudge with numbers, sometimes just to sell more moisturizer but also to ruin our economy, rig our elections, convict the innocent and undercount the needy. Many of his stories would be darkly funny if they weren’t so infuriating.

    Although Seife never says so explicitly, the book’s title alludes to “truthiness” — the Word of the Year in 2005, according to the American Dialect Society, which defined it as “the quality of preferring concepts or facts one wishes to be true, rather than concepts or facts known to be true.” The term was popularized by Stephen Colbert in the first episode of “The Colbert Report.” The numerical cousin of truthiness is proofiness: “the art of using bogus mathematical arguments to prove something that you know in your heart is true — even when it’s not.”

    . . .

    Falsifying numbers is the crudest form of proofiness. Seife lays out a rogues’ gallery of more subtle deceptions. “Potemkin numbers” are phony statistics based on erroneous or nonexistent calculations. Justice Antonin Scalia’s assertion that only 0.027 percent of convicted felons are wrongly imprisoned was a Potemkin number derived from a prosecutor’s back-of-the-envelope estimate; more careful studies suggest the rate might be between 3 and 5 percent.

    “Disestimation” involves ascribing too much meaning to a measurement, relative to the uncertainties and errors inherent in it. In the most provocative and detailed part of the book, Seife analyzes the recounting process in the astonishingly close 2008 Minnesota Senate race between Norm Coleman and Al Franken. The winner, he claims, should have been decided by a coin flip; anything else is disestimation, considering that the observed errors in counting the votes were always much larger than the number of votes (roughly 200 to 300) separating the two candidates.

    “Comparing apples and oranges” is another perennial favorite. The conservative Blue Dog Democrats indulged in it when they accused the Bush administration of borrowing more money from foreign governments in four years than had all the previous administrations in our nation’s history, combined. True enough, but only if one conveniently forgets to correct for inflation.

    Seife is evenhanded about exposing the proofiness on both sides of the political aisle, though we all know who’s responsible for a vast majority of it: the other side.

    He calls Al Gore to task for “cherry-picking” data about global warming. Although Seife doesn’t dispute that the warming is real and that human activities are to blame for a sizable portion of it, he chastises Gore for showing terrifying simulations of what would happen to Florida and Louisiana if sea levels were to rise by 20 feet, as could occur if the ice sheets in Greenland or West Antarctica were to melt almost completely. That possibility, while not out of the question, is generally considered an unlikely “very-worst-case” scenario, Seife writes.

    Meanwhile, the Bush administration committed a more insidious form of proofiness when it crowed, in 2004, that its tax cuts would save the average family $1,586. This is technically correct, but deliberately misleading — a trick that Seife calls “apple polishing.” (Again with the fruit!) The average is the wrong measure to use when a set of numbers contains extreme outliers — in this case, the whopping refunds received by a very few, very wealthy families. In such situations, the average is far from typical. That’s why, paradoxical as it might seem, most families received less than $650.

    In one of the book’s lighter moments, Seife even looks askance at the wholesome folks at Quaker Oats, who in addition to selling a “bland and relatively unappetizing product” once presented a graph that gave the visual impression that their “barely digestible oat fiber” was a “medicinal vacuum cleaner” that would reduce your cholesterol far more than it actually does. For the most part, though, he is deadly serious. A few other recent books have explored how easily we can be deceived — or deceive ourselves — with numbers. But “Proofiness” reveals the truly corrosive effects on a society awash in numerical mendacity. This is more than a math book; it’s an eye-opening civics lesson.

    Steven Strogatz is a professor of applied mathematics at Cornell and a contributor to the Opinionator blog on NYTimes.com. He is the author, most recently, of “The Calculus of Friendship.”

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    Bob Jensen's Rotten to the Core threads are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's threads on theory are at
    http://faculty.trinity.edu/rjensen/theory01.htm

     


    Questions
    How does Apple defer revenue?

    How might the proposed changes to revenue recognition standards by the FASB-IASB affect firms like Apple Corporation?
    Not answered below, but food for student thought

    From The Wall Street Journal Accounting Weekly Review on July 23, 2010

    New Gadgets Power Apple Sales
    by: Yukari Iwatani Kane
    Jul 21, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Interim Financial Statements, Revenue Recognition, Software Industry

    SUMMARY: "Apple Inc.'s quarterly profit surged 78% as the company booked strong initial sales of its IPad tablet computer and the latest version of its Smartphone, the iPhone 4. The company also issued a strong forecast for the current quarter, allaying immediate concerns that the iPhone 4's high-profile antenna problems might slow Apple's sales....The company, which has faced mounting criticism over the antenna design of its iPhone 4, said Friday it would give away cases to owners. On Tuesday, Apple said as a result it would defer until the December quarter about $175 million in revenue."

    CLASSROOM APPLICATION: The article is useful to look at the form of public quarterly reporting in the U.S. and at the revenue recognition deferral that stems from the problems with the iPhone 4 antenna.

    QUESTIONS: 
    1. (Introductory) Access the Apple Inc. Form 10-Q filed on July 21, 2010, on which this report is based. It is available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=320193&accession_number=0001193125-10-162840 What is the difference between this filing and the Form 8-K filing that was made on July 20, 2010, available at http://www.sec.gov/Archives/edgar/data/320193/000119312510161807/0001193125-10-161807-index.htm

    2. (Advanced) Refer to the Form 8-K filing. What is included in the data sheet? What are Apple's operating segments? How is the information presented in this data sheet consistent with financial reporting requirements under U.S. accounting standards? How is it inconsistent with those requirements?

    3. (Advanced) Refer to the Form 10-Q filing and navigate to the Summary of Significant Accounting Policies. What retrospective adoption of accounting did Apple make in its 2009 financial statements? Why is that adoption referenced in this 2010 quarterly filing? In your answer, define both retrospective and prospective adoption of changes in financial accounting and reporting practices.

    4. (Advanced) The company...said Friday it would give away cases to owners" of iPhone 4 because of reception problems stemming from design of the antenna in this phone. Should this step impact the amounts reported in this 10-Q filing? Explain.

    5. (Advanced) Continue to the discussion of "Revenue Recognition." Do you think that any of the issues discussed in this portion of the report relate to the fact that Apple announced it would 'defer until the December quarter about $175 million in revenue"? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    "New Gadgets Power Apple Sales," by: Yukari Iwatani Kane, The Wall Street Journal, July 21, 2010 ---
    http://online.wsj.com/article/SB10001424052748703724104575379473713612064.html?mod=djem_jiewr_AC_domainid

    Apple Inc.'s quarterly profit surged 78%, as the company booked strong initial sales of its iPad tablet computer and the latest version of its smartphone, the iPhone 4.

    The company also issued a strong forecast for the current quarter, allaying immediate concerns that the iPhone 4's high-profile antenna problems might slow Apple's sales. Apple's revenue in the quarter ended June 26 rose 61% to $15.7 billion.

    Chief Executive Steve Jobs in a press release touted the results as "phenomenal" and promised that Apple had "amazing new products still to come this year."

    Apple is selling iPads and iPhones "as fast as we can make them" and "working around the clock to try to get supply and demand in balance," Tim Cook, the company's operating chief, said on a conference call.

    He said the company hadn't seen any decline in iPhone 4 demand because of antenna problems. "My phone is ringing off the hook from people that want more supply," Mr. Cook said.

    The company, which has faced mounting criticism over the antenna design of its iPhone 4, said Friday it would give away cases to owners. On Tuesday, Apple said as a result it would defer until the December quarter about $175 million in revenue.

    Apple's strong results join others in the tech sector as a recovery in business sales is adding to renewed consumer spending, which bounced back from the recession last quarter.

    Shares of Apple rose 2.5% in after-hours trading. The stock closed Tuesday at $251.89 on the Nasdaq Stock Market.

    Despite fears that the April launch of the iPad would cannibalize Macintosh computer sales, Mac desktop and laptop sales remained strong in the quarter. Apple sold 3.5 million computers, up 33% from a year ago.

    Apple said it sold 3.3 million iPads since the tablet went on sale, generating revenue of $2.16 billion. The company said the average sales price for its iPad was $640, suggesting many customers opted for higher-priced models with cellular-data service.

    Journal Communitydiscuss“ Love him or hate him. The only thing that can be said is WOW. ” —Mike Jones "The Mac is on fire and the iPad is on fire," said Gene Munster, an analyst with Piper Jaffray & Co.

    Research company iSuppli earlier raised its estimate for iPad sales in 2010 to 12.9 million from 7.1 million, saying the only limitation was production capacity, not demand. Apple said the iPad would be available in nine more markets, including Hong Kong, Ireland and Mexico on Tuesday.

    While analysts were also concerned that consumers might hold off buying iPhones in the quarter until the iPhone 4 was released, Apple sold 8.4 million iPhones during the period, up 61% from a year ago.

    Overall, the Cupertino, Calif., company posted a fiscal third-quarter profit of $3.25 billion, or $3.51 a share, compared with $1.83 billion, or $2.01 a share a year earlier. Apple reported gross margin of 39.1%, down from 40.9% a year ago.

    IPod sales fell 8.6% in terms of units, but revenue rose 4% to $1.5 billion as consumers continued to upgrade to the more expensive iPod touch model.

    Apple's forecast for the current quarter was stronger than it is typically. Apple said it expects earnings of $3.44 a share on revenue of $18 billion in the September-ended period.

     

    Bob Jensen's threads on revenue recognition are at
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm


    Question
    Why do auditors continue to allow earnings management with loan loss reserves?

    July 19, 2010 message from Francine McKenna [retheauditors@GMAIL.COM]

    Bob,

    Sound familiar? The banks are making what they can based on technical accounting manipulation including playing with loan loss reserves. There's still a lot of bad debt on their books.

    http://www.nytimes.com/2010/07/17/business/17bank.html?_r=1&scp=3&sq=citigroup&st=Search 
    "Citigroup’s net income declined 37 percent, to $2.7 billion, and Bank of America’s net income fell 3 percent, to $3.1 billion, from a year earlier. Both banks padded those results with a big release of funds that had been set aside to cover future loan losses, with executives citing improvements in the economy."

    http://www.businessweek.com/news/2010-07-16/bank-of-america-citigroup-fall-as-loan-books-interest-shrink.html  "
    Citigroup also got $599 million of mark-ups on loans and securities in a “special asset pool” of trading positions left over from before the credit crisis. Citigroup booked a $447 million gain from writing down the value of its own debt, under an accounting rule that allows companies to profit when their creditworthiness declines. The rules reflect the possibility that a company could buy back its own liabilities at a discount, which under traditional accounting methods would result in a profit.

    About $1.2 billion of Bank of America’s revenue came from writing down the value of obligations assumed from its purchase of Merrill Lynch & Co., according to the bank’s CFO, Charles Noski."

    Francine

    Francine

    July 19, 2010 reply from Bob Jensen

    Hi Francine,

    Bank behaviors with auditor blessings are so sad.

    Thanks for the tidbit.

     Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them. “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said
    "Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New York Times, April 20, 2009 --- http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

    This is starting to feel like amateur hour for aspiring magicians.

    Another day, another attempt by a Wall Street bank to pull a bunny out of the hat, showing off an earnings report that it hopes will elicit oohs and aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of America all tried to wow their audiences with what appeared to be — presto! — better-than-expected numbers.

    But in each case, investors spotted the attempts at sleight of hand, and didn’t buy it for a second.

    With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

    Bank of America sold its shares in China Construction Bank to book a big one-time profit, but Ken Lewis heralded the results as “a testament to the value and breadth of the franchise.”

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

    “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

    Investors reacted by throwing tomatoes. Bank of America’s stock plunged 24 percent, as did other bank stocks. They’ve had enough.

    Why can’t anybody read the room here? After all the financial wizardry that got the country — actually, the world — into trouble, why don’t these bankers give their audience what it seems to crave? Perhaps a bit of simple math that could fit on the back of an envelope, with no asterisks and no fine print, might win cheers instead of jeers from the market.

    What’s particularly puzzling is why the banks don’t just try to make some money the old-fashioned way. After all, earning it, if you could call it that, has never been easier with a business model sponsored by the federal government. That’s the one in which Uncle Sam and we taxpayers are offering the banks dirt-cheap money, which they can turn around and lend at much higher rates.

    “If the federal government let me borrow money at zero percent interest, and then lend it out at 4 to 12 percent interest, even I could make a profit,” said Professor Finkelstein of the Tuck School. “And if a college professor can make money in banking in 2009, what should we expect from the highly paid C.E.O.’s that populate corner offices?”

    But maybe now the banks are simply following the lead of Washington, which keeps trotting out the latest idea for shoring up the financial system.

    The latest big idea is the so-called stress test that is being applied to the banks, with results expected at the end of this month.

    This is playing to a tough crowd that long ago decided to stop suspending disbelief. If the stress test is done honestly, it is impossible to believe that some banks won’t fail. If no bank fails, then what’s the value of the stress test? To tell us everything is fine, when people know it’s not?

    “I can’t think of a single, positive thing to say about the stress test concept — the process by which it will be carried out, or outcome it will produce, no matter what the outcome is,” Thomas K. Brown, an analyst at Bankstocks.com, wrote. “Nothing good can come of this and, under certain, non-far-fetched scenarios, it might end up making the banking system’s problems worse.”

    The results of the stress test could lead to calls for capital for some of the banks. Citi is mentioned most often as a candidate for more help, but there could be others.

    The expectation, before Monday at least, was that the government would pump new money into the banks that needed it most.

    But that was before the government reached into its bag of tricks again. Now Treasury, instead of putting up new money, is considering swapping its preferred shares in these banks for common shares.

    The benefit to the bank is that it will have more capital to meet its ratio requirements, and therefore won’t have to pay a 5 percent dividend to the government. In the case of Citi, that would save the bank hundreds of millions of dollars a year.

    And — ta da! — it will miraculously stretch taxpayer dollars without spending a penny more.

     

    "Watch Banks Pull Rabbits Out of Hats, Ably Assisted by Their Auditors," by Francine McKenna, re:TheAuditors, July 19, 2010 ---
    http://retheauditors.com/2010/07/19/watch-banks-pull-rabbits-out-of-hats-ably-assisted-by-their-auditors/

    Do you own stock in a large money center bank?  Work for one?  Count on one to lend you money for a small business?  Expect them to stimulate the economy via commercial loans and lending again for residential or commercial real estate?

    You’ve been deluded by the illusion of their self-serving public relations – rah-rah intended to help you forget financial reform that barely is and no safety net for anyone but the elite.

    The global money center banks are masters at managing financial reporting. Regulators repeatedly feign surprise at balance sheet sleight of hand, prestidigitation at the expert level intended to buy time until the banks can grow out of the black hole that bubble lending put them in. They announce their quarterly results, with all the details – they don’t even try to hide them anymore – and they’re ignored or the con is traded on for short term profits.

    The New York Times, July 16, 2010

    “Citigroup’s net income declined 37 percent, to $2.7 billion, and Bank of America’s net income fell 3 percent, to $3.1 billion, from a year earlier. Both banks padded those results with a big release of funds that had been set aside to cover future loan losses, with executives citing improvements in the economy.”

    Business Week reports that Citigroup flip flopped on the value of assets acquired with Merrill Lynch and magic happened:

    “Citigroup also got $599 million of mark-ups on loans and securities in a “special asset pool” of trading positions left over from before the credit crisis. Citigroup booked a $447 million gain from writing down the value of its own debt, under an accounting rule that allows companies to profit when their creditworthiness declines. The rules reflect the possibility that a company could buy back its own liabilities at a discount, which under traditional accounting methods would result in a profit.

    About $1.2 billion of Bank of America’s revenue came from writing down the value of obligations assumed from its purchase of Merrill Lynch & Co., according to the bank’s CFO, Charles Noski.”

    Interestingly enough, the opposite move also netted them a gain last year. How exactly did this years write down equal a gain too?

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.
    “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

    John Talbott, meanwhile, explains today why Treasury Secretary Tim Geithner doesn’t want watchdog Elizabeth Warren as the head of the new post-reform consumer protection agency – she’ll prevent banks from making money off the little guy while lending and trading remain unreliable profit drivers.

    “Hank Paulson, the Treasury Secretary at the time, had announced that the $700 billion TARP funds would be used to buy toxic assets like bad mortgage loans from the commercial banks. But this never happened and now the amount of bad bank loans has increased in the trillions. Immediately after receiving authorization of the funding for TARP from Congress, Paulson reversed direction and decided to make direct equity investments in the banks rather than using the TARP funds to acquire their bad loans.

    So where are the trillions of dollars of bad loans that the banks had on their books? They are still there. The Federal Reserve took possession temporarily of some of them as collateral for lending to the banks in an attempt to clean up the banks for their supposed” stress tests”. But as of now, the trillions of dollars of underwater mortgages, CDO’s and worthless credit default swaps are still on the banks books. Geithner is going to the familiar “bank in crisis” playbook and hoping that the banks can earn their way out of their solvency problems over time so the banks are continuing to slowly write off their problem loans but at a rate that will take years, if not decades, to clean up the problem.”

    Paul Krugman predicted this roller coaster ride with bank earnings back in October, in particular with regard to Bank of America and Citigroup. What he missed is that when trading profits are down too, the banks – with the assistance of their auditors advice –  must be ever more creative to avoid having to write off those bad assets all at once or without cover.

    …while the wheeler-dealer side of the financial industry, a k a trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.

    You may recall that earlier this year there was a big debate about how to get the banks lending again. Some analysts, myself included, argued that at least some major banks needed a large injection of capital from taxpayers, and that the only way to do this was to temporarily nationalize the most troubled banks. The debate faded out, however, after Citigroup and Bank of America, the banking system’s weakest links, announced surprise profits. All was well, we were told, now that the banks were profitable again.

    But a funny thing happened on the way back to a sound banking system: last week both Citi and BofA announced losses in the third quarter. What happened?

    Part of the answer is that those earlier profits were in part a figment of the accountants’ imaginations.”

    I’ve told you more than once that Citigroup is still a mess. Anyone who isn’t a senior insider is nuts to buy their stock or count on them for a job or business. Listen to me talk about AIG, Bank of America and Citigroup, “an accident waiting to happen,” at the 8:15 mark on this video for Stocktwits TV recorded June 3, 2010.

    . . .

    Both AIG and Goldman Sachs executives have been questioned recently by the Financial Crisis Inquiry Commission.. The Commission seeks to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.” We’ve also seen Lehman executives called to account by Congressional inquisitors.

    But we’ve yet to see the auditors – Pricewaterhouse Coopers (auditor of AIG, Goldman Sachs, and Freddie Mac), Ernst & Young (auditor of Lehman) or KPMG (auditor of Citigroup, previously of Countrywide, Wells Fargo and Wachovia and earlier of Fannie Mae) – called to testify to explain their role in blessing fraudulent bank balance sheet accounting.

    Isn’t it about time?

    July 19, 2010 reply from Bob Jensen

    Hi Francine,

    Here’s an important citation on this topic --- my favorite!

    My all-time heroes 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://makemarketsbemarkets.org/modals/report_off.php 
    Watch the above 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

    July 19, 2010 message from Steven Kachelmeier, University of Texas at Austin [kach@MAIL.UTEXAS.EDU]

    An article by Kanagaretnam, Krishnan, and Lobo that is forthcoming in the November 2010 issue of The Accounting Review is the most recent effort on this topic of which I am aware.  You can find it on the SSRN network at:
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1590506

    The title is "An Empirical Analysis of Auditor Independence in the Banking Insustry," but don't be fooled by the title -- it's about manipulation of banks' loan loss reserves, with an emphasis on how auditors bear upon that phenomenon.  Kanagaretnam et al. (2010) also cite most of the earlier studies on earnings management involving bank loan loss reserves.  Kiridan Kanagaretnam is at McMaster University, Gopal Krishnan is at Lehigh University, and Gerald Lobo is at the University of Houston.

    Best.
    Steve

    July 19, 2010 reply from Jagdish Gangolly [gangolly@CSC.ALBANY.EDU]

    I have briefly gone through this paper. Its main thesis is that there is lack of an association between banks fiddling with earnings via LLLP (loan loss provisions) and "unexpected" audit fees for large banks, while for the small banks that association is strongly negative. The authors consider this evidence of a relationship between audit independence and earnings management at least in the case of smaller banks. They provide a blizzard of regressions and other data.

    The paper is interesting from a policy perspective, and would be a great paper in a policy oriented economics journal. I am glad for the authors that it got accepted. However, does it have a bearing on accounting' practice beyond setting the regulators on a chase of auditors of small banks? Does it give us a better way of computing LLP? Does it give us a way of finding out the reliability of the LLP number? Does it even tell us if the LLP numbers are more (or less) reliable for the larger banks? Does the age distribution of the loan portfolio vary between the two types of banks? What is the distribution of auditors between the two types of banks? There are a host of questions that should be triggered by this thread. Of course, the authors pick the hypothesis they want to study, but an accounting or auditing orientation (as opposed to "about" accounting orientation in Sterling's language) would make a lot more sense for is accountants.

    The other issue, endemic to most of these types of papers is the oblique way of introducing causality (a definite no-no for a positivist) to obfuscate discussions. Figure 1 in the paper is what is usually called a path graph giving the trace of causality (the direction of the arrows indicating causality), but the statistical analysis is entirely associational. Statistical techniques have existed for causal analysis for almost half a century, but accounticians have uniformly pretended they do not exist. Stating the models in causal terms but testing them associationally is certainly less than truthful advertising. Unless, of course, I am misstating the model, which I doubt. I have been in this game for too long.

    Nothing I have said above should be construed as indicating my doubt on the questions raised by the authors; they should be of great interest to a policy oriented audience. It is just that when it comes to accounting practice, they are trying to sell kryptonite or worse.

    Jagdish Gangolly (gangolly@albany.edu)
    Department of Informatics College of Computing & Information
    State University of New York at Albany
    7A, Harriman Campus Road, Suite 220 Albany, NY 12206 Phone: (518) 956-8251, Fax: (518) 956-8247

    Where were the auditors when over 1,000 banks failed ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms


    Benford's Law: How a mathematical phenomenon can help CPAs uncover fraud and other irregularities

    Benford's Law: How a mathematical phenomenon can help CPAs uncover fraud and other irregularities

    A century-old observation about the distribution of significant digits is now being used to detect fraud.
    Thanks to Miguel for the heads up on January 22, 2011--- http://www.simoleonsense.com/benfords-law-difficulty-of-faking-data/

    "The Difficulty of Faking Data," tpHill.net ---
    http://www.tphill.net/publications/BENFORD PAPERS/difficultyOfFakingData1999.pdf

    Benford's Law:  It's interesting to read the "Silly" comments that follow the article.

    "Benford's Law And A Theory of Everything:  A new relationship between Benford's Law and the statistics of fundamental physics may hint at a deeper theory of everything," MIT's Technology Review. May 7, 2010 --- http://www.technologyreview.com/blog/arxiv/25155/?nlid=2963

    In 1938, the physicist Frank Benford made an extraordinary discovery about numbers. He found that in many lists of numbers drawn from real data, the leading digit is far more likely to be a 1 than a 9. In fact, the distribution of first digits follows a logarithmic law. So the first digit is likely to be 1 about 30 per cent of time while the number 9 appears only five per cent of the time.

    That's an unsettling and counterintuitive discovery. Why aren't numbers evenly distributed in such lists? One answer is that if numbers have this type of distribution then it must be scale invariant. So switching a data set measured in inches to one measured in centimetres should not change the distribution. If that's the case, then the only form such a distribution can take is logarithmic.

    But while this is a powerful argument, it does nothing to explan the existence of the distribution in the first place.

    Then there is the fact that Benford Law seems to apply only to certain types of data. Physicists have found that it crops up in an amazing variety of data sets. Here are just a few: the areas of lakes, the lengths of rivers, the physical constants, stock market indices, file sizes in a personal computer and so on.

    However, there are many data sets that do not follow Benford's law, such as lottery and telephone numbers.

    What's the difference between these data sets that makes Benford's law apply or not? It's hard to escape the feeling that something deeper must be going on.

    Today, Lijing Shao and Bo-Qiang Ma at Peking University in China provide a new insight into the nature of Benford's law. They examine how Benford's law applies to three kinds of statistical distributions widely used in physics.

    These are: the Boltzmann-Gibbs distribution which is a probability measure used to describe the distribution of the states of a system; the Fermi-Dirac distribution which is a measure of the energies of single particles that obey the Pauli exclusion principle (ie fermions); and finally the Bose-Einstein distribution, a measure of the energies of single particles that do not obey the Pauli exclusion principle (ie bosons).

    Lijing and Bo-Qiang say that the Boltzmann-Gibbs and Fermi-Dirac distributions distributions both fluctuate in a periodic manner around the Benford distribution with respect to the temperature of the system. The Bose Einstein distribution, on the other hand, conforms to benford's Law exactly whatever the temperature is.

    What to make of this discovery? Lijing and Bo-Qiang say that logarithmic distributions are a general feature of statistical physics and so "might be a more fundamental principle behind the complexity of the nature".

    That's an intriguing idea. Could it be that Benford's law hints at some kind underlying theory that governs the nature of many physical systems? Perhaps.

    But what then of data sets that do not conform to Benford's law? Any decent explanation will need to explain why some data sets follow the law and others don't and it seems that Lijing and Bo-Qiang are as far as ever from this.

    It's interesting to read the "Silly" comments that follow the article.

    "I've Got Your Numbr:  How a mathematical phenomenon can help CPAs uncover fraud and other irregularities," by Mark J. Nigrini, Journal of Accountancy, May 1999 --- http://www.journalofaccountancy.com/Issues/1999/May/nigrini.htm

     
     
    EXECUTIVE SUMMARY

    BENFORD'S LAW PROVIDES A DATA analysis method that can help alert CPAs to possible errors, potential fraud, manipulative biases, costly processing inefficiencies or other irregularities.

    A PHYSICIST AT GE RESEARCH LABORATORIES in the 1920s, Frank Benford found that numbers with low first digits occurred more frequently in the world and calculated the expected frequencies of the digits in tabulated data.

    CPAs CAN USE BENFORD'S DISCOVERY in business applications ranging from accounts payable to Y2K problems. In addition, subset tests identify small lists of serious anomalies in large data sets, making an analysis more manageable.

    DIGITAL ANALYSIS IS WELL SUITED to finding errors and irregularities in large data sets when auditors need computer assisted technologies to direct their attention to anomalies.

    MARK J. NIGRINI, CA (SA), PhD, MBA, is an assistant professor at the Edwin L. Cox School of Business, Southern Methodist University, Dallas, and a Research Fellow at the Ernst & Young Center for Auditing Research and Advanced Technology, University of Kansas, Lawrence.

     

    September 3, 2012 message from Mark Nigrini <mark_nigrini@msn.com>

    Hello Bob,

    I hope that you are doing well. I remember that we've spoken with each other, but the details are hazy now. We wpoke about your home in NEw Hampshire and so it was around the time of you moving up north.

    Your website is one where I can start reading and an hour later feel that I've just scratched the surface and need to come back for more.

    You mention Benford's Law on your site (see attached) and I was hoping that you could reference my new book (especially since it's been 13 years since my JOA 1999 article).

    In "Benford's Law: Applications for forensic accounting, auditing, and fraud detection" (Wiley, 2012) author Mark Nigrini, a pioneer in forensic accounting, describes the mathematical foundations of Benford’s Law in a way that is easily understood by accounting and other business-related professionals. He then shows many examples of authentic and accurate data that conformed to Benford’s Law—and the fraudulent and invented numbers that did not. Nigrini goes way beyond the first digits test and outlines a series of digit- and number-based tests called the Nigrini Cycle. These tests are based on the state-of-the-art with respect to the mathematics underlying Benford’s Law. The companion website http://www.nigrini.com/benfordslaw.htm  has free Excel templates, data sets, photos, and other interesting items.

    Thanks, Mark

    Bob Jensen's threads on accounting theory are at
    http://faculty.trinity.edu/rjensen/Theory01.htm

     


    Just Say No to Wall Street: Putting a Stop to the Earnings Game  --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1583563

    Joseph Fuller
    The Monitor Company

    Michael C. Jensen
    Harvard Business School; Social Science Electronic Publishing (SSEP), Inc.


    Journal of Applied Corporate Finance, Vol. 22, No. 1, Winter 2010
    Harvard Business School NOM Unit Working Paper No. 10-090
     

    Abstract:     
    Putting an end to the “earnings game” requires that CEOs reclaim the initiative by avoiding earnings guidance and managing expectations in such a way that their stocks trade reasonably close to their intrinsic value. In place of earnings forecasts, management should provide information about the company's strategic goals and main value drivers. They should also discuss the risks associated with the strategies, and management's plans to deal with them.

    Using the experiences of several companies, the authors illustrate the dangers of conforming to market pressures for unrealistic growth targets. They argue that an overvalued stock, by encouraging overpriced acquisitions and other risky, value-destroying bets, can be as damaging to the long-run health of a company as an undervalued stock.

    CEOs and CFOs put themselves in a bind by providing earnings guidance and then making decisions designed to meet Wall Street's expectations for quarterly earnings. When earnings appear to be coming in short of projections, top managers often react by suggesting or demanding that middle and lower level managers redo their forecasts, plans, and budgets. In some cases, top executives simply acquiesce to increasingly unrealistic analyst forecasts and adopt them as the basis for setting organizational goals and developing internal budgets. But in cases where external expectations are impossible to meet, either approach sets up the firm and its managers for failure and in the process value is destroyed.

    Keywords: Value Maximization, Overvaluation, Incentives, Managing Earnings, Analyst Expectations, Managing Wall Street, Earnings Guidance, Financial Reporting, Budgeting Process

     


    Oldie But Goodie
    "Earnings Manipulation, Pension Assumptions and Managerial Investment Decisions"
    Daniel Bergstresser Harvard Business School
    Joshua D. Rauh Northwestern University - Department of Finance; National Bureau of Economic Research (NBER)
    Mihir A. Desai Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)
    SSRN, May 2005 --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=551681

    Managers appear to manipulate firm earnings through their characterizations of pension assets to capital markets and alter investment decisions to justify, and capitalize on, these manipulations. Managers are more aggressive with assumed long-term rates of return when their assumptions have a greater impact on reported earnings. Firms use higher assumed rates of return when they prepare to acquire other firms, when they issue equity, when they are near critical earnings thresholds and when their managers exercise stock options. Changes in assumed returns, in turn, influence pension plan asset allocations. Instrumental variables analysis indicates that 25 basis point increases in assumed rates are associated with 5 percent increases in equity allocations.


    The MAAW site has two special links for fraud and creative accounting:

    Professor Martin places every article and book he finds related to fraud on the following pages:

    Auditing Bibliography --- http://maaw.info/AuditingArticles.htm

    Creative Accounting Bibliography --- http://maaw.info/CreativeAccountingMain.htm


    2010 Update on Creative Accounting and Managed Earnings

    February 18, 2010 message from David Albrecht [albrecht@PROFALBRECHT.COM]

    I"m sending two links. Teh first is to the WSJ write-up. The second is to the paper.
    http://online.wsj.com/article/SB10001424052748704479704575061481908470618.html?KEYWORDS=quadrophobia 

     For Some Firms, a Case of 'Quadrophobia' Study Suggests Companies Tweak Per-Share Earnings to Meet Expectations; 4 Is a Lonely Number By SCOTT THURM A new study provides further evidence suggesting many companies tweak quarterly earnings to meet investor expectations, and the companies that adjust most often are more likely to restate earnings or be charged with accounting violations. The study, which examined nearly half a million earnings reports over a 27-year period, reached its conclusion by going beyond the standard per-share earnings results that are reported in pennies and analyzing the numbers down to the 10th of a cent. That deeper look showed that companies tend to nudge their earnings numbers up by a 10th of a cent or two. That lets them round results up to the highest cent. Investors often snap up shares of companies that beat earnings expectations, even by a cent, and, likewise, sell off shares of companies that don't make their numbers. "Managements will exercise accounting discretion to try to make their numbers look better for Wall Street … in a number of subtle ways," said Joseph Grundfest, one of the study's authors. Mr. Grundfest is a law professor at Stanford University and a former member of the Securities and Exchange Commission. Mr. Grundfest and co-author Nadya Malenko, a doctoral candidate at the Stanford Graduate School of Business, said the accounting maneuvers may be legal, even when they have the effect of boosting reported earnings per share. Most of the tactics involve judgment calls, such as the value of inventory or the amount that should be set aside for loans that won't be repaid. The Securities and Exchange Commission declined to comment.

    The authors' conclusions rest on a simple piece of statistical analysis. When they ran the earnings-per-share numbers down to a 10th of a cent, they found that the number "4" appeared less often in the 10ths place than any other digit, and significantly less often than would be expected by chance. They dub the effect "quadrophobia." The amounts of money involved can be small. For the typical company in the study, an increase of $31,000 in quarterly net income would boost earnings per share by a 10th of a cent. But the overall effect is striking. In theory, each digit should appear in the 10ths place 10% of the time. After reviewing nearly 489,000 quarterly results for 22,000 companies from 1980 to 2006, however, the authors found that "4" appeared in the 10ths place only 8.5% of the time. Both "2" and "3" also are underrepresented in the 10ths place; all other digits show up more frequently than expected by chance. Companies tracked by Wall Street analysts are less likely to report "4s" in the 10ths place of an earnings-per-share figure particularly when their results are close to analysts' predictions. Companies with high price-to-earnings ratios also report fewer "4s." Continued:

    Here's the paper.
    http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1521272_code254274.pdf?abstractid=1474668 
    "Quadrophobia: Strategic Rounding of EPS Data ," by Joseph Grundfest and Nadya Malenko, SSRN, October 14, 2009 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1474668

    Bob Jensen's threads on earnings management and creative accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation


    All this now begs the question of how managers of corporations are adapting to new accounting/financing rules with innovative sucker punches.

    Lately on the AECM, debates have recently taken place about what the real purpose is of standard setters like the IASB, FASB, GASB, SEC, PCAOB, etc.. I think a major purpose is to make it more difficult for managers of public corporations and governments to throw sucker punches at the outsiders who invest in their organizations ---
    http://accountingonion.typepad.com/theaccountingonion/2010/01/financial-statement-presentation-a-promising-new-tack.html

    The United States is doing an awful job controlling sucker punches in governmental accounting and auditing so I will pass over this one other than to point out where you can read about it and weep for the suckers ---
    http://faculty.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

    The SEC is doing an awful job in controlling sucker punches in financial markets ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm
    This is discussed in the article below quoted from The Economist.

    I like to think about accountancy standard setting like I think about prize fighting or Olympic boxing. In prize fighting rules are established to prevent such things as cheating about the weight classifications of fighters and prevention of putting steel clamps inside boxing gloves. There are also rules to prevent sucker punches such as hitting below the belt and before or after the bell rings for each round. As fighters take advantages of weaknesses in the rules, rule makers issue new rulings such as rulings on performance enhancing drugs.

    In the roaring technology firm era of the 1990s, there were many startup companies that took advantages of weaknesses in FASB and SEC standards, particularly weaknesses on newer ploys to mislead investors with sucker punches in revenue accounting ---
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 

    In the roaring 1990s, companies like Enron threw sucker punches due to inadequate accounting standards for newer types of financing contracts such as exotic derivative financial instruments and special-purpose entities --- http://faculty.trinity.edu/rjensen/FraudEnron.htm

    Managers particularly like to sucker punch in the area of creative accounting and earnings management ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    The FASB made significant progress thus far in the 21st Century in setting rules against some of the sucker punches that were invented in the roaring 1990s. The IASB is still trying to catch up, and delays in catching up for some sucker punches like securitization accounting are delaying the SEC roadmap for eliminating US GAAP and replace it with international IASB standards for preventing sucker punches.

     

    All this now begs the question of how managers of corporations are adapting to new accounting/financing  rules with innovative sucker punches.

    How firms fool equity analysts
    Stockpickers suckered Chief executives pull the wool over analysts’ eyes, again
    The Economist, February 6, 2010 Page 72
    http://www.economist.com/businessfinance/displaystory.cfm?story_id=15464463

    HOW do you pump up the value of your company in these difficult times? One tried and tested way is to hoodwink equity analysts, according to a new study* of 1,300 corporate bosses, board directors and analysts.

    The authors found that chief executives commonly respond to negative appraisals from Wall Street by managing appearances, rather than making changes that actually improve corporate governance: boards are made more formally independent, but without actually increasing their ability to control management. This is typically done by hiring directors who, although they may have no business ties to the company, are socially close to its top brass. According to James Westphal, one of the study’s co-authors, some 45% of the members of nominating committees on the boards of large American firms have “friendship” ties to the boss—though this varies widely from company to company.

    The tactic pays off with appreciably higher ratings. At firms that make a strenuous effort to persuade analysts that such board changes have boosted independence, and thus made management more accountable, the likelihood of a subsequent stock upgrade rises by 36%, the study concluded. The chance of a downgrade, meanwhile, falls by 45%.

    Why do analysts swallow this self-interested narrative? Respondents acknowledged that social ties could undermine independence, but most said they do not have the time to look into such issues. It would help if companies disclosed such relationships in their standard company literature, suggests Mr Westphal. He thinks they should also list shared appointments—when the boss and a director sit together on another firm’s board.

    Depressingly, these market-distorting shenanigans are part of a pattern. An earlier study found that public companies commonly enjoy lasting share-price gains from plans that please analysts, such as share buybacks and long-term incentive schemes for executives, even when they fail to follow through on announcements. Another concluded that the further a firm’s profits fall below consensus forecasts, the more favours its managers bestow on analysts—such as recommending them for jobs and even securing club memberships for them—and the lower the likelihood of a further downgrade. If investors rated analysts, those taken in by such blatant attempts at manipulation would surely earn a “sell”.

    Bob Jensen's threads on the controversies of accountancy standard setting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting

    Bob Jensen's threads on accounting professionalism or lack thereof are at
    http://faculty.trinity.edu/rjensen/fraud001.htm

    Bob Jensen's threads on the biggest sucker punches in the history of the world are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's threads on the Enron/Andersen scandals are at 
    http://faculty.trinity.edu/rjensen/fraud.htm 

    Bob Jensen's SPE threads are at
    http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm 

    Bob Jensen's threads on accounting theory are at
    http://faculty.trinity.edu/rjensen/theory.htm 

    Bob Jensen's threads on the state of accountancy can be found at
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm

    Bob Jensen's threads are at
    http://faculty.trinity.edu/rjensen/threads.htm

     


    "Going to School on Revenue Recognition," by Tom Selling, The Accounting Onion, December 5, 2009 --- Click Here

    Jensen Comment
    Another question is consistency and whether inconsistencies suggest earnings management.

    "Strategic Revenue Recognition to Achieve Earnings Benchmarks," Marcus L. Caylor, Marcus L. Caylor, SSRN, January 14, 2008 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=885368
    This paper is a free download.

    Abstract:
     I examine whether managers use discretion in the two accounts related to revenue recognition, accounts receivable and deferred revenue, to avoid three common earnings benchmarks. I find that managers use discretion in both accounts to avoid negative earnings surprises. I find that neither of these accounts is used to avoid losses or earnings decreases. For a common sample of firms with both deferred revenue and accounts receivable, I show that managers prefer to exercise discretion in deferred revenue vis-à-vis accounts receivable. I provide a reason for why managers might prefer to manage a deferral rather than an accrual: lower costs to manage (i.e., no future cash consequences). My results suggest that if given the choice, managers prefer to use accounts that incur the lowest costs to the firm.

    Thank you for the heads up Francine!
    "Fifteen Risk Factors for Poor Governance A self-diagnostic to identify risk factors for poor governance and reporting," by Walter Smiechewicz (who at one time worked for the scandalous Countrywide), Directorship, September 8, 2009 ---
    http://www.directorship.com/fifteen-risk-factors-for-poor-governance/

    Some of the best indicators of our overall physical health come from blood tests. Unfortunately, too often we don’t begin to watch and manage these numbers until later on in life. Of course, it’s never too late to improve your diet and exercise, but we’re always left thinking, “if only I’d paid attention to this earlier.”

    With so many recent corporate crises, it is plain it’s suffice to say that a great many corporate board members and executives are experiencing similar regret right now. Perhaps this could have been avoided if they too had practiced routine diagnostic check ups. Like an individual blood test, board members need to know the risks their company is facing, and as with any health risk, they also need to be able to mitigate those exposures.

    Sounds great, but the devils in the details, right? Perhaps not.

    As chief consultant for governance and risk at Audit Integrity, I’ve examined the worst U.S. companies from an “integrity” standpoint in order to help board members and general auditors see how their company’s health stacks up. Audit Integrity’s metrics have shown which companies are 10 times more likely to face SEC Actions; five times more likely to face class action litigation; and four times more likely to face bankruptcy.

    Using Audit Integrity’s proprietary AGR (Accounting, Governance, and Risk) score, 196 companies were identified as laggards or high-risk companies. These companies have been proven to have higher odds of SEC actions and class action litigation, loss of shareholder value, and increased odds of material financial restatement and bankruptcy. All are North American, non-financial, publicly traded companies with over $2 billion in market capitalization with an average-to-weak financial condition.

    Next, I tested the 119 metrics that Audit Integrity flags and discovered that 15 of those metrics appeared consistently as identifiers of problematic companies; the first metric was prevalent in 65 percent of the 196 high-risk companies and the 11th evident in 40 percent. The other 8,000 companies tested had low incidences of these same metrics. A list – dubbed the Risky Business Catalogue – details the common metrics within high-risk companies. Board members, the C-suite, and general auditors should note if their company is a candidate for the RBC. The evidence is not saying that significant issues are imminent if a company has one of the RBCs, but a combination of RBC metrics indicate risk factors to the entity’s business model and strategy.

    RBC’s metrics include:

    1. The company has entered into a merger within the last 12 months. While there is certainly nothing wrong with corporate M&A activity, it’s common for policies to be revised and system integrations to be rushed. Company directors need to caution general auditors to be extra vigilant post merger and increase testing of balance sheet accounts.

    2. The CEO and CFO’s compensation is more highly weighted toward incentive compensation than base compensation. This situation can cause negative motivations and earnings to be increased more creatively to ensure a larger portion of executive pay packages. Close attention should be paid to revenue recognition.

    3. The Board Chairman is also the CEO. An age-old debate, but indispuditedly conflicts of interest invariably result when a company CEO is also its Chairman. Separate the roles to improve governance and reduce compromised oversight.Compromised reliability exists because the very architecture of governance has a built in conflict when the Chairman is also CEO.

    4. The company has undergone a restructuring in the last 12 months. Restructuring may be completely valid, but also can be employed to conceal the lack of sustainable earnings growth. Directors, by role definition, should be intimately involved in restructuring procedures decisions and promised outcomes.

    5. The company has encountered a public regulatory action in the last 12 months. Many corporate stakeholders hold true to the statement that where there’s smoke, there’s fire. Directors should no longer accept “no worries” explanations on regulatory matters. Compliance tests should be employed routinely and if regulatory action does occur, management needs to take action.

    6. The amount of goodwill carried on the balance sheet, when compared to total assets, is high. When intangible assets such as goodwill grow, boards should ask more probing questions about how the business model generated these assets and about concomitant valuation protocols. General Auditors should confirm that models are comprehensively back tested and impairment procedures are adhered to assiduously.

    7. The ratio of the CEO’s total compensation to that of the CFO is high. If a CEO is awarded a much larger paycheck than anyone else (particularly particularally the CFO), it increases governance risk and leads to a top-directed culture, thus limiting collaboration. Boards need to be involved in all executive compensation issues including that which drives pay packages for the CFO, Chief Risk Officer, as well as internal auditors,. etc.

    8. Operating revenue is high when compared to operating expenses. Riskier companies have revenue recognition in excess of what is expected based on operating revenues. Directors should fully understand revenue recognition policies and instruct management to test them to be sure they are not aggressive.

    9. A Divestiture(s) has occurred in the last 12 months. Data shows that riskier companies have more divestures, usually because it is an opportunity for more aggressive accounting activity. Board members should inquire as to how this action fits the strategy.

    10. Debt to equity ratio is high. When a business relies too heavily on debt it reveals that markets are not independently funding the business model or strategy. Boards should know why the markets are not investing in their entity and therefore why debt is so heavily relied upon. Board members should also be knowledgeable on the quality of their equity and not just the amount. Lastly, they should understand management’s funding overall funding strategy and the strength of contingent funding plans.

    11. A repurchase of company stock has taken place in the last 12 months. A repurchase of stock is usually presented to investors as an avenue to increase market demand for the stock, thereby elevating overall shareholder value. Management must provide reasoning for why there are no other ways to invest excess funds. Boards should also request the general auditor to review insider sales during the period of share repurchase programs.

    12. Inventory valuations to total revenue is increasing. When inventory increases in relation to revenue it should raise control questions about inventory valuation. It could indicate changing consumer preferences, which should spur an analysis of a corporation’s business model.

    13. Accounts receivables to sales is increasing. This situation can typically be indicative of relaxed credit standards. Directors should ask whether sales are decreasing due to market conditions and instruct the general auditor to probe receivables to determine their viability.

    14. Asset turnover has slowed when compared to industry peers. If assets are increasing and sales are not flowing it could indicate less productive assets are being brought, or retained, on the balance sheet. Conversely, if sales are decreasing, executives and auditors will again want to analyze changing customer preferences.

    15. Assets driven by financial models make up a larger portion of balance sheet. A collection of other accounting metrics indicates that boards, the C-suite, and general auditors should pay special attention to the controls, assumptions, and governance surrounding assets whose valuations are model driven. This is particularly true if assets that are valued by financial models make up a larger portion of the entities balance sheet.

    To be sure, any one of these in isolation as an indicator of accounting and governance risk can be debated. Company divestitures and M&A can be a healthy indicator. But if a corporation fails more than a few of these metrics, board members need to take action.

    It is easy to dismiss any one of these metrics when you find it is an issue in your company. Human nature is quick to retort – maybe for others but not for us. However, like time and tide, the numbers too, wait for no one. So, if you have any of these AGR metrics, you need to begin confronting these risk characteristics today to improve your corporate health and avoid the much more drastic financial equivalent of cardiovascular surgery tomorrow.

    Walter Smiechewicz is chief consultant for governance and risk at Audit Integrity, a research firm that provides accounting and governance risk analysis

     December 5, 2009 reply from Bob Jensen

    Here are some added thoughts:

    The risk factors are excerpted from AICPA Statement on Auditing Standards 82, “Consideration of Fraud in a Financial Statement Audit” (1997). That statement was issued to provide guidance to auditors in fulfilling their responsibility “to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” Although there risk factor cover a broad range of situations, they are only examples. In the final analysis, audit committee members should use sound informed judgment when assessing the significance and relevance of fraud risk factors that may exist.
    http://www2.gsu.edu/~wwwseh/Financial Reporting Red Flags.pdf
    There may be an update on this material.

    Reflections on the audit committee's role --- http://www.allbusiness.com/accounting-reporting/auditing/173956-1.html

    You might browse some of the Financial Analysis Lab materials at Georgia Tech (directed by Chuck Mulford) ---
    http://mgt.gatech.edu/fac_research/centers_initiatives/finlab/index.html
    This is one of the best centers of academic study of financial reporting and fraud.

    Mulford and Gene Comiskey some great books on red flags in financial reporting.  These include the following:

    ·         Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance

    ·         The Financial Numbers Game: Detecting Creative Accounting Practices

    ·         Financial Warnings: Detecting Earning Surprises, Avoiding Business Troubles, Implementing Corrective Strategies
    This is a bit dated (1996) but it is a classic that I keep within arms reach.

     Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

    Bob Jensen's threads on revenue recognition frauds are at
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

    Creative Earnings Management, Agency Theory, and Accounting Manipulations to Cook the Books
    The Controversy Over Earnings Smoothing and Other Manipulations ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation


    "CFOs and CEOs: Who Have the Most Influence on Earnings Management?" by John (Xuefeng) Jiang,  Kathy R. Petroni, and Isabel Yanyan Wang, SSRN, September 5, 2009 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1461842

    Abstract:
    This study examines the association between CFO equity incentives and earnings management. CEO equity incentives have been shown to be associated with accruals management and the likelihood of beating analyst forecasts (Bergstresser and Philippon, 2006; Cheng and Warfield, 2005). Because CFOs’ primary responsibility is financial reporting, CFO incentives should play a stronger role than those of the CEO. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. Our evidence supports the SEC’s new disclosure requirement on CFO compensation.


    Question
    At this juncture why would IBM spend almost $10 billion for its own shares?

    Hint
    The wildly-popular eps ratio has a denominator.

    "IBM to spend $5 billion more on stock buyback," MIT's Technology Review, October 27, 2009 ---
    http://www.technologyreview.com/wire/23815/?nlid=2465

    IBM Corp. has boosted its stock buyback program by $5 billion, a sign of the company's ability to spit out cash despite the fact the recession has choked off revenue growth.

    The announcement Tuesday brings IBM's pot for stock repurchases to $9.2 billion, and the company, based in Armonk, N.Y., plans to ask for more at a board meeting in April 2010. IBM said it has spent $73 billion on dividends and buybacks since 2003.

    Buybacks are one lever companies pull to meet earnings targets, since they increase earnings per share by reducing the number of shares outstanding. IBM has set aggressive earnings targets, and twice this year raised its profit forecast for 2009, surprising investors since revenue has fallen since last year. IBM has said it sees corporate spending on technology "stabilizing." One way IBM wrings more profit despite lower sales is by using software to automate certain tasks done by humans and focusing on projects like the "smart" power grid that can carry higher profit margins than other services work.

    IBM's current forecasts call for earnings per share of at least $9.85 this year, and the company has maintained that it is "well ahead" of its pace for 2010 earnings of $10 to $11 per share.

    IBM ended the third quarter with $11.5 billion in cash. Free cash flow, a sign of a company's ability to generate more cash, was $3.4 billion, up $1.3 billion from a year ago. Revenue in the past nine months is down nearly 11 percent from a year ago.

    Certainly it’s widely viewed in the financial analyst community that IBM is trying to prop up eps with share buy backs:
    “Jul 16, 2009 ... (As if anyone except Wall Street cared about EPS, which IBM largely makes ... of dollars it expends buying up mountains of its own shares.” ...
    www.theregister.co.uk/2009/07/16/ibm_q2_2009_numbers /

    Time and time again executives manage earnings in demonstration that many (most?) do not believe in efficient markets and strongly believe PT Barnum’s famous quote:  “A sucker is born every minute.”

    Quality of Earnings Disputes --- http://faculty.trinity.edu/rjensen/theory01.htm#CoreEarnings

    Return on Investment Controversies --- http://faculty.trinity.edu/rjensen/roi.htm


    European-Styled Avoidance of Fair Value Earnings Hits for Loan Loss Impairments

    European banks circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

    European banks resorted to a number of misleading ploys to avoid taking fair value adjustment hits to prevent earnings hits due to required fair value adjustments of investments that crashed such a investments in the bonds of Greece, Ireland, Spain, and Portugal.

    The Market Transitory Movements Argument
    Fair value adjustments can be avoided if they are viewed as temporary transitory market fluctuations expected to recover rather quickly. This argument was used inappropriately by European banks hold billions in the Greece, Ireland, Spain, and Portugal after the price declines could hardly be viewed as transitory. The head of the IASB at the time, David Tweedie, strongly objected to the failure to write down financial instruments to fair value. The banks, in turn, threatened to pressure the EU lawmakers to override the IFRS 9 requirement to adjust such value declines to market.

    One of the major concerns of the  is that some nations at some points in time will simply not enforce the IASB standards that these nations adopted. The biggest problem that the IASB was having with European Banks is that the IASB felt many of many (actually most) EU banks were not conforming to standards for marking financial instruments to market (fair value). But the IASB was really helpless in appealing to IFRS enforcement in this regard.

    When the realities of European bank political powers, the IASB quickly caved in as follows with a ploy that allowed European banks to lie about intent to hold to maturity. The banks would probably love to unload those loser bonds as quickly as possible before default, but they could instead claim that these investments were intended to be held to maturity --- a game of make pretend that the IASB went along with under the political circumstances.

    "New accounting rule would ease Greek pain: IASB," By Silke Koltrowitz and Huw Jones,  Reuters, July 5, 2011 ---
    http://www.reuters.com/article/2011/07/05/us-accounting-idUSTRE7643WU20110705

    European Union banks would have more breathing space from losses on Greek bonds if the bloc adopted a new international accounting rule, a top standard setter said on Tuesday.

    The International Accounting Standards Board (IASB) agreed under intense pressure during the financial crisis to soften a rule that requires banks to price traded assets at fair value or the going market rate.

    This led to huge writedowns, sparking fire sales to plug holes in regulatory capital.

    The new IFRS 9 rule would allow banks to price assets at cost if they are being held over time.

    The European Commission has yet to sign off on the new rule for it to be effective in the 27-nation bloc, saying it wants to see remaining parts of the rule finalized first.

    Continued in article

     

    Dynamic Provisioning:  The Cookie Jar Argument If Banks Had Cookies in the Jar
    European Union officials knew this and let Spain proceed with its own brand of accounting anyway.
    "The EU Smiled While Spain’s Banks Cooked the Books," by Jonathan Weil, Bloomberg, June 14, 2012 ---
    http://www.bloomberg.com/news/2012-06-14/the-eu-smiled-while-spain-s-banks-cooked-the-books.html

    Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

    But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

    By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

    This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

    What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia (BKIA) group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

    Name Calling

    Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

    “Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”

    The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

    One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

    “They didn’t implement IFRS, and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS,” McCreevy said, according to a transcript of the meeting on the monitoring board’s website. “The Spanish regulator did not do that, and he survived this. His banks have survived this crisis better than anybody else to date.”

    Ignoring Rules

    McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, went on: “The rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them.”

    Why didn’t he take action? McCreevy said he was a fan of dynamic provisioning. “Why am I like that? Well, I’m old enough to remember when I was a young student that in my country that I know best, banks weren’t allowed to publish their results in detail,” he said. “Why? Because we felt if everybody saw the reserves, etc., it would create maybe a run on the banks.”

    So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

    Continued in article

    "Accounting Board Criticizes European Banks on Greek Debt," REUTERS, August 30, 2011 ---
    http://www.nytimes.com/2011/08/31/business/global/accounting-board-criticizes-european-banks-on-greek-debt.html 

    Some European financial institutions should have booked bigger losses on their Greek government bond holdings in recent results announcements, the International Accounting Standards Board said in a letter to market regulators.

    The criticism comes as Europe’s lenders face calls to shore up their balance sheets and restore confidence to investors unnerved by the euro zone debt crisis, funding market jitters and a slowing economy.

    In a letter addressed to the European Securities and Markets Authority, the I.A.S.B. — which aims to become the global benchmark for financial reporting — criticized inconsistencies in the way banks and insurers wrote down the value of their Greek sovereign debt in second-quarter earnings.

    It said “some companies” were not using market prices to calculate the fair value of their Greek bond holdings, relying instead on internal models. While some claimed this was because the market for Greek debt had become illiquid, the I.A.S.B. disagreed.

    “Although the level of trading activity in Greek government bonds has decreased, transactions are still taking place,” the board chairman Hans Hoogervorst wrote.

    The E.S.M.A. was not immediately available for comment.

    The letter, which was posted on the I.A.S.B.’s website Tuesday after being leaked to the press, did not single out particular countries or banks.

    European banks taking a €3 billion, or $4.2 billion, hit on their Greek bond holdings earlier this month employed markedly different approaches to valuing the debt.

    The writedowns disclosed in their quarterly results varied from 21 to 50 percent, showing a wide range of views on what they expect to get back from their holdings.

    A 21 percent hit refers to the “haircut” on banking sector involvement in a planned second bailout of Greece now being finalized. A 50 percent loss represented the discount markets were expecting at the end of June, the cut-off period for second-quarter results.

    Two French financial companies, the bank BNP Paribas and insurer CNP Assurances, on Tuesday defended their decision to use their own valuation models rather than market prices.

    “BNP took provisions against its Greece exposure in full agreement with its auditors and the relevant authorities, in accordance with the plan decided upon by the European Union on July 21,” a bank spokeswoman said.

    A CNP spokeswoman said the group’s Greek debt provisions had been calculated in accordance with the E.U. plan and in agreement with its auditors.

    Some investors see the issue as serious, however, even if the STOXX Europe 600 bank index was trading higher on Tuesday.

    “The Greek debt issue has been treated very lightly,” said Jacques Chahine, head of Luxembourg-based J. Chahine Capital, which manages €320 billion in assets. “And it’s not just Greek debt — all of it needs to be written down, Spain, Italy.”

    The E.S.M.A. was unable to impose a uniform Greek “haircut” across the E.U. and its guidance published at the end of July simply stressed the need for banks to tell investors clearly how they reflect Greek debt values.

    The I.A.S.B. also has no powers of enforcement in how banks book impairments but is keen to show the United States, which decides this year whether to adopt I.A.S.B. standards, that its rules are consistent and properly represent what’s happening in markets.

    Auditors warned at the time against a patchwork approach that will confuse investors and concerns over Greek haircut reporting will fuel calls for a pan-Europe auditor regulator.

    “The impact is more likely to be to further reduce investors’ confidence in buying bank debt, rather than sovereign debt,” said Tamara Burnell, head of financial institutions/sovereign research at M&G.

    Using the most aggressive markdown approach — namely marking to market all Greek sovereign holdings — would saddle 19 of the most exposed European banks with another €6.6 billion in potential writedowns, according to Citi analysts.

    BNP would take the biggest hit with €2.1 billion in remaining writedowns, followed by Dexia in Belgium with €1.9 billion and Commerzbank in Germany with €959 million, Citi said.

    The European Commission said on Monday that there was no need to recapitalize the banks over and above what had been agreed after a recent annual stress test .

    Spinning Debt Into Earnings With the Wave of a Fair Value Accounting Wand
    "Euro banks' £169bn in accounting alchemy," by: Lindsey White, Financial Times Advisor, January 19, 2009 --- Click Here

    European banks conjured more than £169bn of debt into profit on their balance sheets in the third quarter of 2008, a leaked report shows.

    Money Managementhas gained exclusive access to a report from JP Morgan, surveying 43 western European banks.

    It shows an exact breakdown of which banks increased their asset values simply by reclassifying their holdings.

    Germany is Europe's largest economy, and was the first European nation to announce that it was in recession in 2008. Based on an exchange rate of 1 Euro to £0.89, its two largest banks, Deutsche Bank and Commerzbank, reclassified £22.2bn and £39bn respectively.

    At the same exchange rate, several major UK banks also made the switch. RBS reclassified £27.1bn of assets, HBOS reclassified £13.7bn, HSBC reclassified £7.6bn and Lloyds TSB changed £3.2bn. A number of Nordic and Italian banks also switched debts to become profits.

    Banks are allowed to rearrange these staggering debts thanks to an October 2008 amendment to an International Accounting Standards law, IAS 39. Speaking to MM, IAS board member Philippe Danjou said that the amendment was passed in "record time".

    The board received special permission to bypass traditional due process, ushering through the amendment in a matter of days, in order to allow banks to apply the changes to their third quarter reports.

    However, it is unclear how much choice the board actually had in the matter.

    IASB chairman Sir David Tweedie was outspoken in his opposition to the change, publicly admitting that he nearly resigned as a result of pressure from European politicians to change the rules.

    Danjou also admitted that he had mixed views on the change, telling MM, "This is not the best way to proceed. We had to do it. It's a one off event. I'd prefer to go back to normal due process."

    While he was reluctant to point fingers at specific politicians, Danjou admitted that Europe's "largest economies" were the most insistent on passing the change.

    As at December 2008, no major French, Portuguese, Spanish, Swiss or Irish banks had used the amendment.

    BNP Paribas, Credit Agricole, Danske Bank, Natixis and Societe Generale were expected to reclassify their assets in the fourth quarter of 2008.

    The amendment was passed to shore up bank balance sheets and restore confidence in the midst of the current credit crunch. But it remains to be seen whether reclassifying major debts is an effective tactic.

    "Because the market situation was unique, events from the outside world forced us to react quickly," said Danjou. "We do not wish to do it too often. It's risky, and things can get missed."

    Jensen Comment
    European banks thus circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

     

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue


    "Executive Overconfidence and the Slippery Slope to Fraud," by Catherine M. Schrand University of Pennsylvania - Accounting Department  and Sarah L. C. Zechman University of Chicago Booth School of Business, SSRN, May 1, 2009 --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1265631

    Abstract:
    We propose that executive overconfidence, defined as having unrealistic (positive) beliefs about future performance, increases a firm’s propensity to commit financial reporting fraud. Moderately overconfident executives are more likely to “borrow” from the future to manage earnings thinking it will be sufficient to cover reversals. On average, however, they are wrong, and the managers are compelled to engage in greater earnings management or come clean. Using industry, firm, and executive level proxies for overconfidence, we provide evidence consistent with this hypothesis. Additional analysis suggests a distinction between moderately and extremely overconfident executives. The extremely overconfident executives are simply opportunistic. We find no evidence that non-fraud firms have stronger governance to mitigate fraud.

    Keywords: executive overconfidence, fraud, earnings mangement

    Bob Jensen's threads on earnings management are at
    http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    SEC says:  "GE bent the accounting rules beyond the breaking point"

    "GE Settles Civil-Fraud Charges:  Fine of $50 Million Resolves SEC Probe Into Firm's Accounting Practices," by Paul Glader and Kara Scannell, The Wall Street Journal, August 5, 2009 --- http://online.wsj.com/article/SB124939838428504935.html#mod=todays_us_marketplace

    General Electric Co. agreed to pay a $50 million fine to the Securities and Exchange Commission to settle civil fraud and other charges that GE's financial statements in 2002 and 2003 misled investors.

    The fine settles a probe that started in 2005 into GE's accounting procedures, including financial hedges and revenue recognition. In a complaint filed with U.S. District Court in Connecticut, the SEC said the Fairfield, Conn., conglomerate used improper accounting methods to boost earnings or avoid disappointing investors.

    "GE bent the accounting rules beyond the breaking point," said Robert Khuzami, director of the SEC's Division of Enforcement, in a prepared statement. "Overly aggressive accounting can distort a company's true financial condition and mislead investors."

    GE agreed to pay the fine without admitting or denying the SEC's allegations. The SEC noted efforts by GE's audit committee to correct and improve the company's accounting during the probe. GE twice restated its financial results and disclosed other errors. The probe led to several employees being disciplined or fired.

    "We are committed to the highest standards of accounting," said GE spokeswoman Anne Eisele. "While this has been a difficult and costly process, our controllership processes have been strengthened as a result, and GE is a stronger company today." GE said it doesn't need to further correct or revise its financial statements related to the investigation.

    The SEC complaint focused on GE's accounting for four items over various periods: derivatives, commercial-paper funding, sales of spare parts and revenue recognition. The commission said GE in 2002 and 2003 reported locomotive sales that hadn't yet occurred in order to boost revenue by $370 million. A 2002 change in accounting for spare parts in its aircraft-engine unit increased that year's net income by $585 million, the commission said.

    In early 2003, the SEC alleges, GE changed how it accounted for hedges on its issuances of short-term borrowings known as commercial paper. The commission said the change boosted GE's pretax earnings for 2002 by $200 million. Had it not changed the methodology, the commission said, GE would have missed analysts' earnings estimates for the first time in eight years, by 1.5 cents.

    "Every accounting decision at a company should be driven by a desire to get it right, not to achieve a particular business objective," said David P. Bergers, director of the commission's Boston office, which led the investigation. "GE misapplied the accounting rules to cast its financial results in a better light."

    The settlement resolves the GE accounting inquiry, but Mr. Bergers said similar SEC investigations of other companies continue.

    GE's shares were up 10 cents to $13.82 in 4 p.m. composite trading on the New York Stock Exchange. Investors and analysts said the settlement represented closure.

    "I feel as though the company has corrected its practices," said David Weaver, a portfolio manager at Adams Express in Baltimore, which owns about 1.5 million GE shares. "Going forward, I feel a little more comfortable with the cleanliness of [GE's earnings] numbers."

    Matt Collins, an industrial analyst at Edward Jones in St. Louis, said the accounting issues had been "frustrating for investors, but they were never material." He said investors are now focused on the recession and losses at GE's finance unit.

    The SEC under enforcement chief Mr. Khuzami is trying to close cases older than three years unless they are critical to the agency's program. The goal is to clear out the pipeline so attorneys can work on current cases, although one person familiar with the matter said that wasn't a consideration in this case.

    Jensen Comment
    GM's auditor, KPMG, is not named in the court paper such that the role auditors played in allowing GE to push these alleged accounting abuses is not disclosed.

    Bob Jensen's fraud updates are at
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    How to play tricks on fair value accounting by "managing" the closing price of key securities in the portfolio
    Painting the Tape (also called Banging the Close)
    This occurs when a portfolio manager holding a security buys a few additional shares right at the close of business at an inflated price. For example, if he held shares in XYZ Corp on the last day of the reporting period (and it's selling at, say $50), he might put in small orders at a higher price to inflate the the closing price (which is what's reported). Do this for a couple dozen stocks in the portfolio, and the reported performance goes up. Of course, it goes back down the next day, but it looks good on the annual report.
    Jason Zweig, "Pay Attention to That Window Behind the Curtain," The Wall Street Journal, December 20, 2008 --- http://online.wsj.com/article/SB122973369481523187.html?

    Bob Jensen's threads on fair value accounting are a http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's "Rotten to the Core" document --- http://faculty.trinity.edu/rjensen/FraudRotten.htm


    PwC Auditors Apparently Let This Massive and Long-Term Accounting Fraud Go Undetected
    Price Waterhouse, auditor to Satyam Computer Services Ltd. (500376.BY), Wednesday said it is examining the contents of Satyam Chairman B. Ramalinga Raju's statement in which he said Satyam's accounts were falsified. "We have learnt of the disclosure made by the chairman of Satyam Computer Services and are currently examining the contents of the statement. We are not commenting further on this subject due to issues of client confidentiality," Price Waterhouse said in an e-mailed statement.
    "Price Waterhouse: Currently Examining Satyam Chmn's Statement," Lloyds, January 7, 2008 --- http://www.lloyds.com/dj/DowJonesArticle.aspx?id=416525

    Earlier in the day, Satyam Chairman Raju resigned, admitting to falsifying company accounts and inflating revenue and profit figures over several years.

    "Satyam Chief Admits Huge (multi-year accounting) Fraud," by Heather Timmons, The New York Times, January 7, 2008 --- http://www.nytimes.com/2009/01/08/business/worldbusiness/08satyam.html?_r=1&ref=business

    Satyam Computer Services, a leading Indian outsourcing company that serves more than a third of the Fortune 500 companies, significantly inflated its earnings and assets for years, the chairman and co-founder said Wednesday, roiling Indian stock markets and throwing the industry into turmoil.

    The chairman, Ramalinga Raju, resigned after revealing that he had systematically falsified accounts as the company expanded from a handful of employees into a back-office giant with a work force of 53,000 and operations in 66 countries.

    Mr. Raju said Wednesday that 50.4 billion rupees, or $1.04 billion, of the 53.6 billion rupees in cash and bank loans the company listed as assets for its second quarter, which ended in September, were nonexistent.

    Revenue for the quarter was 20 percent lower than the 27 billion rupees reported, and the company’s operating margin was a fraction of what it declared, he said Wednesday in a letter to directors that was distributed by the Bombay Stock Exchange.

    Satyam serves as the back office for some of the largest banks, manufacturers, health care and media companies in the world, handling everything from computer systems to customer service. Clients have included General Electric, General Motors, Nestlé and the United States government. In some cases, Satyam is even responsible for clients’ finances and accounting.

    The revelations could cause a major shake-up in India’s enormous outsourcing industry, analysts said, and may force many large companies to investigate and perhaps revamp their back offices.

    “This development is going to have a major impact on Satyam’s business with its clients,” said analysts with Religare Hichens Harrison on Wednesday. In the short term “we will see lot of Satyam’s clients migrating to competition like Infosys, TCS and Wipro,” they said. Satyam is the fourth-largest outsourcing firm after the three named.

    In the four-and-a-half page letter distributed by the Bombay stock exchange, Mr. Raju described a small discrepancy that grew beyond his control. “What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew,” he wrote. “It was like riding a tiger, not knowing how to get off without being eaten.”

    Mr. Raju said he had tried and failed to bridge the gap, including an effort in December to buy two construction firms in which the company’s founders held stakes. Speaking of a “deep regret” and a “tremendous burden,” Mr. Raju said that neither he nor the co-founder and managing director, B. Rama Raju, had “taken one rupee/dollar from the company.” He said the board had no knowledge of the situation, nor did his or the managing director’s families.

    The size and scope of the fraud raises questions about regulatory oversight in India and beyond. In addition to India, Satyam has been listed on the New York Stock Exchange since 2001, and on Euronext since January of 2008. The company has been audited by PricewaterhouseCoopers since its listing on the New York Stock exchange.

    Satyam has been under close scrutiny in recent months, after an October report that the company had been banned from World Bank contracts for installing spy software on some World Bank computers. Satyam denied the accusation but in December, the World Bank confirmed without elaboration on the cause that Satyam had been banned. Also in December, Satyam’s investors revolted after the company proposed buying two firms with ties to Mr. Raju’s sons.

    On Dec. 30, analysts with Forrester Research warned that corporations that rely on Satyam might ultimately need to stop doing business with the company. “Firms should take the initial steps of reviewing the exit clauses in their current Satyam contracts,” in case management or direction of the company changed, Forrester said.

    The scandal raised questions over accounting standards in India as a whole, as observers asked whether similar problems might lie buried elsewhere. The risk premium for Indian companies will rise in investors’ eyes, said Nilesh Jasani, India strategist at Credit Suisse.

    R. K. Gupta, managing director at Taurus Asset Management in New Delhi, told Reuters: “If a company’s chairman himself says they built fictitious assets, who do you believe here?” The fraud has “put a question mark on the entire corporate governance system in India,” he said.

    Continued in article

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

    From The Wall Street Journal Accounting Weekly Review on January 16, 2009

    Corporate Scandal Shakes India
    by Niraj Sheth, Jackie Range and Geeta Anand
    The Wall Street Journal
    Jan 08, 2009
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Audit Committee, Audit Quality, Auditing, Corporate Governance

    SUMMARY: The found chairman of the Indian outsourcing company Satyam, B. Ramalinga Raju, wrote a letter of resignation to his Board of Directors in which he said that he "...overstated profits for the past several years, overstated the amount of debt owed to the company and understated its liabilities." Raju prepared the portion of the financial statements that presented over $1 billion in cash when in fact the cash balances were about $66 million. He finally wrote the letter when "...the scheme reached 'simply unmanageable proportions' and he was left in a position that was 'like riding a tiger, not knowing how to get off without being eaten.'" The scandal has raised questions about the role of the auditors, PricewaterhouseCoopers, and the company's Board of Directors, particularly its audit committee. It also has left Indian investors lacking confidence in other Indian investments.

    CLASSROOM APPLICATION: Auditing and management classes may use this article to discuss corporate governance issues, the role of the audit committee, and the question of whether the Satyam Board contained a financial expert as required by Sarbanes-Oxley and supporting SEC regulations.

    QUESTIONS: 
    1. (Introductory) Based on the description in the article, what methods did Mr. Ramalinga Raju say that he had used to improperly inflate Satyam's financial results for the past several years?

    2. (Introductory) What financial controls should prevent fraud, particularly fraud of this magnitude?

    3. (Advanced) What audit procedures should Satyam's auditors, PricewaterhouseCoopers, have undertaken that may have uncovered the fraud prior to the time of Mr. Raju's letter?

    4. (Advanced) What is corporate governance? What role does accounting and auditing play in upholding proper corporate governance?

    5. (Advanced) Refer to the first related article. What impact does the Satyam scandal have on the regulatory environment in India? What factors in India make it difficult, more difficult than, say, in the U.S., to implement such changes in corporate governance behaviors?

    6. (Advanced) In general, what is the role of an audit committee in a corporate Board of Trustees? What is the role of this committee with respect to a fraud, such as this one committed at Satyam?

    7. (Introductory) Refer to the second related article in which a corporate governance review firm notes that it questioned Satyam's fulfillment of U.S. requirements for an audit committee financial expert. What is an audit committee financial expert under SEC guidelines developed to implement the requirements of Sarbanes-Oxley?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Spotlight on India's Corporate Governance
    by Jackie Range and Joann S. Lublin
    Jan 08, 2009
    Page: A9

    Satyam Probe Scrutinizes CFO, Audit Committee
    by Eric Bellman and Jackie Range
    Jan 14, 2009
    Online Exclusive
     

     

     


    Recommended Reading on Creative Accounting

    The Financial Numbers Game: Detecting Creative Accounting Practices. bu Charles W. Mulford, Eugene E. Comiskey (Wiley:  ISBN: 978-0-471-77073-2 Paperback 408 pages September 2005) --- http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471770736.html


    Greenspan's Disastrous Agency Problem
    In political science and economics, the principal-agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or fear of firing. The principal-agent problem is found in most employer/employee relationships, for example, when stockholders hire top executives of corporations. Numerous studies in political science have noted the problems inherent in the delegation of legislative authority to bureaucratic agencies. The implementation of legislation (such as laws and executive directives) is open to bureaucratic interpretation, creating opportunities and incentives for the bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Variance in the intensity of legislative oversight also serves to increase principal-agent problems in implementing legislative preferences.

    Wikipedia --- http://en.wikipedia.org/wiki/Agency_theory

    Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.
    Alan Greenspan in 2004 as quoted by Peter S. Goodman, Taking a Good Look at the Greenspan Legacy," The New York Times, October 8, 2008 --- http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em

    The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as “the pharmacist who fills the prescription ordered by our physician.”

    But others hold a starkly different view of how global markets unwound, and the role that Mr. Greenspan played in setting up this unrest.

    “Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives,” said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

    The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

    If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

    Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences.

    Derivatives were created to soften — or in the argot of Wall Street, “hedge” — investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value “derives” from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes.

    On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid — for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.

    Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions.

    Ever since housing began to collapse, Mr. Greenspan’s record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nation’s real estate market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out price increases with higher rates. Others have criticized Mr. Greenspan for not disciplining institutions that lent indiscriminately.

    But whatever history ends up saying about those decisions, Mr. Greenspan’s legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading.

    Bob Jensen's timeline of derivatives scandals and the evolution of accounting standards for accounting for derivatives financial instruments can be found at http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

    "‘I made a mistake,’ admits Greenspan," by Alan Beattie and James Politi, Financial Times, October 23, 2008 ---
    http://www.ft.com/cms/s/0/aee9e3a2-a11f-11dd-82fd-000077b07658.html?nclick_check=1

    “I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders,” he said.

    In the second of two days of tense hearings on Capitol Hill, Henry Waxman, chairman of the House of Representatives, clashed with current and former regulators and with Republicans on his own committee over blame for the financial crisis.

    Mr Waxman said Mr Greenspan’s Federal Reserve – along with the Securities and Exchange Commission and the US Treasury – had propagated “the prevailing attitude in Washington... that the market always knows best.”

    Mr Waxman blamed the Fed for failing to curb aggressive lending practices, the SEC for allowing credit rating agencies to operate under lax standards and the Treasury for opposing “responsible oversight” of financial derivatives.

    Christopher Cox, chairman of the Securities and Exchange Commission, defended himself, saying that virtually no one had foreseen the meltdown of the mortgage market, or the inadequacy of banking capital standards in preventing the collapse of institutions such as Bear Stearns.

    Mr Waxman accused the SEC chairman of being wise after the event. “Mr Cox has come in with a long list of regulations he wants... But the reality is, Mr Cox, you weren’t doing that beforehand.”

    Mr Cox blamed the fact that congressional responsibility was divided between the banking and financial services committees, which regulate banking, insurance and securities, and the agriculture committees, which regulate futures.

    “This jurisdictional split threatens to for ever stand in the way of rationalising the regulation of these products and markets,” he said.

    Mr Greenspan accepted that the crisis had “found a flaw” in his thinking but said that the kind of heavy regulation that could have prevented the crisis would have damaged US economic growth. He described the past two decades as a “period of euphoria” that encouraged participants in the financial markets to misprice securities.

    He had wrongly assumed that lending institutions would carry out proper surveillance of their counterparties, he said. “I had been going for 40 years with considerable evidence that it was working very well”.

    Continued in the article

    Jensen Comment
    In other words, Greenspan assumed the agency theory model that corporate employees, as agents of their owners and creditors, would act hand and hand in the best interest for themselves and their investors. But agency theory has a flaw in that it does not understand Peter Pan.

    Peter Pan, the manager of Countrywide Financial on Main Street, thought he had little to lose by selling a fraudulent mortgage to Wall Street. Foreclosures would be Wall Street’s problems and not his local bank’s problems. And he got his nice little commission on the sale of the Emma Nobody’s mortgage for $180,000 on a house worth less than $100,000 in foreclosure. And foreclosure was almost certain in Emma’s case, because she only makes $12,000 waitressing at the Country Café. So what if Peter Pan fudged her income a mite in the loan application along with the fudged home appraisal value? Let Wall Street or Fat Fannie or Foolish Freddie worry about Emma after closing the pre-approved mortgage sale deal. The ultimate loss, so thinks Peter Pan, will be spread over millions of wealthy shareholders of Wall Street investment banks. Peter Pan is more concerned with his own conventional mortgage on his precious house just two blocks south of Main Street. This is what happens when risk is spread even farther than Tinkerbell can fly!
    Also see how corporate executives cooked the books --- http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    The Saturday Night Live Skit on the Bailout --- http://patdollard.com/2008/10/it-is-here-the-banned-snl-skit-cannot-hide-from-louie/ 

     

    Bankers (Men in Black) bet with their bank's capital, not their own. If the bet goes right, they get a huge bonus; if it misfires, that's the shareholders' problem.
    Sebastian Mallaby. Council on Foreign Relations, as quoted by Avital Louria Hahn, "Missing:  How Poor Risk-Management Techniques Contributed to the Subprime Mess," CFO Magazine, March 2008, Page 53 --- http://www.cfo.com/article.cfm/10755469/c_10788146?f=magazine_featured
    Jensen Comment
    Now that the Government is going to bail out these speculators with taxpayer funds makes it all the worse. I received an email message claiming that i
    f you had purchased $1,000 of AIG stock one year ago, you would have $42 left;  with Lehman, you would have $6.60 left; with Fannie or Freddie, you would have less than $5 left. But if you had purchased $1,000 worth of beer one year ago, drank all of the beer, then turned in the cans for the aluminum recycling REFUND, you would have had $214. Based on the above, the best current investment advice is to drink heavily and recycle. It's called the 401-Keg. Why let others gamble your money away when you can piss it away on your own?

     

    Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts of Private Companies ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm


    IFRS (or maybe just the EU) Accounting Rule Flexibility in Action

    "Accounting Changes Help Deutsche Bank Avoid Loss," Reuters, The New York Times, October 30, 2008 --- Click Here

    New accounting rules allowed Deutsche Bank to dodge a loss in the third quarter, the company said Thursday as it also announced heavy losses in proprietary trading.

    Josef Ackermann, the chairman of Deutsche, which is Germany’s flagship bank and once was seen as having escaped the worst of the market turmoil, declared a year ago that the financial crisis for his bank was over.

    On Thursday, however, Mr. Ackermann departed from the optimism that had led him to declare seeing the light at the end of the tunnel several times over.

    “Conditions in equity and credit markets remain extremely difficult,” he said, warning that the bank could cut its dividend to shore up capital in a “highly uncertain environment.”

    Also Thursday, Germany’s finance minister, Peer Steinbrück, said that a number of German banks were expected to turn to Berlin for help. Mr. Steinbrück appeared to make a veiled reference to Deutsche Bank when he told a newspaper that those seeking help could include banks that had publicly opposed taking it in the past. Mr. Ackermann recently was quoted as saying he would be “ashamed” to take taxpayer money.

    Deutsche Bank made a pretax profit of 93 million euros ($118.5 million) in the third quarter, a result possible only because of changed accounting rules. These allowed it to cut write-downs by more than 800 million euros, to 1.2 billion euros, during the period.

    The new rules, sanctioned by Brussels lawmakers, soften the old system that demanded all assets reflect market prices.

    Deutsche Bank, for example, has more than 22 billion euros of leveraged loans — commitments often made to private equity investors to lend money to buy companies.

    Farming out these loans had become difficult as worried investors retreated to safe havens and their value had fallen. The new accounting rules allow Deutsche to hold some of these loans on their books at a fixed price.

    Like all other banks, Deutsche is grappling with a freeze in interbank lending. Banks around the world have largely stopped lending to one another after the Wall Street investment bank Lehman Brothers collapsed in mid-September.

    The crisis prompted the German government to start a rescue fund of 500 billion euros, under which it can give guarantees for banks seeking financing on this market or by issuing bonds, for example.

    Bob Jensen's threads on earnings management are at http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    Claims of IFRS Accounting Rule Flexibility --- http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting


    "Market and Political/Regulatory Perspectives on the Recent Accounting Scandals," by Ray Ball at the University of Chicago, SSRN, September 17, 2008 ---
    (free download) --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1272804

  • Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well-researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who killed Arthur Andersen – the SEC, or the market? Did fraudulent accounting kill Enron, or just keep it alive for too long? What is the social cost of financial reporting fraud? Does the US in fact operate a “principles-based” or a “rules-based” accounting system? Was there market failure? Or was there regulatory failure? Or both? Was the Sarbanes-Oxley Act a political and regulatory over-reaction?

    Jensen Comment
    Although Professor Ball is best known for empirical research of capital markets data, the above article is best described as a commentary of his personal opinion. On many issues I agree with him, but on some issues I disagree.

     

    Would market forces have killed the Andersen auditing firm even if there was no criminal case for document destruction?

     

  • Ray Ball (opinion with no supporting evidence)
    I conclude that market forces, left to their own devices, would have closed Andersen.

  • Bob Jensen (agrees completely with supporting evidence)
    I don't think there's any doubt that Andersen would've folded due to market forces of a succession of failed audits for which it did not change its fundamental behavior and questions of auditor independence after losing a succession of failed audit lawsuits prior to Enron. For example, it continued to hire hire the in-charge auditor of Waste Management even after his felony conviction.

    When the Securities and Exchange Commission found evidence in e-mail messages that a senior partner at Andersen had participated in the fraud at Waste Management, Andersen did not fire him. Instead, it put him to work revising the firm's document-retention policy. Unsurprisingly, the new policy emphasized the need to destroy documents and did not specify that should stop if an S.E.C. investigation was threatened. It was that policy David Duncan, the Andersen partner in charge of Enron audits, claimed to be following when he shredded Andersen's reputation.
    Floyd Norris, "Will Big Four Audit Firms Survive in a World of Unlimited Liability?," The New York Times, September 10, 2004


    Although Ray Ball does not cite the empirical evidence, there is empirical evidence that ultimately, due to a succession of incompetent or fraudulent audits, having Andersen as an auditor raised a client's cost of capital.

  • "The Demise of Arthur Andersen," by Clifford F. Thies, Ludwig Von Mises Institute, April 12, 2002 --- http://www.mises.org/fullstory.asp?control=932&FS=The+Demise+of+Arthur+Andersen

    From Yahoo.com, Andrew and I downloaded the daily adjusted closing prices of the stocks of these companies (the adjustment taking into account splits and dividends). I then constructed portfolios based on an equal dollar investment in the stocks of each of the companies and tracked the performance of the two portfolios from August 1, 2001, to March 1, 2002. Indexes of the values of these portfolios are juxtaposed in Figure 1.

    From August 1, 2001, to November 30, 2001, the values of the two portfolios are very highly correlated. In particular, the values of the two portfolios fell following the September 11 terrorist attack on our country and then quickly recovered. You would expect a very high correlation in the values of truly matched portfolios. Then, two deviations stand out.

     

    In early December 2001, a wedge temporarily opened up between the values of the two portfolios. This followed the SEC subpoena. Then, in early February, a second and persistent wedge opened. This followed the news of the coming DOJ indictment. It appears that an Andersen signature (relative to a "Final Four" signature) costs a company 6 percent of its market capitalization. No wonder corporate clients--including several of the companies that were in the Andersen-audited portfolio Andrew and I constructed--are leaving Andersen.

    Prior to the demise of Arthur Andersen, the Big 5 firms seemed to have a "lock" on reputation. It is possible that these firms may have felt free to trade on their names in search of additional sources of revenue. If that is what happened at Andersen, it was a big mistake. In a free market, nobody has a lock on anything. Every day that you don’t earn your reputation afresh by serving your customers well is a day you risk losing your reputation. And, in a service-oriented economy, losing your reputation is the kiss of death.

     

    Did (undetected) fraudulent accounting keep Enron alive too long?
     

  • Ray Ball
    It is difficult to escape the conclusion that market forces caused Enron’s bankruptcy, for the simple reason that it had invested enormous sums and by 2000 was not generating profits. Conversely, its accounting transgressions kept the company alive for some period (perhaps one or two years) longer than would have occurred if it had reported its true profitability. The welfare loss arose from keeping an unprofitable company alive longer than optimal, and wasting capital and labor that were better used elsewhere.

    Bob Jensen (disagrees with the power of GAAP in the case of Enron)
    I think Ray Ball is attributing too much to financial reports of past transactions. Even if Enron's financial reports were "true" in terms of conformance with GAAP, the market may well have kept Enron alive because of profit potential of some of the huge, albeit presently losing, ventures. The counter example here is the more legitimate reporting losses in Amazon.com  for almost its entire history and the willingness of investors to "bet on the come" of Amazon's ventures in spite of the reported losses in conformance with GAAP. Furthermore, Enron's executives were so skilled at sales pitches, I think Enron might've actually kept going much, much longer if it conformed to GAAP and simply pitched its sweet-sounding ventures and political connections in Washington DC. Enron was primarily brought down by fraud that commenced to appear in the media and the pending lawsuits that formed overhead due to the fraud.

     

    Who killed Enron – the SEC or the market?
     

  • Ray Ball
    It is difficult to escape the conclusion that market forces caused Enron’s bankruptcy, for the simple reason that it had invested enormous sums and by 2000 was not generating profits. Conversely, its accounting transgressions kept the company alive for some period (perhaps one or two years) longer than would have occurred if it had reported its true profitability. The welfare loss arose from keeping an unprofitable company alive longer than optimal, and wasting capital and labor that were better used elsewhere.

    Bob Jensen (disagrees because losing divisions could've been dropped in favor of continued operations of highly profitable divisions)
    What Ray does not seek out is the first tip of the demise of Enron. The single event that commenced Enron's dominos to fall has to be the reporting of illegal related party transactions by a Wall Street Journal Reporter. Once these became known, the SEC had to act and commenced a chain of events from which Enron could not possibly survive in terms of lawsuits and market reactions with lawsuit risks that bore down on the market prices of Enron shares.

    After John Emshwiller's WSJ report, determining whether the market or the SEC brought down Enron is a chicken versus egg question!

    Eichenwald states the following on pp. 490-492 in Conspiracy of Fools --- http://faculty.trinity.edu/rjensen/FraudEnronQuiz.htm#22

    It was section eight, called "Related Party Transactions," that got John Emshwiller's juices flowing.

    After being assigned to follow the Skilling resignation, Emshwiller had put in a request for an interview, then scrounged up a copy of Enron's most recent SEC filing in search of any nuggets.

    What he found startled him.  Words about some partnerships run by an unidentified "senior officer."  Arcane stuff, maybe, but the numbers were huge.  Enron reported more than $240 million in revenues in the first six months of the year from its dealings with them.

    One fact struck Emshwiller in particular.  This anonymous senior officer, the filing said, had just sold his financial interest in the partnerships.  Now, it said, the partnerships were no longer related to Enron.

    The senior officer had just sold his interest, Skilling had just resigned.  The connection seemed obvious.

    Could Enron have actually allowed Jeff Skilling to run partnerships that were doing massive business with the company?  Now that, Emshwiller thought, would be a great story.

    Emshwiller was back on the phone with Mark Palmer.  With no better explanation for Skilling's resignation, he said, the Journal was going to dig through everything it could find.  Right now he was focusing on these partnerships.  Were those run by Skilling?

    "No, that's not Skilling," Palmer replied, almost nonchalantly.  "That's Andy Fastow."

    A pause.  "Who's Andy Fastow?" Emshwiller asked.

    The message was slipped to Skilling later that day.  A Journal reporter was pushing for an explanation of his departure and now was rooting around, looking for anything he could find.  Probably best just to give the paper a call.

    Emshwiller was at his desk when the phone rang.

    "Hi," a soft voice said.  "It's Jeff Skilling."

    It was a startling moment.  Emshwiller had been on the hunt, and suddenly the quarry just walked in and lay down on the floor, waiting for him to fire.  So he did: why was Skilling quitting his job?

    "It's all pretty mundane," Skilling replied.  He'd worked hard and accomplished a lot but now had the freedom to move on.  His voice was distant, almost depressed.

    He and been ruminating about it for a while, Skilling went on, but had wanted to stay on at the company until the California situation eased up.  Then, he took the conversation in a new direction.

    "The stock price has been very disappointing to me," Skilling said.  "The stock is less than half of what it was six months ago.  I put a lot of pressure on myself.  I felt I must not be communicating well enough."

    Skilling rambled as Emshwiller took it down.  India.  California.  Expense cuts.  The good shape of Enron.

    "Had the stock price not done what it did..."  He paused.  "I don't think I would have felt the pressure to leave if the stock price had stayed up."

    What?  Had Emshwiller heard that right?  Was all this stuff about "personal reasons" out the window?  Had Skilling thrown in the towel because of the stock price?

    "What was that, Mr. Skilling?" Emshwiller asked.

    The employees at Enron owned lots of shares, Skilling said.  They were worried, always asking him about the direction of the price.  He found it very frustrating.

    "Are you saying that you don't think you would have quit if the stock price had stayed up?"

    Skilling was silent for several seconds.

    "I guess so," he finally mumbled.

    Minutes later, Emshwiller burst into his boss's office.  "You're not gong to believe what Skilling just told me!"
     


  •  

    Here's a pleasant surprise: The Supreme Court agreed yesterday to hear arguments in a case challenging the constitutionality of the Sarbanes-Oxley Act of 2002. This could get interesting.
    "Sarbox and the Constitution," The Wall Street Journal, May 19, 2009 --- http://online.wsj.com/article/SB124268754900032175.html
    Jensen Comment

    This is a pleasant surprise for CEOs who do not want to take responsibility for internal controls in their companies and for companies that want weaker and cheaper financial audits. It is not a pleasant surprise for auditing firms. It could return auditing to the 1990s when audits became unprofitable commodities.

    This could be a disaster to auditing firm revenues. Hopefully the Supreme Court will instead lock in SOX for the smelly feet of unscrupulous corporations. It also could badly hurt the recovery of the stock market since investors will have less confidence in the integrity of financial statements.

    The poor services of auditing firms became a focal point in the U.S. Congress when equity markets appeared of the verge of collapse due to fear and distrust of the financial reporting of corporations dependent upon equity markets for capital. The Roaring 1990s burned and crashed. In a desperation move Congress passed the Sarbanes-Oxley Act (SOX) of 2002 --- http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act 

    SOX was a shot in the arm for the auditing industry. SOX forced the auditing industry to upgrade services with SOX legal backing that doubled or even tripled or quadrupled fees for such services. Clients continue to grumble about the soaring costs of audits, but in my opinion SOX was a small price to pay for saving our equity capital markets.

    What are the incentives to commit fraud?
     

  • Ray Ball
    My view, based on mainly anecdotal experience, is that non-financial motives are more powerful than is commonly believed, and sometimes are the dominant reason for committing accounting fraud. An important motivator seems to be maintaining the esteem of one’s peers,ranging from co-workers to the public at large. Enron executives reportedly were celebrities in Houston, and in important places like the White House.

    Bob Jensen (disagrees as to level of importance of non-financial motives except in isolated instances such as possibly Ken Lay)
    Although there are instances where non-financial motives may have been powerful, I believe that they generally pale when compared to the financial reasons for committing all types of financial fraud, including accounting fraud --- http://faculty.trinity.edu/rjensen/FraudRotten.htm


     

    Was Sarbanes-Oxley Necessary?

    Ray Ball (who is generally critical of the need for Sarbanes-Oxley relative to market forces without such regulation and fraud penalties)
    Markets need rules, and rely on trust. U.S. financial markets historically had very effective rules by world standards, the rules were broken, and there were immense consequences for the transgressors.

    Bob Jensen (strongly disagrees)
    One need only look how the market-based system worldwide moved in cycles of being rotten to the core among the major corporations, investment banks, insurance companies, and credit rating companies --- http://faculty.trinity.edu/rjensen/FraudRotten.htm
    After getting caught these firms simply moved on to new schemes without fear of market forces.

    Nowhere is the wild west of market-based fraud more evident than in the timeline history of derivative financial instruments frauds --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

    Frank Partnoy, Page 283 of a Postscript entitled "The Return"
    F.I.A.S.C.O. : The Inside Story of a Wall Street Trader
    by Frank Partnoy - 283 pages (February 1999) Penguin USA (Paper); ISBN: 0140278796 

    Perhaps we don' think we deserve a better chance. We play the lottery in record numbers, despite the 50 percent cut (taken by the government). We flock to riverboat casinos, despite substantial odds against winning. Legal and illegal gambling are growing just as fast as the financial markets, Las Vegas is our top tourist destination in the U.S., narrowly edging out Atlantic City. Are the financial markets any different? In sum, has our culture become so infused with the gambling instinct that we would afford investors only that bill of rights given a slot machine player:  the right to pull the handle, their right to pick a different machine, the right to leave the casino, abut not the right to a fair game.

     

    Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 17, ISBN 0-8050-7510-0)

    In February 1985, the United States Financial Accounting Standards Board (FASB) --- the private group that established most accounting standards (in the U.S.) --- asked whether banks should begin including swaps on their balance sheets, the financial statements that recorded their assets and liabilities . . .since the early 1980s banks had not included swaps as assets or liabilities . . . the banks' argument was deeply flawed. The right to receive money on a swap was a valuable asset, and the obligation to pay money on a swap was a costly liability.

    But bankers knew that the fluctuations in their swaps (swap value volatility) would worry their shareholders, and they were determined to keep swaps off their balance sheets (including mere disclosures as footnotes), FASB's inquiry about banks' treating swaps as off-balance-sheet --- a term that would become widespread during the 1991s --- mobilized and unified the banks, which until that point had been competing aggressively and not cooperating much on regulatory issues. All banks strongly opposed disclosing more information about their swaps, and so they threw down their swords and banded together a serveral high-level meetings.

    Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 77, ISBN 0-8050-7510-0)

    The process of transferring receivables to a new company and issuing new bonds became known as securitization, which became a major part of the structured finance industry . . . One of the most significant innovations in structured finance was a deal called the Collateralized Bond Obligation, or CBO. CBOs are one of the threads that run through the past fifteen years of financial markets, ranging from Michael Milken to First Boston to Enron and WorldCom. CBOs would mutate into various types of credit derivatives --- financial instruments tied to the creditworthiness of companies --- which would play and important role in the aftermath of the collapse of numerous companies in 2001and 2002.

    . . .

    In simple terms, here is how a CBO works. A bank transfers a portfolio of junk bonds to a Special Purpose Entity, typically a newly created company, partnership, or trust domiciled in a balmy tax haven, such as the Cayman Islands. This entity then issues several securities, backed by bonds, effectively splitting the junk bonds into pieces. Investors (hopefully) buy the pieces.

    . . .

    The first CBO was TriCapital Ltc., a $420 million deal sold in July 1988. There were about $900 million CBOs in 1988, and almost $ $3 billion in 1989. Notwithstanding the bad press junk bonds had been getting, analysts from all three of the credit-rating agencies began pushing CBOs. Ther were very profitable for the rating agencies, which received fees for rating the various pieces.

    . . .

    With the various types of structured-finance deals, a trend began of companies using Special Purpose Entities (SPEs) to hide risks. From an accounting perspective, the key question was whether a company that owned particular financial assets needed to disclose those assets in its financial statements even after it transferred them to an SPE. Just as derivatives dealers had argued that swaps should not be included in their balance sheets, financial companies began arguing that their interest in SPEs did not need to be disclosed . . . In 1991. the acting chief accountant of the SEC, concerned that companies might abuse this accounting standard, wrote a letter saying the outside investment had to be at least three percent (a requirement that helped implode Enron and its auditor Andersen because the three percent investments were phony):

    Infectious Greed:  How Deceit and Risk Corrupted the Financial Markets  (Henry Holt and Company, 2003, Page 229, ISBN 0-8050-7510-0)

    Third, financial derivatives were now everywhere --- and largely unregulated. Increasingly, parties were using financial engineering to take advantage of the differences in legal rules among jurisdictions, or to take new risks in new markets. In 1994, The Economist magazine noted, "Some financial innovation is driven by wealthy firms and individuals seeking ways of escaping from the regulatory machinery that governs established financial markets." With such innovation, the regulators' grip on financial markets loosened during the mid-to-late 1990s . . . After Long-Term Capital (Management) collapsed, even Alan Greenspan admitted that financial markets had been close to the brink.

    The decade was peppered with financial debacles, but these faded quickly from memory even as they increased in size and complexity. The billion dollar-plus scandals included some colorful characters (Robert Citron of Orange County, Nick Leeson of Barings, and John Meriwether of Long-Term Capital Management), but even as each new scandal outdid the others in previously unimaginable ways, the markets merely hic-coughed and then started going up again. It didn't seem that anything serious was wrong, and their ability to shake off a scandal made markets seem even more under control.
    Frank Portnoy, Infectious Greed (Henry Holt and Company, 2003, Page 2, ISBN 0-8050-7510-0).

    "Does the use of Financial Derivatives Affect Earnings Management Decisions?" by Jan Barton, The Accounting Review, January 2001, pp. 1-26.

    I present evidence consistent with managers using derivatives and discretionary accruals as partial substitutes for smoothing earnings. Using 1994-1996 data for a sample of Fortune 500 firms, I estimate a set of simultaneous equations that captures managers' incentives to maintain a desired level of earnings volatility through hedging and accrual management. These incentives include increasing managerial compensation and wealth, reducing corporate taxes and debt financing costs, avoiding underinvestment and earnings surprises, and mitigating volatility caused by low diversification. After controlling for such incentives, I find significant negative association between derivatives' notional amounts and proxies for the magnitude of discretionary accruals.

     
     

    Frank Partnoy introduces Chapter 7 of Infectious Greed as follows:

    Pages 187-188

    The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

    Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

    Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

    Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

    But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.
     

     

    I do agree with Ray Ball that regulation in and of itself is not panacea when either preventing or detecting fraud.

    "Greater Regulation of Financial Markets?" by Richard Posner, The Becker-Posner Blog, April 28, 2008 ---
    http://www.becker-posner-blog.com/

    Re-Regulate Financial Markets?--Posner's Comment I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983.

    Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans.

    The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank’s riskiness.

    Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects.

    Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated.

    There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.

     

    If auditors and their clients do not take there professional and ethical responsibilities more seriously then neither market forces nor regulators will prevent frauds from increasingly undermining our prized capital markets.

    Bob Jensen's Rotten to the Core threads are at http://faculty.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's Fraud Conclusions are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm

     


    The Accounting Hall of Fame Citation for Leonard Spacek --- http://fisher.osu.edu/acctmis/hof/spacek.html

    It must be kept in mind that the statements certified are not ours but are our clients--and our clients do not care to mix explanations of accounting theory with explanations of their business nor can we pass onto our readers the responsibility for appraisal of differences in accounting theory. Those fields are for you and me to grapple with, not the public. In general, clients are not primarily interested in arguments of accounting theory at the time of preparing their reports. The companies whose accounts are certified are chiefly interested in what is said to their shareholders, and in the hard practical facts of how accounting rules affect them, their competitors and other companies. Usually they are very critical of what we call accounting principles when these called principles are unrealistic, inconsistent, or do not protect or distinguish scrupulous management from the scrupulous.
    "The Need for An Accounting Court," by Leonard Spacek, The Accounting Review, 1958, Pages 368-379  --- http://faculty.trinity.edu/rjensen/FraudSpacek01.htm

    Jensen Comment
    Fifty years later I'm a strong advocate of an accounting court, but I envision a somewhat different court than than envisioned by the great Leonard Spacek in 1958. Since 1958, the failure of anti-trust enforcement has allowed business firms to merge into enormous multi-billion or even trillion dollar clients who've become powerful bullies that put extreme pressures on auditors to bend accounting and auditing principles. For example see the way executives of Fannie Mae pressured KPMG to bend the rules (an act that eventually got KPMG fired from the audit).

    In my opinion the time has come where auditors and clients can take their major disputes to an Accounting Court that will use expert independent judges to resolve these disputes much like the Derivatives Implementation Group resolved technical issues for the implementation of FAS 133. The main difference, however, is that an Accounting Court should hear and resolve disputes in private confidence that allows auditors and clients to keep these disputes away from the media. The main advantage of such an Accounting Court is that it might restrain clients from bullying auditors such as became the case when Fannie Mae bullied KPMG.

    Who would sit on accounting courts is open to debate, but the "judges" could be formed by the State Boards of Accountancy much like a grand jury is formed by a court of law. Accounting court cases, however, should be confidential since they deal with sensitive client information.

    I really don't anticipate a flood o cases in an accounting court. But I do view the threat of taking client-auditor disputes to such courts (in confidence) as a means of curbing the bullying of auditors by their enormous clients.

    The problem is that poor anti-trust enforcement coupled with mergers of huge companies have combined to create mega-clients that auditing firms cannot afford to lose after gearing up to handle such large clients. I think we saw this in the "clean opinions" given to all the enormous failing banks (like WaMu) and enormous Wall Street investment banks (like Lehman). The big auditing firms just could not afford to question bad debt estimates, mortgage application lies, and CDO manipulations of such clients.

    I find it hard to believe that auditors failed to detect an undercurrent of massive subprime "Sleaze, Bribery, and Lies" that transpired in the Main Street banks and mortgage lending companies --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
    The sleaze was so prevalent the auditors must've worn their chest-high waders on these audits.

    Earnings Management Deception at AIG
    The 1999 bulletin also said that if accounting practices were intentionally misleading "to impart a sense of increased earnings power, a form of earnings management, then by definition amounts involved would be considered material." AIG hinted some errors may have been intentional, saying that certain transactions "appear to have been structured for the sole or primary purpose of accomplishing a desired accounting result."
    Jonathan Weil, "AIG's Admission Puts the Spotlight On Auditor PwC," The Wall Street Journal, April 1, 2005 --- http://online.wsj.com/article/0,,SB111231915138095083,00.html?mod=home_whats_news_us
    Bob Jensen's threads on the AIG mess are at http://faculty.trinity.edu/rjensen/fraudRotten.htm#MutualFunds


    It's not clear who got the earnings game going (meeting earnings forecasts by one penny): executives or investors. But it's past time for it to stop. As the Progressive example shows, those companies that continue the charade do it by choice.
    Gretchen Morgenson, "Pennies That Aren't From Heaven," The New York Times, November 7, 2004 --- http://www.nytimes.com/2004/11/07/business/yourmoney/07watch.html?ex=1100836709&ei=1&en=8f6b67cd8cfe4757 

    Ask any chief executive officer if he or she practices the art of earnings management and you will undoubtedly hear an emphatic "Of course not!" But ask those same executives about their company's recent results, and you may very well hear a proud "we beat the analysts' estimate by a penny."

    While almost no one wants to admit to managing company earnings, the fact is, almost everybody does it. How else to explain the miraculous manner in which so many companies meet or beat, by the preposterous penny, the consensus earnings estimates of Wall Street analysts?

    After years of such miracles, investors finally seem to be wising up to the fact that an extra penny of profit is not only meaningless but may also be evidence of earnings management and, therefore, bad news. After all, the practice can hide 

    what's genuinely going on in a company's books.

    A study by Thomson Financial examined how many of the 30 companies in the Dow Jones industrial average missed, met or beat analysts' consensus earnings estimates during each quarter over the last five years. It also looked at how the companies' shares responded to the results.

    Over the period, on average, almost half of the companies - 46.1 percent - met consensus estimates or beat them by a penny.

    Pulling off such a feat in an uncertain world smacks of earnings management. "It is not possible for this percentage of reporting companies to hit the bull's-eye," said Bill Fleckenstein, principal at Fleckenstein Capital in Seattle. "Business is too complicated; there are too many moving parts."

    The precision has a purpose, of course: to keep stock prices aloft. According to Thomson's five-year analysis, companies whose results came in below analysts' estimates lost 1.08 percent of their value, on average, the day of the announcement. The loss averaged 1.59 percent over five days.

    Executives have lots of levers to pull to make their numbers. Lowering the company's tax rate is a favorite, as is recognizing revenues before they actually come in or monkeying with reserves set aside to cover future liabilities.

    If all else fails and a company faces the nightmare of an earnings miss, its spinmeisters can always begin a whispering campaign to persuade Wall Street analysts to trim their estimates, making them more attainable. Their stock might drift downward as a result, but the damage is not usually as horrific as it is when earnings miss the target unexpectedly.

    So it is not surprising that the strategy has become so widespread and that fewer companies in the Thomson study are coming in below their target these days. For the first three quarters of 2004, 10.9 percent missed their expected results, down from 11.7 percent in 2003 and 25 percent in 2002.

    At the heart of earnings management is - what else? - executive compensation. The greater the percentage of pay an executive receives in stock, the bigger the incentive to produce results that propel share prices.

    Continued in the article

    Coke:  Gone Flat at the Bright Lines of Accounting Rules and Marketing Ethics
    The king of carbonated beverages is still a moneymaker, but its growth has stalled and the stock has been backsliding since the late '90s.  Now it turns out that the company's glory days were as much a matter of accounting maneuvers as of marketing magic. 
    Guizuenta's most ingenious contribution to Coke, the ingredient that added rocket fuel to the stock price, was a bit of creative though perfectly legal balance-sheet rejeiggering that in some ways prefigured the Enron Corp. machinations.  Known inside the company as the "49% solution," it was the brain child of then-Chief Financial Officer M. Douglas Ivester.  It worked like this:  Coke spun off its U.S. bottling operations in late 1986 into a new company known as Coca-Cola Enterprises Inc., retaining a 49% state for itself.  That was enough to exert de facto control but a hair below the 50% threshold that requires companies to consolidate results of subsidiaries in their financials.  At a stroke, Coke erased $2.4 billion of debt from its balance sheet.
    Dean Foust, "Gone Flat," Business Week, December 20, 2004, Page 77.  
    This is a Business Week cover story.
    Coca Cola's outside independent auditor is Ernst & Young

    There were other problems, some of which did not do the famed Warren Buffet's reputation any good.  See "Fizzy Math and Fishy Marketing Lawsuit, Probes Prove Damaging to Coke," by Margaret Webb Pressler, Washington Post, June 20, 2003 --- http://www.washingtonpost.com/ac2/wp-dyn?pagename=article&contentId=A14384-2003Jun19&notFound=true 

    Coca Cola's marketing tactics were unethical and unhealthy for kids --- http://www.econ.iastate.edu/classes/econ362/hallam/Coke%20Officials%20Beefed%20Up.pdf 

    Also see "The Ten Habits of Highly Defective Corporations," From The Nation --- http://www.greenmac.com/World_Events/thetenha.html 


    From Jim Mahar's blog on November 5, 2007 --- http://financeprofessorblog.blogspot.com/
    Does short-term debt lead to more "earnings management"?
     
    In another paper from the FMAs, Gupta and Fields look at whether more short term debt leads to more "earnings management."

    Does short-term debt lead to more "earnings management"?

    Short answer: YES.

    Longer answer:

    Intuitively the idea behind the paper is that if a firm has to go back to the capital markets, they do not want to do so when times are bad. Of course, sometimes times are bad. In those times, management may be tempted to "manage" earnings so that things do not appear as bad as they may be.

    The findings? Sure enough, managers seemingly manage their firm's earnings more when the firm has more short term debt.

    A few look-ins:

    From the Abstract (this is the best summary of the entire paper):
     
    "...results indicate that (i) firms with more current debt are more susceptible to managing earnings, (ii) this relation is stronger for firms facing debt market constraints (those without investment grade debt) and (iii) auditor characteristics such as auditor quality and tenure help diminish this relation...."
     

    Which fits intuition. Why?
    * The more the constraints, the more incentive the management has to manage earnings since if they do not, they may not be able to refinance.
    * Auditors would frown upon this behavior and the stronger the auditor, the less likely it is that the manager would manage earnings.

    How does this "earnings management" manifest itself? The most common way (although not the only way) that managers manipulate earnings is through the use of accruals . Thus, the authors examine this and find:
     
    "A one standard-deviation increase in short-term debt (total current liabilities) increases discretionary accruals by 1.69% and increase total accruals by 2.28%. Our evidence supports the idea that debt maturity significantly impacts the tendency of firms to manage earnings."
     
    Which is a really interesting finding!

     

    "The Crisis over How to Audit in a Crisis: The PCAOB's standing advisory committee examines the task of recession-time auditing, including the likelihood that fraud will be a growing problem," by Alan Rappeport, CFO.com, October 22, 2008 --- http://www.cfo.com/article.cfm/12465140/c_12469997

    The Public Company Accounting Oversight Board, which oversees U.S. auditors, convened its standing advisory group on Wednesday to discuss the impact of the financial crisis on the auditing profession. Its conclusion: There's a lot to worry about, included increased pressure for fraudulent behavior.

    Members of the 36-person group of advisors were concerned not only about increases in fraud, however, but also about the need for more thorough analysis of financial statements, the importance of considering liquidity, and various puzzles connected with the auditing of companies that are recipients of government bailouts.

    Martin Baumann, the PCAOB's director of research and analysis, said that auditors will also need to concentrate on underfunded pension plans, lagging corporate receivables, excess inventory, and other types of asset impairment.

    "When you look at the past and see where auditors didn't get the job done right, there were indicators that they didn't pay attention to," said Lynn Turner, a former CFO and former chief accountant of the Securities and Exchange Commission. "Auditors are going to need to take off the blinders."

    An increase in fraudulent behavior was a top concern among PCAOB advisors. Gregory Jonas, Managing Director, Moody's Investors Service, noted that senior managers are facing increased pressure to perform right now, and that "cooking the books" could become a problem.

    "The pressure is going to be enormous on people," Jonas said. "The temptation is growing."

    A favorite recipe for cooking the books, according to Joseph Carcello, director of research at the Corporate Governance Center, involves improper revenue recognition.

    But whatever the source of the crisis-related challenge, Lawrence Salva, senior vice president, chief accounting officer and controller of Comcast Corp., argued that the PCAOB needs to issue a risk alert to guide companies about how to improve their financial reporting during the crisis.

    Advisors stressed that auditors will need to take extra care when reading financial statements, giving special scrutiny to the truthfulness of the Management Discussion and Analysis section and to corporate assets. Turner also stressed that auditors will need to be looking at performance quarter-by-quarter.

    "You have to throw out historical trends and look at what is happening on a real-time basis," Turner said. "What was there in the past will no longer be there in the future."

    Auditors may also be worried about their own futures as a recession takes hold. J. Richard Dietrich, an accounting professor at The Ohio State University, noted that audit fees have been suppressed lately. That could change, he explained, as auditors are asked to work more hours while keeping companies honest.

    "Paying more for audit fees this year may be one of the best uses you can have for stockholders funds," Dietrich said.

     

    Agency Theory Question
    Why do corporate executives like fair value accounting better than shareholders like fair value accounting?

    Answer
    Cash bonuses on the upside are not returned after the downturn that wipes out the previous unrealized paper profits.

    Phantom (Unrealized) Profits on Paper, but Real Cash Outflows for Employee Bonuses and Other Compensation
    Rarely, if ever, are they forced to pay back their "earnings" even in instances of earnings management accounting fraud

    "On Wall Street, Bonuses, Not Profits, Were Real," by Louise Story, The New York Times, December 17, 2008 --- http://www.nytimes.com/2008/12/18/business/18pay.html?partner=permalink&exprod=permalink

    "Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

    “As a result of the extraordinary growth at Merrill during my tenure as C.E.O., the board saw fit to increase my compensation each year.”

    — E. Stanley O’Neal, the former chief executive of Merrill Lynch, March 2008

    For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.

    The difference between the two amounts was his bonus, a rich reward for the robust earnings made by the traders he oversaw in Merrill’s mortgage business.

    Mr. Kim’s colleagues, not only at his level, but far down the ranks, also pocketed large paychecks. In all, Merrill handed out $5 billion to $6 billion in bonuses that year. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.

    But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

    Unlike the earnings, however, the bonuses have not been reversed.

    As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.

    Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning.

    “Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”

    Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.

    “That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.

    The highest-ranking executives at four firms have agreed under pressure to go without their bonuses, including John A. Thain, who initially wanted a bonus this year since he joined Merrill Lynch as chief executive after its ill-fated mortgage bets were made. And four former executives at one hard-hit bank, UBS of Switzerland, recently volunteered to return some of the bonuses they were paid before the financial crisis. But few think others on Wall Street will follow that lead.

    For now, most banks are looking forward rather than backward. Morgan Stanley and UBS are attaching new strings to bonuses, allowing them to pull back part of workers’ payouts if they turn out to have been based on illusory profits. Those policies, had they been in place in recent years, might have clawed back hundreds of millions of dollars of compensation paid out in 2006 to employees at all levels, including senior executives who are still at those banks.

    A Bonus Bonanza

    For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses. Bonus season became an annual celebration of the riches to be had in the markets. That was especially so in the New York area, where nearly $1 out of every $4 that companies paid employees last year went to someone in the financial industry. Bankers celebrated with five-figure dinners, vied to outspend each other at charity auctions and spent their newfound fortunes on new homes, cars and art.

    The bonanza redefined success for an entire generation. Graduates of top universities sought their fortunes in banking, rather than in careers like medicine, engineering or teaching. Wall Street worked its rookies hard, but it held out the promise of rich rewards. In college dorms, tales of 30-year-olds pulling down $5 million a year were legion.

    While top executives received the biggest bonuses, what is striking is how many employees throughout the ranks took home large paychecks. On Wall Street, the first goal was to make “a buck” — a million dollars. More than 100 people in Merrill’s bond unit alone broke the million-dollar mark in 2006. Goldman Sachs paid more than $20 million apiece to more than 50 people that year, according to a person familiar with the matter. Goldman declined to comment.

    Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities. As the financial industry’s role in the economy grew, workers’ pay ballooned, leaping sixfold since 1975, nearly twice as much as the increase in pay for the average American worker.

    “The financial services industry was in a bubble," said Mark Zandi, chief economist at Moody’s Economy.com. “The industry got a bigger share of the economic pie.”

    A Money Machine

    Dow Kim stepped into this milieu in the mid-1980s, fresh from the Wharton School at the University of Pennsylvania. Born in Seoul and raised there and in Singapore, Mr. Kim moved to the United States at 16 to attend Phillips Academy in Andover, Mass. A quiet workaholic in an industry of workaholics, he seemed to rise through the ranks by sheer will. After a stint trading bonds in Tokyo, he moved to New York to oversee Merrill’s fixed-income business in 2001. Two years later, he became co-president.

    Skip to next paragraph

    Bloomberg News Dow Kim received $35 million in 2006 from Merrill Lynch.

    The Reckoning Cashing In Articles in this series are exploring the causes of the financial crisis.

    Previous Articles in the Series » Multimedia Graphic It Was Good to Be a Mortgage-Related Professional . . . Related Times Topics: Credit Crisis — The Essentials

    Patrick Andrade for The New York Times Brian Lin is a former mortgage trader at Merrill Lynch who lost his job at Merrill and now works at RRMS Advisors. Readers' Comments Share your thoughts. Post a Comment »Read All Comments (363) »

    Even as tremors began to reverberate through the housing market and his own company, Mr. Kim exuded optimism.

    After several of his key deputies left the firm in the summer of 2006, he appointed a former colleague from Asia, Osman Semerci, as his deputy, and beneath Mr. Semerci he installed Dale M. Lattanzio and Douglas J. Mallach. Mr. Lattanzio promptly purchased a $5 million home, as well as oceanfront property in Mantoloking, a wealthy enclave in New Jersey, according to county records.

    Merrill and the executives in this article declined to comment or say whether they would return past bonuses. Mr. Mallach did not return telephone calls.

    Mr. Semerci, Mr. Lattanzio and Mr. Mallach joined Mr. Kim as Merrill entered a new phase in its mortgage buildup. That September, the bank spent $1.3 billion to buy the First Franklin Financial Corporation, a mortgage lender in California, in part so it could bundle its mortgages into lucrative bonds.

    Continued in article

    Bob Jensen's threads on fair value accounting are a http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's "Rotten to the Core" document --- http://faculty.trinity.edu/rjensen/FraudRotten.htm

    For More on Creative Accounting
    Threads on Accounting Tricks and Creative Accounting --- http://faculty.trinity.edu/rjensen//theory/00overview/AccountingTricks.htm


    Goodwill and Other Asset Impairment

    KPMG’s “Unusual Twist”
    While KPMG's strategy isn't uncommon among corporations with lots of units in different states, the accounting firm offered an unusual twist: Under KPMG's direction, WorldCom treated "foresight of top management" as an intangible asset akin to patents or trademarks.
     
    See  http://faculty.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

    Punch Line
    This "foresight of top management" led to a 25-year prison sentence for Worldcom's CEO, five years for the CFO (which in his case was much to lenient) and one year plus a day for the controller (who ended up having to be in prison for only ten months.) Yes all that reported goodwill in the balance sheet of Worldcom was an unusual twist.


    From the CFO Journal's Morning Ledger on January 22, 2020

     Accounting for Goodwill Leading to a Showdown Between Investors and Business Firms

    Good morning. A brewing battle over how to treat more than $5.5 trillion in assets on company books is pitting investors against businesses, investment advisers against academics and even banks against their own trade association.

    At issue is an accounting term known as goodwill, which is the premium a company pays when it buys another for more than the value of its net assets. An unprecedented five-year boom in mergers and acquisitions has added urgency over how to account for the financial concept. The Financial Accounting Standards Board, the accounting-rules maker, is weighing whether to continue to assess goodwill by tests—or return to a similar approach to the guidelines of nearly 20 years ago, when companies wrote down a set portion of goodwill each year for up to 40 years.

    The recent wave of deal making has created a pile of goodwill. S&P 500 companies had $3.5 trillion worth of goodwill on their books at the end of September, according to data provider Calcbench. This was up 67% from 2013 and represented 9% of total S&P 500 assets and 42% of total equity, the Calcbench data show. For all public companies trading on U.S. markets, goodwill exceeds $5.5 trillion, according to the most recent figures from Calcbench, based on company reports.

    Going back to the old ways could cost investors valuable information because the annual write-down of goodwill means specific problems may not be separately announced, some analysts, academics and investors said.

    Many companies disagree. Corporate giants Chevron, IBM and Pfizer are among those advocating for goodwill to be amortized—an option already available to privately-owned firms.

    Bob Jensen's threads on accounting for goodwill ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Impairment


    Teaching Case From The Wall Street Journal Weekly Accounting Review on January 28, 2019

    Goodwill Sparks Deep Division, at Least on Balance Sheets

    By Jean Eaglesham | January 21, 2020

    Topics: Goodwill , Goodwill Impairments

    Summary: “The recent wave of deal making [in record-breaking stock market pricing] has created a pile of goodwill. S&P 500 companies had $3.5 trillion worth of goodwill on their books at the end of September, according to data provider Calcbench.” For the S&P 500 companies, that balance represents 9% of total assets, 42% of total stockholders’ equity, and an increase of 67% from 2013. The article provides perspectives on both the impairment and amortization models of accounting for goodwill from the Financial Accounting Standards Board (FASB), analysts, academics, corporate representatives, and others.

    Classroom Application: The article may be used in a financial reporting class covering intangible assets or covering business combination accounting. By providing comparisons of different accounting methods for goodwill, the article also is a good one for showing that accounting requirements are not fixed and are set by choices subject to social influences.

    Questions:

    ·         How significant are goodwill balances on U.S. companies’ consolidated balance sheets?

    ·         Why are these goodwill balances so significant?

    ·         Describe the current accounting requirements for goodwill balances. Consider both publicly-traded firms and privately-held entities.

    ·         How does the graph entitled “Accounting under current rules” depict these accounting requirements? Specifically identify in your description the implied caption for the y-axis, or height of the graph, which is missing.

    ·         What is(are) the problem(s) with the current method(s) of accounting for goodwill?

    ·         What is(are) the problem(s) with the change in accounting requirements being considered by the Financial Accounting Standards Board (FASB)?

    Read the Article

    Reviewed By: Judy Beckman, Ph.D., CPA, University Of Rhode Island (Uri)

     

    "Goodwill Sparks Deep Division, at Least on Balance Sheets," by Jean Eaglesham, The Wall Street Journal, January 21, 2020
    https://www.wsj.com/articles/goodwill-sparks-deep-division-at-least-on-balance-sheets-11579613906

    The FASB weighs changes to financial concept; companies, investors, academics not shy about weighing in

    A brewing battle over how to treat more than $5.5 trillion in assets on company books is pitting investors against businesses, investment advisers against academics and even banks against their own trade association.

    At issue is an accounting term known as goodwill, which is the premium a company pays when it buys another for more than the value of its net assets. An unprecedented five-year boom in mergers and acquisitions has added urgency over how to account for the financial concept.

    When Amazon.com Inc. bought Whole Foods Market Inc. for $13.7 billion in 2017, the e-commerce giant paid $9 billion more than the value of the supermarket’s stores and other net assets. That amount was added to Amazon’s books as goodwill.

    As things stand now, Amazon is supposed to evaluate, or test, that $9 billion every year to see if its value still holds. If not, they have to write down a portion of it, a move that cuts profit.

    The Financial Accounting Standards Board, the accounting-rules maker, is weighing whether to continue to assess goodwill by tests—or return to a similar approach to the guidelines of nearly 20 years ago, when companies wrote down a set portion of goodwill each year for up to 40 years.
     

    The FASB has asked for comments on the possible change, and companies haven’t been shy about weighing in.

    Many companies argue the test approach is costly and subjective. As it is, companies can be slow to write down goodwill, even when stock markets are signaling that they no longer believe in the value of the asset, according to research by academics and analysts.

    The annual review requires “an inordinate amount of time to validate and document,” Indianapolis-based drugmaker Eli Lilly & Co. said in a comment letter to the FASB.

    SHARE YOUR THOUGHTS

    How would you change the rules governing goodwill, if at all? Join the conversation below.

    However, critics say the old approach, the so-called amortization of goodwill year by year, allows companies to mask problems and costs investors valuable information.

    In addition, going back to the old rules could also be costly. The CFA Institute, which represents chartered financial analysts, said amortization might cause “the write-off of a substantial portion of the assets and equity of U.S. public companies and … reduce profits to nearly zero for a significant number of companies in the S&P 500” in a comment letter to FASB this month.

    The recent wave of deal making has created a pile of goodwill. There were $7.4 trillion in U.S. deals the five years through 2019, the highest five-year tally for at least two decades, according to Dealogic.

    S&P 500 companies had $3.5 trillion worth of goodwill on their books at the end of September, according to data provider Calcbench. This was up 67% from 2013 and represented 9% of total S&P 500 assets and 42% of total equity, the Calcbench data show.

    Continued in article


    Teaching Case from IAE:  Is a Reported Goodwill Impairment Loss Really a Goodwill Impairment Loss? A Financial Reporting Case on Evaluating the Efficacy of Authoritative Guidance
    by Casey J. McNellis and Walter R. Teets
    Issues in Accounting Education
    Volume 34, Issue 3 (August 2019)
    https://aaajournals.org/doi/full/10.2308/iace-52460

    While undergraduate financial reporting courses focus primarily on the application of generally accepted accounting principles and the mechanics of accounting treatments, graduate-level courses should motivate students to explore standard-setting's theoretical perspective and to develop a more rigorous understanding of accounting issues not necessarily discussed in textbooks, but included, implicitly or explicitly, in the authoritative guidance. Anecdotal evidence suggests that accounting students face difficulties transitioning from the undergraduate setting to the higher expectations common in graduate accounting programs and the workplace. This hypothetical case provides an interesting scenario on goodwill impairment to facilitate the development of students' understanding of accounting theory and its connection to professional research skills. While students are accustomed to computing goodwill impairment losses from knowledge acquired in undergraduate financial accounting courses, this topic contains interesting theoretical and practical issues and serves as a salient example of the analysis of interesting accounting issues possible at the graduate level.

    . . .

    f the case is used in practice or theory courses after the latest effective date for ASU 2017-04, minor modifications of the case and requirements could be made. Instead of dealing with the first formal quantitative goodwill impairment testing process, the case could focus on comparing the process used for impairment testing in the then-current year with impairment testing in the “last year where a formal quantitative test was performed,” and assuming that last test was done using the two-step test required prior to adoption of ASU 2017-04. Students would be required to use the Archive tabs of the Codification to support conclusions about impairment tests made in previous years, thereby keeping the issues relating to the two-step versus one-step test relevant, and giving students an opportunity to learn about the Archive feature.

    Evidence of Efficacy

    The case was tested in a graduate-level theory and practice course at a private university. When the case was first assigned to the class, the instructor asked students to complete seven complex multiple-choice questions, partially adapted from McNellis et al. (2015), to assess their understanding of the goodwill impairment process and four scale questions to assess their level of practical and conceptual understanding of the topic. After students completed the requirements, they were provided with the same questions and items.

    Regarding the multiple-choice assessment, the post-case average (Mean = 0.456, Standard Deviation = 0.184) is significantly higher (p < 0.001) than the pre-case average (Mean = 0.177; Standard Deviation = 0.095). This result indicates that students' understanding of goodwill was enhanced by completion of the case. It should be noted that the post-case average was still below 50 percent, a result that warrants further discussion. From one standpoint, the scores may be reflective of a scaling issue, as the questions were very detailed and complex in nature, in some cases beyond the scope of typical intermediate-level instruction. For example, a few of the questions compelled students to understand specific details related to the grouping of subsidiaries into reporting units for the purposes of goodwill impairment testing. This level of complexity may have contributed to the relatively low pre-case score. A commonly missed question during both the pre-case and post-case administration was one that required students to select a number of activities to be performed prior to a quantitative test of goodwill impairment. The correct response contained three of the six possible choices in the problem. While most students identified one or two of the correct activities, very few students selected the correct combination of activities and, thus, the majority of students were marked down for an incorrect response. Furthermore, the post-case questions were completed approximately one week after the second class discussion, and the time lag may have been a factor in student recall of the most detailed and complex points related to goodwill in the post-case assessment. Accordingly, the nature of the questions and the relative timing of the assessment requiring detailed recall likely lowered both the pre-case and post-case scores. Finally, and perhaps most importantly, the questions were not part of a larger classroom assessment for course points. As such, the context in which the students answered the questions may have resulted in a lack of urgency in scrutinizing the various choices in the questions. Nevertheless, the significant difference suggests improvement on the part of the students and complements the survey results, which are presented in Table 1.


    The CPA Journal:  The 2018 Guidance for Goodwill Impairment ---
    https://www.cpajournal.com/2018/09/26/the-new-guidance-for-goodwill-impairment/

    Bob Jensen's threads on goodwill and other asset impairment issues ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Impairment


    Negative Goodwill Illustration

    From the CFO Journal's Morning Ledger on April 15, 2019

    Deutsche Bank AG will likely depend on an obscure but valuable accounting quirk—known as negative goodwill, or badwill—to make a deal for smaller rival Commerzbank AG workable.


    Goodwill Impairment Testing Just Got Easier ---
    http://www.accountingweb.com/aa/standards/goodwill-impairment-testing-just-got-easier?source=ei040517

    Accounting Standards Update (ASU) No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, eliminates Step 2 from the quantitative goodwill impairment test. Before adopting this ASU, there are a few things that an entity should consider.

    Continued in article


    "The Asset “Impairment“ Song and Dance (Part 1 of 2)," by Tom Selling, The Accounting Onion, February 28, 2017 ---
    http://accountingonion.com/2017/02/the-asset-impairment-song-and-dance-part-1-of-2.html

     

    Jensen Comment

    The above article touches on goodwill impairment although ti focuses more on asset impairment in general (with Exxon's recent impairment charge for oil reserves as an illustration).

    Tom has a succession of archived Onion posts criticizing the booking of purchased goodwill and the accounting for it afterwards (including write downs for "impairment" ----
    http://accountingonion.typepad.com/theaccountingonion/goodwill/

    In doing so he proposes a solution with a broad brush that has some promise.

    A Proposed Solution

    In olden days, the British permitted a charge to contributed capital for the amount that would otherwise have been recognized as goodwill.  While imperfect, it may well be the only reasonable solution to the problem; for as I have shown above, there can be no perfect solution.  If you can't describe what something is, than what possible good can come from purporting to measure it?
    "What Good Comes from Goodwill Accounting," by Tom Selling, February 18, 2008.

    Jensen Comment
    I'm inclined to agree with Tom on accounting for purchased goodwill. The problem with booking of purchased goodwill is that it puts assets (possibly liabilities?) on the books that accountants don't traditionally book such as the value of human resources and other intangibles that accountants cannot reliably measure except when they are purchased in exchanges --- paying for them with items that can be measured (such as cash purchase prices). Personally, I've never liked putting the ambiguous purchased "goodwill" on the books, because purchase price is subject to a lot of error (Tom provided us with a number of real-world examples over the years such as Caterpillar's purchase of ERA Mining Machinery Limited). Even worse, companies that retain this type of "goodwill" and do not sell it have financial statements that are no longer comparable with financial reports of companies that acquired purchased goodwill.

    Tom's contributed capital booking solution on the date goodwill is "acquired" is admittedly not a perfect solution, but I'm inclined to think is is the best of the worst alternatives. I disagree with Tom on many accounting theory issues, but I'm inclined to lean his way on this one. I'm not yet convinced that he's correct about other issues of "impairment" on items other than purchased goodwill (such a impairments in values of oil reserves). But that's an issue for another day.

    There are a lot of missing details in Tom's "proposed solution," but I like his initial 2008 suggestion.

     


    "Goodwill Impairment Test Disclosures Under IAS 36: Disclosure Quality and its Determinants in Europe," by Marius Gros and Sebastian Koch, SSRN, Updated  July 20, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2636792

    Abstract:
    The European Securities and Markets Authority (EMSA) criticizes the low disclosure quality and boilerplate disclosures in the accounting for goodwill among European listed companies, but it does not identify possible causes. Prior research also finds generally low compliance with disclosure requirements but usually does not consider disclosure quality or systematically examine the drivers of the observed levels of either compliance or disclosure quality. In this study, we analyze compliance and disclosure quality among European listed companies. We find low levels of compliance and disclosure quality and both are positively associated with firm size, goodwill intensity, enforcement and free float. In addition, disclosure quality is positively affected by board skills and company growth but negatively affected by proprietary cost. Our findings are of interest to regulators and enforcers who intend to increase the quality of disclosures. Moreover, we direct the attention of capital market participants to large differences in disclosure quality and the associated firm and governance characteristics.

    Bob Jensen's threads on goodwill impairment ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Impairment


    Teaching Case (from Real Life)
    "Bleak Weather for Sun-Shine AG: A Case Study of Impairment of Assets," by  Dominic Detzen, Tobias Stork genannt Wersborg, and Henning Zülch, Issues in Accounting Education, Volume 30, Issue 2 (May 2015) ---
    http://aaajournals.org/doi/full/10.2308/iace-51007
    Not a Free Case

    ABSTRACT:

    This case originates from a real-life business situation and illustrates the application of impairment tests in accordance with IFRS and U.S. GAAP. In the first part of the case study, students examine conceptual questions of impairment tests under IFRS and U.S. GAAP with respect to applicable accounting standards, definitions, value concepts, and frequency of application. In addition, the case encourages students to discuss the impairment regime from an economic point of view. The second part of the instructional resource continues to provide instructors with the flexibility of applying U.S. GAAP and/or IFRS when students are asked to test a long-lived asset for impairment and, if necessary, allocate any potential impairment. This latter part demonstrates that impairment tests require professional judgment that students are to exercise in the case.

    THE CASE
    Introduction

    On a rainy and gray December morning in 20X1, Thomas Schmidt enters the offices of Sun-Shine AG on the 20th floor of the “Opera Tower” in Frankfurt, Germany.1 He has been the accounting manager of Sun-Shine for several years and enjoys working for a company in the solar industry.

    Today, however, Thomas appears a little tense as he enters the office. He has been thinking for a while about the analyst conference that is set for the next morning and for which he still needs to brief Sun-Shine's CEO, Sebastian Albers. When walking down the corridor, Thomas is stopped by Daniela Gruber, his assistant. Daniela is an International Financial Reporting Standards (IFRS) specialist and has been with Sun-Shine for four years. Typically a rather relaxed person, she appears very anxious today because of a message she received the previous night from California-Sun Corp., Sun-Shine's U.S.-based subsidiary, which was acquired six months ago and mainly produces solar modules for the U.S. market. Daniela tells her boss that the state government of California has unexpectedly decided to cut its subsidies of solar installations by 50 percent. Due to the financial and economic crisis, the state of California has been forced to lower its budget deficit, with the subsidy cut being its latest measure. Daniela says, “California-Sun now expects a severe decline in demand for solar modules and a significant drop in sales. Their assets may need to be written down, which would certainly ruin our numbers this year.”

    Background

    Sun-Shine was founded ten years ago by its current CEO, Sebastian Albers, who expected to profit from the increasing interest in renewable energies from both the German government and the German public. Still headquartered in the city of Frankfurt where the company was founded, Sun-Shine has ever since specialized in the production of solar modules and now runs several solar parks, mainly in the sunnier Mediterranean countries of Italy and Spain. In recent years, Sun-Shine recorded a tremendous sales and profit growth because renewable energies have been on the rise, not only in Germany, but also in the entire European Union.

    Five years ago, the company's great economic success led the management to list all of Sun-Shine's 10 million shares on the German stock exchange, which also brought about the requirement to apply IFRS in the company's consolidated financial statements. The shares were first listed at a face value of 5 euros each.

    . . .

    Implementation Guidance

    We tested this case in two classes at the Master's level: “Advanced International Financial Reporting” is an elective in the Master of Science program, while “International Accounting” is part of the M.B.A. program. The classes are similar in nature in that they aim at educating students in applying IFRS, providing them with problem-solving skills, and an understanding of IFRS accounting. Students passing the courses are generally able to handle IFRS and critically reflect on them. Naturally, the M.B.A. class focuses more on decision-making issues, while the M.Sc. class covers the standards more comprehensively.

    Students were to prepare the case for discussion in class, after having heard about the accounting rules behind impairment tests, which was about halfway through the course. Following the lecture, the case was distributed for completion as an individual exercise (M.Sc. class) and as a group exercise (M.B.A. class). Our assistance was limited to giving hints as to where to find background material and to explaining the more technical issues. We then allocated one class session (90 minutes) to the discussion, which seemed sufficient for an in-depth coverage of the case. The discussion in the M.B.A. class gravitated to the management-relevant questions and the implications of impairment charges. We expect that students spend about seven hours on the case. This estimate considers one hour for reading, about two hours for searching and reading empirical research, and four hours discussion with team members to work out the case requirements. The time needed to complete the case depends on students' knowledge and is reduced if the case is used as an individual exercise.

    While we used the case on a discussion basis, it can also be applied as a written exercise, either individually or in small groups. Such an assignment would have to allow students more time to complete the case because the written answers can be quite extensive. Accordingly, some guidance should be given regarding the length of answers expected. Grading could be done along the answers provided in the Teaching Notes. To increase the case's ease of use, we have prepared the resource such that each part can be assigned separately.

    The resource can be used in a number of classes, primarily at a graduate level. Financial reporting classes in a Master of Accountancy program, e.g., (Advanced) Financial Accounting, (Advanced) Financial Reporting, or a Capstone Seminar, seem to be suited best for the case. International Accounting and, especially, Comparative Accounting would be able to discuss the differences between IFRS and U.S. GAAP in detail. With a slight change of focus, instructors could also use the case in an Auditing class. The case may be too complex for Intermediate Accounting at an undergraduate level because it requires basic knowledge of accounting and finance. However, instructors may well choose to discuss the case in senior-level classes such as Advanced Financial Accounting or Special Topics in Accounting.

    As for students' background knowledge, we believe that a basic understanding of impairment requirements and corporate finance (determining cash flows, discount rate, etc.) should be provided. To some extent, this knowledge can be expected from students at a more advanced level. To be sure, we recommended Palepu, Healy, and Peek (2013, Chaps. 7 and 8) to students as background reading. Detailed understanding of impairment tests is not necessary, as it is part of the assignment and students should work this out independently.

    We estimate that a first-time adopter of the case needs approximately four hours to prepare the case (one hour of reading and preparing classroom discussion, one hour for the technical aspects and Part I, and two hours for Part II). While focusing on impairment tests, the resource allows instructors flexibility when distributing the case. It can be applied by focusing on comparing U.S. GAAP and IFRS requirements, or on one of the two frameworks. The accompanying handout (see the Teaching Notes) helps instructors discuss similarities and differences between impairment requirements, if they choose to discuss only one of the accounting frameworks.

    Student Feedback

    The effectiveness of the case study was assessed by a feedback questionnaire of 12 questions, based on a five-point Likert scale, where 1 indicated “Strongly Agree” and 5 “Strongly Disagree.” Thirty-two students completed the questionnaire (Table 4).

    Continued in article


     

    "Determinants of Goodwill Impairment: International Evidence," by Martin Glaum, Wayne R. Landsman, and Sven Wyrwa, SSRN, May 20, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2608425

    Abstract:     
    This study investigates the determinants of firms’ decision to impair goodwill under IFRS. Our empirical analysis is based on data for the years 2005 to 2011 for 8,110 non-financial firm-years and 1,358 financial firm-years from 21 countries where firms apply IFRS. We specifically investigate which role national enforcement systems play for firms’ decisions whether or not to impair goodwill. We find that firms’ decisions are related to measures of performance, but also to proxies for managerial and firm-level incentives. We also find that goodwill impairment is associated with lagged stock-market return, suggesting that firms tend to delay necessary impairment. Further investigations reveal that the timeliness of goodwill impairment depends on the strength of national accounting and auditing enforcement systems: in countries with weak enforcement systems firms tend to delay necessary goodwill impairments, while firms in countries with strong enforcement systems tend to write off goodwill in a timely fashion, both before and after the Financial Crisis. However, even in countries with strict enforcement impairment decisions appear to be influenced by managerial and firm-level incentives, such as CEO reputation concerns and by management’s preferences for smooth earnings.

    Bob Jensen's threads on goodwill impairment ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Impairment


    Teaching Case
    "Using the Codification to Research a Complex Accounting Issue: The Case of Goodwill Impairment at Jackson Enterprises," by Casey J. McNellis, Ronald F. Premuroso, and Robert E. Houmes , Issues in Accounting Education, Volume 30, Issue 1 (February 2015) ---
    http://aaajournals.org/doi/full/10.2308/iace-50949

    This case is designed to help students develop research skills using the Financial Accounting Standards Board's (FASB) Accounting Standards Codification (Codification or ASC). The case also helps develop students' abilities to analyze and recommend alternatives for a complex accounting issue, goodwill impairment, which is very relevant in today's business world. This case can be used in an undergraduate or graduate accounting class, either in groups of students or as an individual student project.

    . . .

    Shortly after the case was tested in the graduate course, it was administered to undergraduate students enrolled in an Intermediate I course (n = 50). These students had learned the basics of the two-step impairment test in the week preceding the assignment of the case. As indicated in Table 1, the undergraduate class averaged 57.33 percent on the six-question post-case assessment. These students did not receive the six-question assessment prior to reading the case. This was done partially out of necessity because of the time constraints imposed by the intermediate-level curriculum. The Intermediate I course contains a fixed amount of material that must be learned by students prior to their enrollment in the Intermediate II course.7 Given the demands of the curriculum, the instructor only had a portion (approximately 60 minutes) of one class period in which to devote to the case. This class period was used to discuss the case and to administer the case-related survey items (see paragraph below) after the students read the case and answered the case requirements.8 However, given the pre-test scores that we observed in the graduate class, we also felt this course of action was appropriate, as it was deemed unlikely that the undergraduate students' pre-case knowledge of the in-depth issues would be greater than the graduate students, who had already taken the Intermediate I course. As such, we believe the undergraduate post-case assessment average provides additional evidence of the efficacy of this case.

    After the case study was completed and the results and the answers to the case study were discussed and reviewed with the students in each respective class, the instructors had each student complete a five-question survey found in Appendix A. The results of the survey are summarized in Table 2. In general, the mean responses to the five survey questions exceeded 4 on a scale of 1 (disagree) to 5 (totally agree) for the students performing this case study.

    Bob Jensen's threads on impairment ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Impairment

     


    From the CFO Journal's Morning Ledger on January 15, 2014

  • Goodwill Impairment: Minimizing Global Discrepancies ---
    http://deloitte.wsj.com/cfo/2014/01/15/goodwill-impairment-minimizing-global-discrepancies/

    For acquirers, inaccurate goodwill accounting can have serious consequences, including distorted financial reporting, a falling share price and exposure to legal, regulatory and reputational risks. CFOs and other executives can benefit from understanding differences in the way goodwill impairment is analyzed across countries, lessons learned from a case study and the global efforts underway to improve the reliability of goodwill accounting information.

    Bob Jensen's threads on impairment issues ---
    |http://faculty.trinity.edu/rjensen/Theory02.htm#Impairment


    Teaching Case
    "Using the Codification to Research a Complex Accounting Issue: The Case of Goodwill Impairment at Jackson Enterprises," by Casey J. McNellis, Ronald F. Premuroso, and Robert E. Houmes, Issues in Accounting Education, February 2015 ---
    http://aaajournals.org/doi/full/10.2308/iace-50949

    Abstract
    This case is designed to help students develop research skills using the Financial Accounting Standards Board's (FASB) Accounting Standards Codification (Codification or ASC). The case also helps develop students' abilities to analyze and recommend alternatives for a complex accounting issue, goodwill impairment, which is very relevant in today's business world. This case can be used in an undergraduate or graduate accounting class, either in groups of students or as an individual student project.

    . . .

    Shortly after the case was tested in the graduate course, it was administered to undergraduate students enrolled in an Intermediate I course (n = 50). These students had learned the basics of the two-step impairment test in the week preceding the assignment of the case. As indicated in Table 1, the undergraduate class averaged 57.33 percent on the six-question post-case assessment. These students did not receive the six-question assessment prior to reading the case. This was done partially out of necessity because of the time constraints imposed by the intermediate-level curriculum. The Intermediate I course contains a fixed amount of material that must be learned by students prior to their enrollment in the Intermediate II course.7 Given the demands of the curriculum, the instructor only had a portion (approximately 60 minutes) of one class period in which to devote to the case. This class period was used to discuss the case and to administer the case-related survey items (see paragraph below) after the students read the case and answered the case requirements.8 However, given the pre-test scores that we observed in the graduate class, we also felt this course of action was appropriate, as it was deemed unlikely that the undergraduate students' pre-case knowledge of the in-depth issues would be greater than the graduate students, who had already taken the Intermediate I course. As such, we believe the undergraduate post-case assessment average provides additional evidence of the efficacy of this case.

    After the case study was completed and the results and the answers to the case study were discussed and reviewed with the students in each respective class, the instructors had each student complete a five-question survey found in Appendix A. The results of the survey are summarized in Table 2. In general, the mean responses to the five survey questions exceeded 4 on a scale of 1 (disagree) to 5 (totally agree) for the students performing this case study.


    Teaching Case on How Much Harder Technology Firms Make it to Account for Purchased Goodwill and Unbooked Goodwill
    From The Wall Street Journal Accounting Weekly Review on February 21, 2014

    Facebook's Zuckerberg: WhatsApp Worth More than Its Price Tag
    by: Sam Schechner
    Feb 25, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: business combinations, Financial Ratios, Financial Statement Analysis

    SUMMARY: Facebook's announcement that it has purchased WhatsApp for $19 billion-a company that had $20 million in sales last year-had most who heard about it wondering whether the Zuckerberg team had gone crazy. In the main article and its related video, Mr. Zuckerberg justifies the purchase price on the basis of its widespread use. In the related article, comparisons are made to Verizon Wireless's subscriber base and its recent purchase of the 45% of Verizon Wireless that was owned by Vodafone.

    CLASSROOM APPLICATION: The article may be used in a class on business combinations or financial statement analysis.

    QUESTIONS: 
    1. (Introductory) What is so notable about Facebook's purchase of WhatsApp?

    2. (Advanced) How does an acquirer generally decide on a purchase price for a target? Consider the related article in your answer.

    3. (Introductory) Given Mark Zuckerberg's statements in the related video as well as the comments in the related article, do you think that Facebook approached their decision on buying WhatsApp similarly to any other acquisition the company has made? Support your answer.

    4. (Advanced) What do you think will be the primary asset recorded in the entry made by Facebook upon finalizing this purchase of WhatsApp?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Is Facebook' WhatsApp Deal Crazy? Let's Do Some Math
    by Dennis Berman
    Feb 25, 2014
    Page: B1

    "Facebook's Zuckerberg: WhatsApp Worth More than Its Price Tag," by Sam Schechner, The Wall Street Journal, February 26, 2014 ---
    http://online.wsj.com/news/articles/SB10001424052702303426304579403160484584946?mod=djem_jiewr_AC_domainid

    BARCELONA— Mark Zuckerberg has a message for doubters of Facebook Inc. FB +2.18% 's acquisition of mobile-messaging service WhatsApp: $19 billion was cheap.

    The Facebook chief executive said Monday that the five-year-old mobile application was worth more than Facebook agreed to pay for it last week, because the app is a rare platform that has the potential to reach over a billion users.

    In a question-and-answer session here at the yearly Mobile World Congress, Mr. Zuckerberg said that other messaging apps are already monetizing their users at $2 to $3 a head. Meanwhile WhatsApp, with little revenue so far, is on a trajectory to grow quickly from 450 million users to over a billion, Mr. Zuckerberg said.

    "The reality is that there are very few services that reach a billion people in the world. They're all incredibly valuable, much more valuable than that," Mr. Zuckerberg said, referring to the price tag, which included $16 billion in cash and stock and $3 billion in restricted stock units.

    Mr. Zuckerberg's comments underscore his company's complicated relationship with the room he was addressing. Telecommunications executives on one hand appreciate how Facebook drives people to subscribe to Internet service on home and on mobile phones—giving Mr. Zuckerberg top billing at their biggest conference.

    But telecom chiefs—who also pride themselves on reaching billions—chafe at how Silicon Valley companies like Facebook capture much of the value of the Internet. Facebook's $175 billion market capitalization dwarfs that of almost every telecommunication firm.

    During the 45-minute-long discussion, Mr. Zuckerberg spoke mostly about a Facebook-led coalition that aims to push operators to connect poor people in emerging countries to the Internet, by offering "on-ramp" Internet service, with free access to some services like Facebook. He also reiterated his view that the U.S. government had "blown it," when it came to being transparent about its surveillance activities, following leaks from former U.S. National Security Agency contractor Edward Snowden.

    The subject, however, did keep coming back to Facebook's deep pockets. Asked if he was prepared to make another run at messaging-service Snapchat, which Facebook had explored buying last year, Mr. Zuckerberg chuckled.

    "After buying a company for $16 billion," he said, "you're probably done for a little while."


    From the CFO Journal's Morning Ledger on November 12, 2013

    Write-downs from deals gone bad soared last year, but 2013 is turning out different. Suitors are paying the lowest premiums for target companies in nearly 20 years and stocks are trading near records, giving companies cover to avoid write-downs on the value of their assets, write CFOJ’s Emily Chasan and Maxwell Murphy in today’s Marketplace section. That’s a big change from last year, when U.S. companies slashed the value of their past acquisitions by $51 billion because the deals didn’t pan out as expected, according to a study set for release today.”There could be less stress on values now than there was in prior years,” said Gary Roland, a managing director at Duff & Phelps, the financial-advisory firm that led the study.

    Goodwill write-downs don’t affect cash flow, but they could indicate the acquiring company’s management botched its evaluation and overpaid, Chasan and Murphy write. “There’s a reason you put goodwill on the books. Yes, it’s a noncash charge, but at the end of the day, it’s a measure of whether we have been able to derive the value we said we would from those assets,” said Perrigo CFO Judy Brown. Perrigo expects to book $1.19 billion of goodwill on its acquisition of Irish biotech company Elan. “Ultimately, it’s a measure of whether you put your shareholders’ money to work in an effective way,” Ms. Brown said.

    There’s a risk that a rise in interest rates or a drop in the stock market could spark an increase in goodwill write-downs. But corporate boards are showing more discipline in approving acquisitions. U.S. buyers this year are paying an average premium of 19% to the target’s share price the week before the deals are announced. Historically, premiums have averaged 30%. And last year was the first year in which companies could use a new FASB rule that lets them judge on a qualitative basis whether they need to perform traditional quantitative tests on their asset values. Because the new rule makes the decision more subjective, optimistic executives may be able to stave off a potential write-down, says PJ Patel, a managing director at Valuation Research, which advises companies on goodwill accounting.


    "Are Fair Value Estimates a Source of Significant Tension in the Auditor-Client Relationship? Evidence from Goodwill Accounting," by Douglas Ray Ayres. Terry L. Neal, Lauren C. Reid, and Jonathan E Shipman, SSRN, August 2, 2014 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2474674

    Abstract:     
     
    In recent decades, there has been a substantial increase in the use of complex fair value estimates in financial reporting. These uncertain and forward-looking estimates pose additional challenges for auditors who are required to evaluate the reasonableness of accounting estimations. We extend prior literature by investigating whether or not uncertain estimates create significant tension between audit firms and their clients. Specifically, we use the context of goodwill estimations to examine the effect of accounting estimates on the auditor-client relationship. We find a positive and significant relation between a material goodwill write-off and a subsequent auditor change. In addition, our results indicate that the likelihood of an auditor switch increases as the impairment decision becomes less favorable to the client. Furthermore, we find that as the relative magnitude of a goodwill write-off increases, the greater the likelihood the auditor-client relationship will discontinue. In addition to providing important insights into the challenges faced by auditors in their evaluation of goodwill impairments, this study informs discussions regarding the audit of other complex estimates, which is particularly relevant given the continued expansion of fair value estimation in financial reporting.

    Question
    Goodwill Impairment: What Happens When U.S. GAAP and IFRSs Clash?

    From CFO.com on March 25, 2013

    Differences in the goodwill impairment standards under U.S. GAAP and IFRSs may create significant disparities as to whether goodwill is viewed as impaired and, if so, how much is written off in the United States and the other country, or even country to country. Learn more about the challenges companies, especially acquisitive ones, may face in performing goodwill impairment testing both in the U.S. and around the world.
    More --- http://deloitte.wsj.com/cfo/2013/03/25/goodwill-impairment-what-happens-when-u-s-gaap-and-ifrss-clash/

    For acquisitive companies, determining whether goodwill booked in transactions has become impaired and if it has, by how much, is now a fairly regular occurrence. However, the accounting involved can be anything but straightforward when the acquirer is a U.S.-based company and subsidiary businesses are located elsewhere or vice versa.

    Differences in the goodwill impairment standards under U.S. GAAP and International Financial Reporting Standards (IFRSs) may create significant disparities as to whether goodwill is viewed as impaired and, if so, how much is written off in the United States and the other country, or even country-to-country. Other factors creating such disparities include the varying application of valuation methodologies and historical cultural differences in the application of impairment accounting.

    Such situations may be especially troublesome for U.S. businesses because of country-to-country differences around the world. For example, a U.S. company with operations in Germany, France, Spain and Greece may write off goodwill entirely on a consolidated basis under U.S. GAAP. However, when a corporate life event, such as a spin-off or carve out, is undertaken related to the subsidiary outside of the U.S. depending on how the IFRSs principles are applied, some or none of its goodwill might be written off. (See: U.S. GAAP-IFRSs Dilemma: A Case Study further below).

    Sorting out these differences may be a challenging process for management of companies operating in numerous countries across the world, when U.S. GAAP, IFRSs and potentially other financial reporting frameworks need to be addressed. Relief from the dilemma of distinguishing between the treatment under U.S. GAAP and IFRSs does not appear to be on the way any time soon. On one hand, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) are continuing their now decade-long work to converge IFRSs and U.S. GAAP. However, converging goodwill impairment accounting does not appear to be a near-term project.

    In addition, on July 13, 2012, the SEC issued its final staff report on the “Work Plan for Consideration of incorporating IFRSs into the Financial Reporting System for U.S. Issuers” without offering a timetable for potential U.S. adoption of IFRSs for domestic filers¹. This leaves companies for the foreseeable future still facing difficult situations when dealing with disparities such as goodwill impairment.

    The Conceptual Foundation of Impairment Issues

    The differences in U.S. GAAP and IFRSs goodwill impairment treatment flow largely from a fundamental difference in accounting approaches. As a principles-based accounting approach, IFRSs provide a conceptual basis for accountants to follow in a one-step test that has both a fair value and an asset-recoverability aspect. U.S. GAAP, on the other hand, dictates that goodwill is tested for impairment through a two-step, fair value test with the level of impairment, if present, determined in Step 2 after an extensive analysis of related asset values. However, the FASB’s recent issuance of a “step zero” qualitative assessment for goodwill impairment testing did introduce an element of a principles-based approach under U.S. GAAP³. Principles-based standards allow accountants to apply significant professional judgment in assessing a transaction. This is substantially different from the underlying “box-ticking” approach historically common in rules-based accounting standards.

    The lack of precise guidelines in a principles-based approach may create inconsistencies in the application of standards across organizations and countries, particularly in a very subjective area such as fair value. On the other hand, rules-based standards can be viewed as insufficiently flexible to accommodate a topic such as fair value, which often requires significant professional judgments gained through experience, with extremely limited market data.

    However, the U.S. has gradually been embracing the principles-based approach. The recently converged standards on fair value measurement (IFRS 13 and ASC 820), an IASB-FASB joint effort, supports this.

    Even though the SEC has not set a timetable for if, when, or how the U.S. might move to IFRSs in the future, convergence efforts themselves in recent years have started to influence how new accounting standards are applied in practice.

    U.S. GAAP-IFRSs Dilemma: A Case Study

    The experience of a U.S.-based consolidated company comprising six Reporting Units (RUs) demonstrates how differences in U.S. GAAP and IFRSs may affect goodwill impairment. The company was considering a spinoff of an RU located in a country following IFRSs, as a standalone company through an IPO. Therefore, a standalone audit of the RU was necessary under IFRSs. At the end of its fiscal year, the U.S. consolidated company wrote off the goodwill in its foreign-based RU and some other domestic RUs under U.S GAAP.

    Outside the U.S., meanwhile, the subsidiary—a standalone RU in the U.S. and a single Cash Generating Unit (CGU) under IFRSs—performed an independent goodwill impairment analysis. The standalone CGU management did not believe there should be a goodwill write-off under IFRSs guidelines and following typical valuation procedures in that country related to goodwill impairment testing. As a result, the standalone CGU reported goodwill under IFRSs but the standalone RU under U.S. GAAP wrote the entire amount off, at the same point in time.

    Addressing the Dilemma

    In a world where investors often react to new or inconsistent financial information within seconds, it is important for company management to understand environments where different conclusions may be reached relative to topics such as goodwill impairment.

    Sometimes differences need to be addressed and initial conclusions potentially modified. In other situations differences are just the result of the various financial reporting frameworks and environments across the world. However, it is important to be aware that situations may occur where various parties involved may not agree or understand each other’s perspectives, and then be able to navigate them effectively to get to supportable and reasonable conclusions.

    Understanding real differences due to statutory guidance—such as non-convergent accounting versus interpretations of principles-based standards, or the varying application of valuation methods—is extremely important.

    The Effects of Culture and Translation

    As accounting standards, IFRSs are still relatively recent, with European nations as early adopters in 2005; although, in some countries, IFRSs have been around longer. Numerous countries around the world have been transitioning to IFRSs in recent years. In many of those countries, fair value was not present in the original accounting framework. Indeed, a number of the countries now following IFRSs do not have fully functioning market- based economies, making the complexity of arriving at supportable fair value estimates even greater.

    Countries around the world have operated for decades within their own accounting systems, and cultural differences cause accountants in different countries to interpret and apply accounting standards differently. Such differences can affect the measurement and disclosure of financial information in financial reports and potentially affect cross-border financial statement comparability.

    National culture is most likely to influence the application of financial reporting standards where judgment is required. This is of concern due to IFRSs being principles- based and requiring substantial judgment on the part of the accountant and the valuation specialist performing the valuation.

    The official working language of the IASB, and the language in which IFRSs are published, is English. Translation of IFRSs into various languages introduces an added complexity in comparability of application of IFRSs across the world, as well as comparability with U.S. GAAP. In some cases, words and phrases used in English- language accounting standards cannot be translated into other languages without some distortion of meaning. For instance, words such as “probable,” “not likely,” “reasonable assurance” and “remote” can be problematic during interpretation.

    In addition, many countries that have moved to IFRSs may have introduced their own country’s version of IFRSs; such localization of the standards has led to the creation of many slightly different versions of IFRSs.

    Therefore, when analyzing and contrasting financial reporting practices, such as those involving goodwill impairment testing, it is not as simple as a comparison of U.S GAAP and IFRSs.

    To highlight the need for greater consistency, the European Securities and Markets Authority (ESMA) issued a Public Statement on November 12, 2012, regarding European common enforcement priorities for 2012 financial statements. ESMA’s reason for issuing the statement was “to promote consistent application of the European securities and markets legislation, and more specifically that of [IFRSs].” One of the four “…financial reporting topics which they believe are particularly significant for European listed companies…”⁴ was impairment of non-financial assets, including goodwill.

    The Effects of Different Accounting Treatments

    Taking a goodwill impairment can be a necessary, if disappointing, step for a company. For publicly traded companies in particular, depending on how the company has managed market expectations, the move may or may not affect the company’s market pricing. Dealing with inconsistencies from market to market can be even more perplexing. Whatever the situation, companies operating across the global economy continue to face the challenge of differing application of valuation methodologies and accounting principles under U.S. GAAP and IFRSs, local country GAAP and even country-to-country under IFRSs regarding goodwill impairment testing.


    Teaching Case
    From the Wall Street Journal Accounting Weekly Review on November 15, 2013

    Companies Get More Wiggle Room on Soured Deals
    by: Emily Chasan and Maxwell Murphy
    Nov 12, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: business combinations, Goodwill, Impairment, Intangible Assets, Mergers and Acquisitions

    SUMMARY: "Last year U.S. companies slashed the value of their past acquisitions by $51 billion because the deals didn't pan out as expected...This year, however, there have been only a handful of big corporate mea culpas." The article is an excellent introduction to the meaning of accounting for goodwill and related impairment charges. In 2012, nearly half of the total goodwill write-downs came from three companies: Hewlett-Packard, stemming from its acquisition of software firm Autonomy; Microsoft, mostly from its purchase of aQuantive; and Boston Scientific, primarily from its acquisition of Guidant. The H-P/Autonomy acquisition and goodwill write-off were covered in this review for which this review lists a related article.

    CLASSROOM APPLICATION: The article may be used in any financial reporting class either covering intangible assets or business combination accounting.

    QUESTIONS: 
    1. (Introductory) According to the article, how is goodwill determined?

    2. (Advanced) Would you like to add any further details to the description given in the article about how goodwill is determined? Explain.

    3. (Introductory) How much goodwill have companies written off in recent years? What factors have led to this trend in goodwill write-offs?

    4. (Advanced) What is an alternative name for a goodwill write-off used in accounting standards?

    5. (Advanced) What does a goodwill write-off imply about the business combination transaction from which it was generated?

    6. (Introductory) According to the article, how are goodwill write-offs determined?

    7. (Advanced) Would you like to add any further details to the description given in the article about determining and/or recording goodwill write-offs? Explain.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    H-P Says It Was Duped, Takes $8.8 Billion Charge
    by Ben Worthen
    Nov 28, 2012
    Page: A1

    "Companies Get More Wiggle Room on Soured Deals," by Emily Chasan and Maxwell Murphy, The Wall Street Journal, November 12, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304868404579191940788875848?mod=djem_jiewr_AC_domainid

    Last year U.S. companies slashed the value of their past acquisitions by $51 billion because the deals didn't pan out as expected, according to a study set for release Tuesday. That was the highest yearly total for such write-downs since the financial crisis.

    This year, however, there have been only a handful of big corporate mea culpas. Suitors are paying the lowest premiums for target companies in nearly 20 years, stocks are trading near records, giving companies cover to avoid write-downs on the value of their assets, and new accounting rules may be allowing more of them to delay the charges.

    "There could be less stress on values now than there was in prior years," said Gary Roland, a managing director at Duff & Phelps, the financial advisory firm that led the study.

    Write-downs of soured acquisitions jumped 76% last year from 2011, but remained far below the $188 billion in charges recorded in 2008, as the recession bit down.

    Nearly half last year's write-downs came from three deals gone bad. Hewlett-Packard Co. HPQ +0.40% took the biggest—$13.7 billion—thanks largely to the vanishing value of its 2011 acquisition of software firm Autonomy, which H-P said it was duped into buying at an inflated price. Autonomy's former chief executive has denied the allegation.

    Microsoft Corp. MSFT -0.19% took a $6.2 billion write-down largely on its 2007 purchase of online-advertising company aQuantive, and Boston Scientific Corp. BSX -0.21% shaved off another $4.35 billion, mostly related to its problem-plagued 2006 takeover of medical-device maker Guidant. In all, 235 companies erased value from prior deals last year. That's up from 227 the year before but down from 502 in 2008.

    Last year's list also included Cliffs Natural Resources Inc. CLF +2.32% 's roughly $1 billion charge on its 2011 purchase of Consolidated Thompson Iron Mines.

    When one company acquires another it calculates the value of the target's assets, including property, equipment, trademarks and licenses. If the purchase price is higher, the acquirer carries the difference on its books as so-called goodwill.

    At least once a year, companies must verify the value of what they bought. If the acquired company had a product recall, for example, the value of some of its assets might have to be discounted.Goodwill write-downs don't affect cash flow, and so are often ignored by investors, but they could indicate the acquiring company's management botched its evaluation and overpaid.

    "There's a reason you put goodwill on the books. Yes, it's a noncash charge, but at the end of the day, it's a measure of whether we have been able to derive the value we said we would from those assets," said Judy Brown, chief financial officer of Perrigo Co. PRGO -0.46%

    Perrigo, a drug manufacturer and distributor, expects to book $1.19 billion of goodwill on its acquisition of Irish biotech company Elan Corp. DRX.DB -0.15% , according to a regulatory filing. "Ultimately, it's a measure of whether you put your shareholders' money to work in an effective way," Ms. Brown said.

    There is a risk, of course, that a run-up in interest rates or a drop in the stock market could spark an increase in goodwill write-downs. Companies in the S&P 500 index are still carrying a total of $2 trillion in goodwill on their books. They include AT&T Inc., T +0.80% Bank of America Corp. BAC +0.61% , Procter & Gamble Co. PG +0.50% , Berkshire Hathaway Inc. BRKB +0.10% and General Electric Co. GE +0.63% , which each have more than $50 billion in goodwill on their balance sheets, according to S&P Capital IQ.

    Boston Scientific, for example, has written down goodwill in five of the past six years for a total of $9.9 billion in charges, including $423 million this year. The company said in a recent regulatory filing that another roughly $1.36 billion of its $5.55 billion in remaining goodwill is at "higher risk" of a write-down.

    "They clearly overpaid" in buying Guidant for $28.4 billion, said Tau Levy, an analyst at Wedbush Securities. Part of the reason was a bidding war with Johnson & Johnson, JNJ -0.01% but part was because Boston Scientific's prior top managers "underestimated the problems going on with Guidant," Mr. Levy said.

    A Boston Scientific spokeswoman declined to "speculate on the reasons for past decisions."

    Only a handful of other large companies have taken hefty goodwill charges this year. U.S. Steel Co. X +1.96% took a $1.8 billion write-down, and Best Buy Co. BBY +0.72% recorded an $822 million charge. Cardinal Health CAH -0.37% slashed the value of its pharmacy business by $829 million.

    In a separate Duff & Phelps survey this summer, more than two-thirds of the 115 companies participating said they don't expect goodwill write-downs this year. Only 10% of the public companies polled said they expected such a charge, down from 17% in last year's survey.

    Corporate boards are showing more discipline in approving acquisitions, despite favorable borrowing conditions and a soaring stock market. U.S. buyers this year are paying an average premium of 19% to the target's share price the week before the deals are announced, according to Dealogic. That's the lowest average premium since at least 1995, as far back as Dealogic's records go. Historically, premiums have averaged 30%.

    Continued in article


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

    A new expected credit loss impairment model

    "FASB takes new path in contentious financial instruments project," by Ken Tysiac, Journal of Accountancy, August 31, 2012 ---
    http://journalofaccountancy.com/News/20126359.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


    Question (FEI)
    Which industries have the most goodwill on their balance sheets, which industries' goodwill was hardest hit, and the impact of impairments on each industry's total assets?

    "Goodwill Impairment Holds Steady," by Bill Sinnett, FEI's FERF Research Blog, February 1, 2013 --- Click Here
    http://www.financialexecutives.org/KenticoCMS/FEI_Blogs/FERF-Research-Blog/November-2012/2012-Goodwill-Impairment-Study.aspx#axzz2JwlCV2io

    he 2012 Goodwill Impairment Study, done by Duff & Phelps, examines the general and industry trends of goodwill impairment for U.S. companies and includes the results of a survey of FEI members.
     
    New in this year’s study are ten industry sector spotlights which highlights key goodwill impairment metrics, as well as cross-tabulation analyses which evaluate the relationships between FEI member responses to two or more questions.
     
         2012 Study Highlights

     
    Click here to download the 2012 Goodwill Impairment Study ---
    https://www.financialexecutives.org/KenticoCMS/Research/Research-Publications/publication.aspx?prd_key=00eb4c43-bc03-43e0-9cc6-c24275a9c4b6
     

     


    From IAS Plus on January 21, 2011 Jan 21, 2013

    ESMA report shows room for improvement regarding disclosures related to goodwill impairment ---
    http://www.iasplus.com/en/news/2013/01/esma-report-on-disclosures-related-to-goodwill-impairment

    The European Securities and Markets Authority (ESMA) has published a review of 2011 IFRS financial statements related to impairment testing of goodwill. The report shows that significant impairment losses of goodwill were limited to a handful of issuers. According to ESMA, this raises the question as to whether the level of impairment disclosed in 2011 financial reports appropriately reflects the difficult economic operating environment for companies. ESMA also finds that although the major disclosures related to goodwill impairment testing were generally provided, in many cases these were boilerplate and not entity-specific. ESMA expects issuers and their auditors to consider the findings of the review when preparing and auditing the 2012 IFRS financial statements.

    A Curious Case of Negative Goodwill
    "NEED PROFIT? BUY SOMETHING!" by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/733

    We first voiced our concern about an obscure accounting rule that allows companies to “create” profits when purchasing other businesses in the “Curious Case of Miller Energy’s 10-K and Its Huge Bargain Purchase.” The offending tenet relates to the treatment of something called “negative goodwill” which purportedly is created when a company makes an acquisition, and pays less than what the assets are worth. This fantastic “bargain purchase” creates a negative goodwill anomaly because the acquirer supposedly gets more assets than it pays for, as in this example:

    Continued in article

    Jensen Comment
    Yet another illustration of how the FASB and IASB made a black hole out of bottom-line earnings.

    Bob Jensen's threads on impairment issues ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Impairment

     


    A Curious Case of Negative Goodwill
    "NEED PROFIT? BUY SOMETHING!" by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/733

    We first voiced our concern about an obscure accounting rule that allows companies to “create” profits when purchasing other businesses in the “Curious Case of Miller Energy’s 10-K and Its Huge Bargain Purchase.” The offending tenet relates to the treatment of something called “negative goodwill” which purportedly is created when a company makes an acquisition, and pays less than what the assets are worth. This fantastic “bargain purchase” creates a negative goodwill anomaly because the acquirer supposedly gets more assets than it pays for, as in this example:

    Continued in article

    Jensen Comment
    Yet another illustration of how the FASB and IASB made a black hole out of bottom-line earnings.

    Bob Jensen's threads on the radical new changes on the way ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay


    February 26, 2012 message from Dennis Beresford

    Bob,

    Warren Buffett's annual letter to shareholders, available at the Berkshire Hathaway website, is, as always, a must read. Of particular interest is his comment on page 15 about a very nonsensical aspect of GAAP for business combinations.

    Denny

    After which Bob Jensen added the following tidbit

    Abpve is a message from Denny about the Uselessness of GAAP for Business Combinations

    I don't think anybody considers GAAP the most useful input to management when making decisions regarding mergers and acquisitions since GAAP mainly deals with booked items and management focuses very heavily on the values and risks of unbooked items like human resources, contingencies, and interaction (covariance) values of booked and unbooked items.

    But GAAP could conceivably be of more interest to investors when evaluating the stewardship of management with respect to mergers and acquisitions.

    Added Note:
    I've always enjoyed the folksy writing style in these shareholder letters. If you peruse through all of them you will get a greater sense of the value added by corporate executives on investments.

    BERKSHIRE HATHAWAY INC.SHAREHOLDER LETTERS ---
    http://www.berkshirehathaway.com/letters/letters.html

    Shareholder Letter for 2011 ---
    http://www.berkshirehathaway.com/letters/2011ltr.pdf

    . . .

    Partially offsetting this overstated liability is $15.5 billion of “goodwill” attributable to our insurance companies that is included in book value as an asset. In effect, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its true value. If an insurance business produces large and sustained underwriting losses, any goodwill asset attributable to it should be deemed valueless, whatever its original cost. Fortunately, that’s not the case at Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would pay to purchase float of similar quality – to be far in excess of its historic carrying value. The value of our float is one reason

    . . .

    Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary.

    But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock. Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.

    Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.

    Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

    Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

    If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $112 billion more than if the “high-price” repurchase scenario had taken place.

    The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

    Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.

    In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.

     

    . . .

    Certain shareholders have told me they hunger for more discussions of accounting arcana. So here’s a bit of GAAP-mandated nonsense I hope both of them enjoy.

    Common sense would tell you that our varied subsidiaries should be carried on our books at their cost plus the earnings they have retained since our purchase (unless their economic value has materially decreased, in which case an appropriate write-down must be taken). And that’s essentially the reality at Berkshire – except for the weird situation at Marmon.

    We purchased 64% of the company in 2008 and put this interest on our books at our cost, $4.8 billion. So far, so good. Then, in early 2011, pursuant to our original contract with the Pritzker family, we purchased an additional 16%, paying $1.5 billion as called for by a formula that reflected Marmon’s increased value. In this instance, however, we were required to immediately write off $614 million of the purchase price retroactive to the end of 2010. (Don’t ask!) Obviously, this write-off had no connection to economic reality. The excess of Marmon’s intrinsic value over its carrying value is widened by this meaningless write-down.

    . . .

    There is little new to report on our derivatives positions, which we have described in detail in past reports.

    (Annual reports since 1977 are available at www.berkshirehathaway.com.) One important industry change,however, must be noted: Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.

    Our insurance-like derivatives contracts, whereby we pay if various issues included in high-yield bond indices default, are coming to a close. The contracts that most exposed us to losses have already expired, and the remainder will terminate soon. In 2011, we paid out $86 million on two losses, bringing our total payments to $2.6 billion. We are almost certain to realize a final “underwriting profit” on this portfolio because the premiums we received were $3.4 billion, and our future losses are apt to be minor. In addition, we will have averaged about $2 billion of float over the five-year life of these contracts. This successful result during a time of great credit stress underscores the importance of obtaining a premium that is commensurate with the risk.

    Charlie and I continue to believe that our equity-put positions will produce a significant profit, considering both the $4.2 billion of float we will have held for more than fifteen years and the $222 million profit we’ve already realized on contracts that we repurchased. At yearend, Berkshire’s book value reflected a liability of $8.5 billion for the remaining contracts; if they had all come due at that time our payment would have been $6.2 billion.

     

    Tom Selling has some posts of possible interest on business combinations:

    Business Combinations
    http://accountingonion.typepad.com/theaccountingonion/business-combinations/

    Goodwill ---
    http://accountingonion.typepad.com/theaccountingonion/goodwill/

    Bob Jensen's threads on accounting theory ---
    http://faculty.trinity.edu/rjensen/Theory01.htm

     

     


    China Yurun Foods has generated about 9% of its profit from goodwill....That should be a red flag for investors.

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

    China's Yurun Seeks Investor Goodwill
    by: Duncan Mavin
    Aug 13, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Audit Quality, Auditing, Business Ethics, Goodwill

    SUMMARY: "Since 2006, China Yurun Foods has generated about 9% of its profit from goodwill....That should be a red flag for investors....Several areas in the firms' accounts are under scrutiny from investors, including high levels of government subsidies, which are above industry norms, and margins that appear out of whack with those of its peers." The article notes that Yurun and its auditors KPMG declined to comment on the issues raised in this article.

    CLASSROOM APPLICATION: The article is useful to discuss the topic of negative goodwill. It also may be used to generally cover financial statement analysis used for either investment decision-making or audit reasonableness testing. This article is the first of three this week discussing the current rash of concerns with financial reporting by Chinese companies traded on North American exchanges.

    QUESTIONS: 
    1. (Introductory) What business combination transactions did the Hong Kong- based company Yurun undertake in the last five years?


    2. (Advanced) What is negative goodwill? How does this account balance arise from a business combination transaction?


    3. (Advanced) What parts of the accounting for a business combination giving rise to negative goodwill-or positive goodwill-are subject to management judgment?



    4. (Advanced) What are a company's auditors-in this case, KPMG LLP-responsible for doing to assess the reasonableness of asset values assigned by a company in business combination transactions? In this case, what issue raises questions about concerns in those valuations?



    5. (Introductory) Refer to the related article as well as comments in the main article regarding "several areas in the firms accounts" that are "under scrutiny." What are investors analyzing in company's annual reports? What investment actions are they taking based on their assessments?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    Special report: The "Shorts" Who Popped a China Bubble
    by Daniel Bases, Ryan Vlastelica, and Clare Bal of the International Business Times
    Aug 05, 2011
    Online Exclusive


     

    "China's Yurun Seeks Investor Goodwill," by: Duncan Mavin, The Wall Street Journal, August 13, 2011 ---
    http://professional.wsj.com/article/SB10001424053111904332804576540364006721704.html?mod=djem_jiewr_AC_domainid

    Five years of "negative goodwill" sounds like a run of seriously bad luck. For China Yurun Foods Group, the opposite is true.

    Since 2006, China Yurun Foods Group has generated about 9% of its profits from negative goodwill, an accounting quirk that allows the company to mark up the value of the pig slaughterhouses it buys. That should be a red flag for investors.

    Yurun, a Hong Kong-listed pork processor with a market capitalization of about $4.2 billion, has bought eight slaughterhouses at knock-down prices over the past five years and booked 587 million Hong Kong dollars (US$75.3 million) in gains.


     

    To generate profits this way from negative goodwill several years running and across multiple transactions is highly unusual, says Prof. Gary Biddle, chairman of accounting at the University of Hong Kong. [yurunherd0830] Bloomberg News
     


     

    Yurunshares lost a third of their value since mid-June.
     


     

    Negative goodwill is rare because sellers don't usually part with their assets at bargain prices. The other concern is it is the buyer who determines how much it underpaid for the assets and what they are worth now.
     


     

    The company and its auditors KPMG declined to comment.
     


     

    Yurun is one of a number of Chinese businesses under fire from short sellers targeting alleged accounting problems. The company's shares have already lost a third of their value since mid-June, and several areas in the firm's accounts that are under scrutiny from investors. Another area of concern: High levels of government subsidies, which are above industry norms, and margins that appear out of whack with those of its peers.

    Continued in article


     


    "A Case Against Impairment Testing:  A decline in share price may not necessarily mean a company should test its goodwill for impairment," by David M. Katz, CFO.com, October 7, 2010 ---
    http://www.cfo.com/article.cfm/14528983/?f=rsspage

    CFOs shouldn't automatically assume that a drop in share price should trigger a goodwill-impairment charge by their companies, a new research report suggests.

    To be sure, bad news from the market is the most common — and attention-getting — reason for an impairment test. But given the overall rebound in share prices since March 2009, companies that chose not to test their corporate goodwill for impairment "may have been right," according to the report from the Georgia Tech Financial Analysis Lab. "A price decline in the absence of other developing problems may not be in and of itself a valid goodwill impairment triggering event."

    That's because share prices are known to be fickle indicators. In one case cited in the study, which is culled from the 2008 and 2009 annual reports of 48 companies, Alcoa appears to have thumbed its nose at the market and chosen not to respond to a share-price drop with a goodwill-impairment test. "Management believes the Company's forecasted cash flows constitute a better indicator of the current fair value of Alcoa's reporting units than the current pricing of its common shares," the company stated in its 2008 10-K.

    As the report's authors suggest, Alcoa's management may have been right. Like many other companies, the aluminum giant was under pressure to write down its goodwill after a devastating 2008. After its share price peaked at $43.15 on May 16 of that year, it went on a long dive to $8.06 on December 4, according to a CFO analysis of Capital IQ data. Then, however, it rose steadily to $17.45 on Jan. 11, 2010, and has hovered around $12 through September 2008.

    Seven other companies in the study, which was authored by Georgia Tech professors Eugene Comiskey and Charles Mulford, also didn't assume that a share-price decline or a drop in their market capitalizations should routinely spur an impairment test. They were EMTEC, Keynote Systems, Misonix, Parkvale Financial, Quanex Building Products, Schnitzer Steel Industries, and Tyson Foods.

    Under pressure to test for impairment, especially in a recession, companies that choose not take a charge in the face of a share-price decline must mount a strong argument for that decision, according to Mulford. One common defense such companies make is that "just because their share price is depressed, it doesn't mean that the operating units are depressed or that their values are impaired," he says.

    To be sure, many more companies test for goodwill impairment in response to stock drops and other triggers. Of the 40 other companies the Georgia Tech lab studied, 22 ultimately took a goodwill charge and 18 decided against one.

    At least once a year, companies with goodwill — the premium that an acquiring company pays in excess of an acquired company's book value — must evaluate it to gauge whether or not it is impaired. If it is impaired, the company must report a decrease in the goodwill's value.

    But when an event that the company regards as a possible trigger of an impairment occurs between annual testing times, the company must test its goodwill immediately. Under generally accepted accounting principles, there are seven such triggering events (see chart). The triggering event and the later evaluation of goodwill for impairment can lead to contentious debates among the CFO, other senior managers, auditors, and outside investors, says Mulford. The company's senior executives may not think that an impairment is warranted, while auditors and outside investors may argue otherwise.

    Why all the hubbub about a balance-sheet charge that doesn't actually involve cash? "They still impact analyst assessments of future cash flows and call into question past prices paid for acquisition targets," says Mulford. "Moreover, such impairments do reduce current period earnings and result in a direct reduction in shareholders' equity."


    From The Wall Street Journal Accounting Weekly Review on January 16, 2009

    Time Warner Takes $25 Billion Hit
    by Merissa Marr and Nat Worden
    The Wall Street Journal

    Jan 08, 2009
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Advanced Financial Accounting, Asset Disposal, Goodwill, Impairment

    SUMMARY: "Time Warner has made a slew of acquisitions since the company's last major write-down in 2002 for the value of AOL and its cable systems...Investors chided AOL last year for the steep $850 million price tag of its Bebo acquisition." Time Warner has announced a $25 billion write down of its assets "to account for the tumbling value of its cable, publishing and AOL businesses." The write down includes goodwill; an investment in Clearwire; a lease restructuring for floors in Manhattan held by Lehman Brothers; an increase in credit loss reserves for bankruptcy filings by retail customers; and charges for a court judgment against Turner Broadcasting.

    CLASSROOM APPLICATION: Accounting for goodwill and other asset impairments, as well as loss accruals, is covered with this article, including addressing implications for future financial reporting.

    QUESTIONS: 
    1. (Introductory) In general, what are the accounting requirements for writing down goodwill and other intangible assets?

    2. (Advanced) Refer to the related article. How do companies have "discretion in implementing accounting rules on impairment"?

    3. (Introductory) Refer again to the related article. Time Warner says that the impairment charge was prompted by "...the dip in its stock price last year. 'If our stock price was higher we would not have to take this charge..." How is this possible?

    4. (Introductory) What assets besides goodwill has Time Warner also written down? What other charges have been recorded? Identify each as listed in the article and state the authoritative accounting literature establishing requirements in these areas.

    5. (Advanced) How do all of these writedowns "reset the level of shareholders' equity" as stated in the related article? What are the future implications of these writedowns today? Be sure to explain your answer.

    6. (Introductory) How do these write downs impact other companies in the cable industry?

    7. (Advanced) "Time Warner still expects cash flows for 2008 to total $5.5 billion, matching its outlook provided in November...." After this announcement of a downturn to a loss, why hasn't this projection changed?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Timely Warning on Cable Values
    by Martin Peers
    Jan 08, 2009
    Page: C12
     

    "Time Warner Takes $25 Billion Hit," by Merissa Marr and Nat Worden, The Wall Street Journal, January 8, 2009 --- http://online.wsj.com/article/SB123133534152760741.html?mod=djem_jiewr_AC

    Responding to past problems and the future perils of the economic downturn, Time Warner Inc. attempted to clear its slate by writing down $25 billion of assets to account for the tumbling value of its cable, publishing and AOL businesses.

    The move, coming as the advertising outlook sours, could signal more write-downs for media and cable companies. After a rash of acquisitions at peak prices, companies in those industries are having to scale back accounting values in the now-sullen climate. The media industry also faces secular declines in areas such as newspapers, broadcast television and radio, which are being ravaged by ad declines.

    Coupled with weaker-than-expected advertising revenue,Time Warner's fourth-quarter write-down is expected to swing the company to an annual loss for 2008 -- its first in six years.

    Time Warner Cable Inc., whose shares have fallen 50% in the past couple of years, represented the bulk of the non-cash write-down, at nearly $15 billion. The news also highlights the lingering effects of Time Warner's disastrous 2001 merger with AOL and a gloomy outlook for the magazine-publishing business.

    Time Warner has made a slew of acquisitions since the company's last major write-down in 2002 for the value of AOL and its cable systems. Time Warner Cable spent about $9 billion of cash and 16% of its equity acquiring assets from rival Adelphia in 2005. AOL also has been on a buying spree in its bid to revamp itself as an ad-based company. Investors chided AOL last year for the steep $850 million price tag of its Bebo acquisition.

    Cable-TV company Comcast Corp. similarly plans to write down its stake in wireless broadband company Clearwire Corp., whose shares have fallen about 60% in the past 12 months, said people familiar with the situation. Last October, CBS Corp. recorded a $14.1 billion charge, largely for the shrinking value of its local television and radio stations. "We believe that similar announcements from other media companies could be forthcoming," said UBS analyst Michael Morris.

    Time Warner's write-down says a lot about the challenges that face Chief Executive Jeff Bewkes. Mr. Bewkes has signaled a shift to focus more on the TV and movie businesses and less on non-content assets such as Time Warner Cable, which he expects to spin off by the end of the current quarter.

    But he still needs to find long-term solutions for AOL and publishing. Time Warner CFO John Martin, speaking at an investor conference, said the company is still interested in finding AOL a partner, after on-off talks with potential candidates, but noted the current climate "is not conducive to" quick action.

    Time Warner rang more alarm bells about the advertising climate, saying "the economic environment has proved somewhat more challenging" than previously expected, particularly at its AOL and publishing units. The company scaled back its operating projection for 2008, saying it now expects adjusted operating income before depreciation and amortization to be $13 billion, up 1%, a drop from its previous forecast of a 5% increase.

    Time Warner shares were down 6.3% at $10.29 in 4 p.m. composite trading on the New York Stock Exchange, while Time Warner Cable stock was down 4.8% at $21.56.

    In addition to the write-down, Time Warner will record charges of as much as $380 million in the fourth quarter, including as much as $60 million from the restructuring of a lease for floors in its Time & Life Building in Manhattan held by Lehman Brothers Holdings Inc.; a $40 million increase in its credit-loss reserves for bankruptcy filings by retail customers; and $280 million for a court judgment against its Turner Broadcasting System Inc.

    Time Warner still expects cash flows for 2008 to total $5.5 billion, matching its outlook provided in November, because of strong performances from its film division and its cable-television networks.

    Time Warner was expected to come under pressure to write down assets as it carried over $42.5 billion in goodwill on the books for 2008. Mr. Martin said he expects no "adverse impacts" from the write-down, noting there are no debt covenants or tax implications that will lead to more financial pain.

    The Time Warner Cable write-down reflects the decline in the market value of the company, a drop in the value of its franchise rights and lowered expectations for cash flow amid increased competition and higher borrowing costs. Time Warner Cable said it also plans to take a charge of about $350 million related to its investment in Clearwire.

    Time Warner is to report fourth-quarter earnings Feb. 4.

     


    From The Wall Street Journal Accounting Weekly Review on November 14, 2008

    AutoNation's Big Loss Traces Back to Detroit
    by Neal E. Boudette and Sharon Terlep
    The Wall Street Journal

    Nov 07, 2008
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Business Segments, Goodwill, Impairment

    SUMMARY: The article reports on a business segment analysis undertaken by AutoNation which revealed profitability issues tied directly to automotive dealerships selling the Big Three U.S. auto makers' products. The segment analysis led to a write down of $1.46 billion "to cover a sharp decline in the value of dealerships selling vehicles made by General Motors Corp., Ford Motor Co. and Chrysler LLC. Without the charge, the auto retailer would have earned $44 million." Questions ask students to verify their determination of the analysis leading to this write-down (a goodwill impairment test) in the company's 10-Q filing for the quarter ended September 30, 2008, made on November 7, 2008. The filing also reveals that the company initiated segment reporting along these three product lines in this quarterly report.

    CLASSROOM APPLICATION: Goodwill impairment testing and segment reporting are covered in this article.

    QUESTIONS: 
    1. (Introductory) Describe AutoNation Inc.'s business, using some of the information about the three different business segments discussed in the article.

    2. (Introductory) How do each of AutoNation's three business segments differ in profitability?

    3. (Advanced) AutoNation's CEO Jackson states, "There has to be a justifiable return on capital." What is the problem with AutoNation's return on capital invested in the franchises selling automobiles from the Big Three U.S. manufacturers? In your answer, define the ratio "return on capital".

    4. (Advanced) What is a "noncash charge...to cover a sharp decline in the value of dealerships selling vehicles made by General Motors Corp., Ford Motor Co. and Chrysler LLC"? From what analysis do you think this charge stems?

    5. (Advanced) Why do you think that AutoNation analyzed this breakdown of sales and profitability into three categories for the first time in the third quarter of this year?

    6. (Advanced) Examine the AutoNation 10-Q filing for the quarter ended September 30, 2007, and filed on November 7, 2008, available at http://www.sec.gov/Archives/edgar/data/350698/000095014408008262/g16446e10vq.htm#104. Alternatively, click on the live link to AutoNation in the on-line WSJ article, click on SEC Filings in the left-hand column, and click on the html link to the 10-Q filing. Confirm your answers to questions 4 and 5 above with evidence from the financial statements. Describe and explain the significance of the evidence you find.

    7. (Advanced) "The large write-down means the company has very little value tied up in its Big Three stores." What might happen to reported income if these automobile dealership locations are sold?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    "AutoNation's Big Loss Traces Back to Detroit," by Neal E. Boudette and Sharon Terlep, The Wall Street Journal, November 7, 2008 --- http://online.wsj.com/article/SB122598503324005039.html?mod=djem_jiewr_AC

    AutoNation Inc., the country's largest car-dealership chain, reported a $1.4 billion loss in the third quarter and left little doubt it sees Detroit as its problem.

    It also suggested that in the future it's likely to put more resources into stores selling foreign-made cars at the expense of those carrying Big Three vehicles.

    The loss, AutoNation's first quarterly setback since 1999, was the result of a noncash charge of $1.46 billion to cover a sharp decline in the value of dealerships selling vehicles made by General Motors Corp., Ford Motor Co. and Chrysler LLC. Without the charge, the auto retailer would have earned $44 million.

    This is the first time AutoNation has broken out earnings generated by its Big Three, import-brand and luxury-car dealerships, and they showed what a drag GM, Ford and Chrysler were on its business.

    In a telephone interview, Chairman and Chief Executive Michael J. Jackson said the earnings breakdown reveals "where the greatest weakness is and where the greatest strength is" in AutoNation's operations.

    He also said the breakdown will drive future decision-making and could result in allocating more capital to the franchises of import manufacturers like Toyota Motor Corp. and Honda Motor Co. and luxury nameplates like Mercedes-Benz and BMW AG.

    "There has to be a justifiable return on capital, and we are on a very different track with the domestic manufacturers than we are with the imports or premium-luxury" brands, he said.

    Big Three franchises account for almost half of AutoNation's 238 stores but generated just $23 million in pretax profit, only a fifth of the total and a decline of 57% from a year earlier. Import stores, which mainly include Toyota and Honda vehicles, produced pretax profit of $53 million, down 19%. Pretax profit from luxury franchises, which include Mercedes-Benz, BMW and Lexus, was $43 million, down 24%.

    AutoNation's loss was a reversal from its $72 million profit a year ago. It amounted to a per-share loss of $7.95, compared with a profit of 39 cents a share the year before. Revenue declined to $3.5 billion from $4.5 billion.

    Michael Maroone, AutoNation's chief operating officer, said the company is likely to join other large dealership chains in selling some of its Detroit-brand dealerships in the next few years. "As the industry moves forward, the auto retail landscape will include fewer domestic stores," he said.

    The large write-down means the company has very little value tied up in its Big Three stores. Most are located on real estate that AutoNation owns and could sell if it decided to close the stores, Mr. Jackson said.

    U.S. auto sales have been falling since the spring because of high gasoline prices and the sluggish economy. But the decline worsened in September and October as credit dried up for both consumers and dealers.

    In October, new-car sales fell 30% to a 25-year low, with the Big Three suffering the most. GM's sales fell 45%. Together the Detroit auto makers had 47% of the market, down from 51% a year ago.


    "The GM IPO: Are You Buying It?" by Francine McKenna, Forbes, November 4, 2010 ---
    http://blogs.forbes.com/francinemckenna/2010/11/04/the-gm-ipo-are-you-buying-it/

    The Obama administration says the bailout of General Motors (NYSE:GM) is a success.  Their former car czar, Steve Rattner, may have moved the ball out of the opposing team’s end zone by avoiding a full scale, free-for-all bankruptcy like Lehman’s, but that doesn’t mean we should be celebrating any touchdowns just yet.

    Mr. Rattner has a new book out about his experience at GM. It’s Rattner’s view – or his publicist’s – that Overhaul: An Insider’s Account of the Obama Administration’s Emergency Rescue of the Auto Industry,  “captures a unique moment in American business that will have lasting influence on all industries, as the archetypal American industry (which helped create our nation’s wealth and status) is used to write the playbook for corporate bailouts.”

    God, I hope not.

    The U.S. government plans to sell the GM garbage barge back to investors after taxpayers poured $50 billion in to save it. GM will report final third-quarter figures on November 10th, a week ahead of its November 18th IPO. The company “projects” a third-quarter profit of between $1.9 billion and $2.1 billion, according to preliminary results the automaker released yesterday. It’s supposedly the third consecutive quarterly profit for post-bankruptcy GM but none of those numbers were audited and the financial statements included in the prospectus for the share offering are also unaudited.

    I’m skeptical about any numbers GM issues, whether blessed by their auditor Deloitte or not.

    Tom Selling, blogging at The Accounting Onion, extends an argument made by Jonathan Weil in early September: “GM’s shareholders’ equity at December 31, 2009 would have been a negative $6.2 billion if it were not able to book a whole bunch of goodwill. To say that few companies would be able to pull off a successful IPO with a negative number for shareholders’ equity on its balance sheet would be an understatement. To say the same after applying fresh-start accounting would be a statement of fact.”

    General Motors included a litany of potential risks in its IPO prospectus. One of them is the “current” weakness of internal controls over its internal financial reporting. GM’s internal controls over financial reporting were still not effective on June 30. The issue was previously disclosed in GM’s 2009 annual report. And its 2008, 2007 and 2006 annual reports.

    In March of 2007, GM reported, “ineffective internal controls over financial reporting might make it difficult for the company to execute on its business plan.” At that time, GM was also under investigation by the SEC on several matters, including financial reporting related to pension accounting, transactions with suppliers including their former subsidiary Delphi (another bankrupt company) and transactions in precious metals.

    The only news here is that a lot of suckers will invest in a company that hasn’t produced financial reports anyone should trust in a long time. Amongst many other weaknesses, they never have enough competent accounting professionals to book the complex transactions it takes to create their balance sheet.

    When companies go bankrupt, their underfunded pensions are taken over by the Pension Benefit Guaranty Corp. (PBGC), a government-run, industry-funded insurance agency, which then pays retirees a fraction of what they were owed. But that didn’t happen in the GM bankruptcy. The UAW resisted, according to the Washington Post. GM’s defined-benefit plans for US employees were underfunded by $16.7 billion as of June 30. GM’s prospectus says federal law will require it to start pumping in “significant” amounts by 2014 if not sooner.

    When I wrote about my preference for a real GM bankruptcy, I thought it would also be great for GM’s employees to see how the other half lives with regard to health insurance.  Putting GM’s former employees on the rolls of a single-payer, government-funded program (my hope at the time) would provide additional economies of scale and volume buying power for the government as well as get rid of this monkey on our back. No longer would taxpayers, or car buyers, subsidize health benefit entitlements that are way beyond what anyone else gets these days.  Reset expectations for this constituency and we can all move on.

    Unfortunately, neither the outsize pension liabilities nor the unrealistic healthcare benefits for these employees and retirees were cut down to size by the US government’s approach.

    In August of 2008, General Motors and their auditor Deloitte settled a class-action securities lawsuit against them alleging the automaker filed misleading financial reports between 2002 and 2006. GM paid $277 million and Deloitte kicked in $26 million.

    GM was forced to reduce the amount paid to auditor Deloitte after the Sarbanes-Oxley Act prohibited companies from using the same firm as a consultant and an auditor. About $49 million was spent on Deloitte for consulting services in 2001 and only $21 million was for audit work.  By 2008, GM’s bill for audit work was up to $31.5 million.

    Deloitte has been GM’s auditor since 1918.  That’s ninety-two years of making sure GM survives to pay another invoice.  Don’t bet on independence, objectivity, or lawsuits ruining this beautiful relationship anytime soon.

    Equity shareholders, including pension funds, were completely wiped out in the government's takeover of GM. Why are they so eager to jump back into this kind of risk once again, especially with the pension obligations "hanging over GM's turnaround"?

    "General Motors IPO Insights From Harvard Business School Faculty," by Joseph Bower, Vineet Kumar, and Dante Roscini, Harvard Business Review Blog, November 16, 2010 --- Click Here
    http://blogs.hbr.org/hbsfaculty/2010/11/general-motors-ipo-insights-fr.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    I notice that these three Harvard professors are not accountants or engineers.

    GM pins its hopes on the forthcoming Volt hybrid --- http://en.wikipedia.org/wiki/Chevrolet_Volt
    The above link seems to be relatively fair on the pluses and minuses of the Volt. I suspect this module was edited by GM and all the minuses are shoved to the end of the module.

    An engineer would probably note that the forthcoming Volt was supposed to be an all-electric car that fails to be an all-electric car and is more of a relatively low mileage hybrid --- in part because it's almost as heavy as a tank. The batteries are very expensive to replace, thereby leading to some question as to the resale value of the car relatively to similarly priced competitors. The only hope for GM  is that taxpayers are paying for much of the cost to buyers of new Volts. There certainly appear to be better alternatives for buyers who just do not want to be the first kid on their blocks with a Volt ---
    http://blogs.forbes.com/digitalrules/2010/08/02/twenty-better-values-than-a-chevy-volt/

    At this point, GM’s balance sheet remains loaded with fluff and OBSF Worries
    An accountant might note the fluff in the GM's financial statements going into this IPO. Is the financial risk for investors in this IPO distinguishing the Las Vegas nature of this IPO?

    Equity shareholders, including pension funds, were completely wiped out in the government's takeover of GM. Why are they so eager to jump back into this kind of risk once again, especially with the pension obligations "hanging over GM's turnaround"?

     

    "How GM Made $30 Billion Appear Out of Thin Air," by Jonathan Weil, Bloomberg, September 8, 2010 ---
    http://www.bloomberg.com/news/2010-09-09/how-gm-made-30-billion-appear-from-thin-air-commentary-by-jonathan-weil.html

    It will be a long time before General Motors Co. can shake the stigma of being called Government Motors. Here’s another nickname for the bailed-out automaker: Goodwill Motors.

    Sometimes the wackiest accounting results are the ones driven by the accounting rules themselves. Consider this: How could it be that one of GM’s most valuable assets, listed at $30.2 billion, is the intangible asset known as goodwill, when it’s been only a little more than a year since the company emerged from Chapter 11 bankruptcy protection?

    That’s the amount GM said its goodwill was worth on the June 30 balance sheet it filed last month as part of the registration statement for its planned initial public offering. By comparison, GM said its total equity was $23.9 billion. So without the goodwill, which isn’t saleable, the company’s equity would be negative. This is hardly a sign of robust financial strength.

    GM listed its goodwill at zero a year earlier. It’s as if a $30.2 billion asset suddenly materialized out of thin air. In the upside-down world that is GM’s balance sheet, that’s exactly what happened.

    Indeed, the company’s goodwill supposedly is worth more than its property, plant and equipment, which GM listed at $18.1 billion. The amount is about eight times the $3.5 billion GM is paying to buy AmeriCredit Corp., the subprime auto lender. Another twist: GM said its goodwill would have been worth less had its creditworthiness been better. Talk about a head- scratcher. (More on this later.)

    Not Normal

    This isn’t the way goodwill normally works. Usually it comes about when one company buys another company. The acquirer records the other company’s net assets on its books at their fair market value. It then records the difference between the purchase price and the net assets it bought as goodwill.

    The origins of GM’s goodwill are more convoluted. Shortly after it filed for bankruptcy last year, GM applied what’s known as “fresh-start” financial reporting, used by companies in Chapter 11. Through its reorganization, GM initially slashed its liabilities by about $93.4 billion, or 44 percent. Under fresh- start reporting, though, GM’s assets rose by $34.6 billion, or 33 percent, mainly because of the increase to goodwill.

    GM’s explanation? The company said it wouldn’t have registered any goodwill under fresh-start reporting if it had booked all its identifiable assets and liabilities at their fair market values. However, GM recorded some of its liabilities at amounts that exceeded fair value, primarily related to employee benefits. The company said the decision was in accordance with U.S. accounting standards on the subject.

    Funky Numbers

    The difference between those liabilities’ carrying amounts and fair values gave rise to goodwill. The bigger the difference, the more goodwill GM booked. In other instances, GM said it recorded certain tax assets at less than their fair value, which also resulted in goodwill.

    On the liabilities side, for example, GM said the fair values were lower than the carrying amounts on its balance sheet because it used higher discount rates to calculate the fair value figures. The higher discount rates took GM’s own risk of default into account, which drove the fair values lower.

    Here’s where it gets really funky. If GM’s creditworthiness improves, this would reduce the difference between the liabilities’ fair values and carrying amounts. Put another way, GM said, the goodwill balance implied by that spread would decline. That could make GM’s goodwill vulnerable to writedowns in future periods, which would reduce earnings.

    Unexpected Outcome

    A similar effect would ensue on the asset side if GM’s long-term profit forecasts improved. Under that scenario, GM could recognize higher tax assets and bring their carrying amount closer to fair value, narrowing the spread between them.

    So, to sum up, the stronger and more creditworthy GM becomes, the less its goodwill assets may be worth in the future. An intuitive outcome, this is not.

    There’s a broader storyline here. Normally when companies go public, they’re supposed to be prepared from a business and financial-reporting standpoint to take on the responsibilities of public ownership. GM’s IPO, of course, is a much different animal. Taxpayers already own most of the company. Now the government is trying to unload its 61 percent stake back onto the investing public, though it may take years before the government can sell it completely.

    Fluffy Balance Sheet

    At this point, GM’s balance sheet remains loaded with fluff, as the goodwill illustrates. GM said its August deliveries were down 25 percent from a year earlier, so it’s not as if business is booming. Moreover, GM disclosed that it still has material weaknesses in its internal controls, which is a fancy way of saying it doesn’t have the necessary systems in place to ensure its financial reporting is accurate.

    This being the political season, the Obama administration has made clear that it wants GM to complete the IPO this year, so the president can claim a policy success. It’s bad enough GM needed a taxpayer bailout. What would be worse is taking the company public again prematurely.

    This much is certain: The next time GM wants to create $30 billion out of nothing, it won’t be so easy.

    Also see Francine's article at
    http://blogs.forbes.com/francinemckenna/2010/11/04/the-gm-ipo-are-you-buying-it/

    "Pension time bomb: The shadow hanging over GM's turnaround," The Washington Post, August 27, 2010

    PRESIDENT OBAMA has a riposte for critics of his decision to rescue General Motors and Chrysler: You can't argue with success. And much good news has emanated from Detroit of late, especially from GM. Having wiped out almost all of its debt through an administration-orchestrated bankruptcy process, slashed excess plants and streamlined operations, GM is once again turning a profit: $2.2 billion so far in 2010. Sales are up; promising new models are coming to market. GM's aggressive new management is planning a public stock offering, which would let the Treasury Department start unloading the 61 percent stake it bought for nearly $50 billion. U.S. officials speak of escaping with modest losses -- a small price for averting industrial catastrophe.

     

    All true -- up to a point. But the company's stock prospectus points to several reasons for caution, including such obvious ones as the sluggish U.S. economy and overcapacity in global auto manufacturing. And then there's a threat that the Obama-supervised bankruptcy did not address: the precarious condition of GM's immense pension plans.

     

    With almost $100 billion in liabilities, GM's defined-benefit plans for U.S. employees (one covers a half-million United Auto Workers members, another, 200,000 white-collar personnel) are the largest of any company in America. Yet they were underfunded by $17.1 billion as of the end of 2009, and the underfunding had only slightly lessened, to $16.7 billion, as of June 30. (Chrysler has a similar problem, on a smaller scale.) Having been filled with borrowed money before Chrysler's bankruptcy, the funds can limp along for a couple of years. But, as GM's prospectus acknowledges, federal law will require it to start pumping in "significant" amounts by 2014 if not sooner. GM does not say exactly how much, but an April Government Accountability Office report suggested that a $5.9 billion injection might be required initially, with larger ones to follow. In other words, any investor who buys GM stock is buying stock in a firm whose revenue is already partially committed to retired workers.

     

    When companies go bankrupt, their underfunded pensions often are taken over by the Pension Benefit Guaranty Corp. (PBGC), a government-run, industry-funded insurance agency, which then pays retirees a fraction of what they were owed. But that didn't happen in the GM-Chrysler bankruptcy. The UAW resisted what would have been a huge reduction in the generous benefits of its members, especially the many who retire before age 65. And the Obama administration chose not to push back.

     

    The net effect is that the pension time bomb is still ticking. If GM earns robust profits, even more robust than it is making now, the bomb won't detonate. Otherwise -- well, in a worst-case scenario, GM winds up back in bankruptcy, with PBGC intervention both unavoidable and more expensive than it would have been last year. And that could necessitate a bailout from Congress, because of the PBGC's own deficits.

    We're not offering investment advice -- just a dash of realism about a still-troubled industry, and a warning that its dependence on taxpayers may not be ended so easily.

    Bob Jensen's threads on pension accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#Pensions

    Bob Jensen's threads on the bailout are at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm

    Equity shareholders, including pension funds, were completely wiped out in the government's takeover of GM. Why are they so eager to jump back into this kind of risk once again, especially with the pension obligations "hanging over GM's turnaround"?

    Bob Jensen's threads on Deloitte ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm


     

    "MCI Inc. Posts $3.4 Billion Loss For 3rd Quarter," by Shawn Young, The Wall Street Journal, November 5, 2004, Page B2 --- http://online.wsj.com/article/0,,SB109956924948864745,00.html?mod=technology_main_whats_news 

    Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop 

    Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop By SHAWN YOUNG Staff Reporter of THE WALL STREET JOURNAL November 5, 2004; Page B2

    MCI Inc. reported a $3.4 billion third-quarter loss, reflecting a $3.5 billion write-off the phone giant has said it is taking on assets that have lost value.

    The company also cautioned that 2004 revenue will be slightly below the $21 billion to $22 billion it had projected early in the year.

    "Slightly means slightly," said Chief Executive Michael Capellas. He noted that the company hadn't changed its projections since a regulatory setback led MCI and larger rival AT&T Corp. to virtually abandon marketing of home phone service to consumers. Both companies are now focused almost exclusively on business customers.

    Despite the revenue decline, MCI projects a fourth-quarter profit, the result of improving margins, lower costs and a little stabilization in the price wars that have wracked the long-distance industry. The profit would be the first for the former WorldCom Inc. in years. The company filed for Chapter 11 bankruptcy protection in 2002 in the wake of a massive accounting fraud. It emerged under the name MCI in April.

    The improving trends that could produce a fourth-quarter profit were also evident in operating results for the third quarter, which largely met investor expectations.

    Continued in the article

    Bob Jensen's threads on the Worldcom and MCI scandals are at http://faculty.trinity.edu/rjensen/FraudEnron.htm#WorldCom 


    "How to Avoid the Goodwill Asteroid," by Jon D. Markman, TheStreet.com, May 24, 2002 --- http://www.thestreet.com/funds/supermodels/10024147.html 

    One of the gravest fears of investors today is being totaled by an "asteroid" event -- moments when a stock gets pushed to the edge of extinction by a bolt from the blue, such as a drug application rejection, a securities probe revelation or a surprise earnings restatement.

    Yet many shareholders seem blithely unaware that at least one asteroid speeding toward their companies is entirely foreseeable: the likelihood that management will have to write down a decent-sized chunk of their net worth sometime this year and perhaps rather soon.

    This unfortunate prospect is faced, potentially, by companies such as AOL Time Warner (AOL:NYSE - news - commentary - research - analysis), Allied Waste Industries (AW:NYSE - news - commentary - research - analysis), Georgia-Pacific (GP:NYSE - news - commentary - research - analysis) and Cendant (CD:NYSE - news - commentary - research - analysis) that have accumulated a great deal of goodwill on their balance sheets over the past few years. That's accountant-speak for the amount a company pays for another company over its book value because of expectations that some of its intangible assets -- such as patented technology, a prized brand name or desirable executives -- will prove valuable in a concrete, earnings-enhancing sort of way.

    New Accounting Rules

    Companies carry goodwill on their balance sheets as if it were an asset as solid as a piece of machinery, and therefore it is one of many items balanced against liabilities, such as long-term debt, to measure shareholder equity or book value. Just as hard assets are depreciated, or expensed, by a certain amount each year to account for their diminished value as they age, intangibles have long been amortized by a certain amount annually to account for their waning value.

    The value of machinery rarely dissipates quickly, but the value of goodwill can evaporate in a flash if a company determines that it paid too much for intangible assets -- e.g., if a patent or brand turns out not to be as defensible as originally believed, or demand for a new technology falters. As you can imagine, companies typically don't want to admit they overpaid. But once they do, they must write down the vanished value so that the "intangibles" lines on their balance sheets reflect fair-market pricing. If the writedown leaves a company's assets at a level lower than liabilities, the company is left with a negative net worth, which, as you would expect, is frowned upon, and often results in a dramatically lower stock price.

    Until last year, companies tried to avoid recording goodwill after acquisitions by using a method of accounting called "pooling of interests." In these stock-for-stock deals, companies were allowed to record the acquiree's assets at book value even though the value of the stock it had given up was greater than the amount of real stuff its shareholders received. The advantage: No need to drag down earnings each quarter by amortizing, or expensing, goodwill.

    The rulebook changed this year, however, and pooling went the way of the dodo; now companies are forced to record goodwill on their books. As a compromise to serial acquirers, who have a powerful lobby, the Financial Accounting Standards Board (FASB) decided that companies would no longer have to amortize goodwill regularly against earnings. Instead, a new standard -- encompassed in Rule 142 -- requires companies to test goodwill for "impairment" periodically.

    Essentially, this means that while the diminished value of goodwill won't count against a company's earnings annually anymore, companies might need to write down huge gobs of it from time to time when accountants decide they can't ignore the fact that an acquisition didn't turn out as planned. It also means that because FASB 142 does not dictate a set of strictly objective rules for calculating impairment, writedowns will be somewhat subjective in both timing and amount.

    Don't Fall for These Three Ploys

    As a result, many market skeptics believe that FASB 142, which was intended to improve earnings transparency, may in some cases actually result in more egregious earnings manipulation than ever. Donn Vickrey, vice president at Camelback Research Alliance, a provider of analytical tools and consulting services for financial information, says he sees three ways that companies interested in managing their earnings could end-run shareholders using the new rule.

    The big bath. In this approach, companies will write off a big portion of the goodwill on their books, telling investors it is an insignificant "paper loss" that should have no impact on the firm's share price. The benefit: Future write-offs would be unnecessary, and the company's earnings stream could be more effectively smoothed out in future periods. This approach would work only if it does not put the company at risk of violating debt covenants that require it to maintain a certain ratio of assets vs. liabilities.

    Cosmetic earnings boost. Under FASB 142, many companies will record earnings that appear higher than last year's because of the elimination of goodwill amortization. However, the increase will be purely cosmetic, as the company's underlying cash flow and profitability would remain unchanged. Investors should thus ensure they are comparing prior periods with the current period on an apples-to-apples basis by eliminating goodwill amortization from comparable year-earlier financial statements. The amount might be buried in footnotes to the balance sheet, though Kellogg (K:NYSE - news - commentary - research - analysis) explains the issue clearly in its latest 10-k in the section devoted to its acquisition of cookie maker Keebler in March 2001. Kellogg says it recorded $90.4 million in intangible amortization expense during 2001 and would have recorded $121 million in 2002 had it not adopted FASB 142 at the start of the year.

    Avoid-a-write-off. Some companies might take advantage of the new rule by avoiding a goodwill write-off as long as possible to prevent the big charge to earnings. Since the tests for impairment are subjective, Camelback believes it will not be hard for firms to avoid write-offs in the short run -- a strategy that could both help them avoid violations in debt covenants and potentially provide a boost in executive compensation formulas.

    While any public company that does acquisitions will find itself facing decisions about how to account for goodwill impairment, companies with the greatest absolute levels of goodwill -- as well as ones with the greatest amount of goodwill relative to their market capitalization -- will be the most vulnerable in the future to having their earnings blasted by the FASB 142 asteroid.

    Continued at http://www.thestreet.com/funds/supermodels/10024147.html 


    "The Revisions to IFRS 3:  Bad Enough to Abandon Faith in IFRS?" by Tom Selling, The Accounting Onion, June 16, 2008 --- http://accountingonion.typepad.com/theaccountingonion/2008/06/ifrs-3-fall-short-of-convergence-again.html

    In my previous post, I described how an SEC honcho, while speaking to the choir at an event sponsored by FEI, espoused his version of faith-based accounting; though he could not provide a single, solid reason to explain why the U.S. should adopt IFRS, he has seen the light and has become a true believer. In contrast, reason-based accounting permits recitation of a vast litany of blasphemies against IFRS to make one a serious, if not committed, agnostic. Today, I write of one of these latest abominations: the latest revision to IFRS 3 on the accounting for business combinations.

    Goodwill and NCI: IASB Fakes Right and Goes Left

    Perhaps the most significant development in the accounting for business combinations is that FAS 141(R) now requires the same basis of measurement for assets acquired and liabilities assumed, regardless of the percentage of a company acquired (so long as control is achieved). Therefore, if control is attained without purchasing 100% of the existing equity interests in the acquiree, non-controlling interests (NCI) must be measured at full fair value.

    As you may be aware from reading my post "What Good Comes from Goodwill Accounting?", I am not a big fan of recognizing 'goodwill' under any circumstance, so I will grant that the justification for the FASB's approach is not airtight. Nevertheless, it was common knowledge that the FASB was given to understand that, by sticking its neck out to make these controversial changes to FAS 141(R), the IASB would follow suit.

    Instead, the IASB renegged on its promise in the worst way imaginable: they voted to allow entities a free choicebetween the partial and full fair value alternatives to goodwill and NCI measurement. What's more, issuers can make their choice on a transaction-by-transaction basis -- kind of like going to church one week and synagouge the next. Not even the most devoted acolyte can spin this any other way except as a significant step backwards from establishing the IASB as a credible agent of quality financial reporting and investor protection.

    And, it's not just me who is outraged. Read the strongly-worded dissents* of Mary Barth and John Smith, two of the three Americans on the IASB. As to the third American, Jim Leisenring, I guess I shouldn't be surprised that he capitulated to the majority. Leisenring was the most prominent voice in support of FAS 133 (on hedge accounting) when he was on the FASB; a standard whose middle name is inconsistency. Be that as it may, one can only imagine where the IASB will take the interests of U.S. investors when our membership, and hence our influence, on IFRS inevitably wanes.

    Mind These GAAPs, Too

    If the unprincipled and unconstrained choice of accounting treatments for goodwill and NCI aren't enough for you to abandon any faith in a high-quality convergence, consider two more of the numerous departures from U.S. GAAP; these may be even worse.

    First, the devilish game of managing the timing of contingent liabilities still thrives in IFRS. FAS 141(R) now requires that any non-contractual, contingent liability assumed in a business combination must be recognized at fair value, if the probability of occurrence is more likely than not. IFRS allows any contingent liability to be recognized, regardless of likelihood, if it can be reliably measured.

    As I discussed in a previous post on IASB machinations of contingent liability accounting, the ubiquitous criterion of "reliable measurement" is one of those areas of "judgement" in IFRS that help management make their numbers with little chance of being challenged by auditors. Here is how this game will be played in a business combination under IFRS 3(R): if management thinks that goodwill won't be impaired any time soon, they will recognize contingent liabilities to the max. The effect is to create an earnings bank of liability writedowns when unlikely events become, as anticipated, resolved without the incurrence of an actual liability. And speaking of inconsistency, IFRS 3(R) provides that all intangible assets are to be recognized, even if their fair values cannot be measured reliably. Where is the "principle" for that one?

    Second, FAS 141(R) requires extensive disclosures that are designed to aid analysts in determining the past and future effect of a business combination on earnings and financial position. For example, FAS 141(R) requires the following disclosures:

    The amount of revenue and earnings of the acquiree since the date of acquisition. Revenue and earnings of the combined entity for the current period as though the acquisition had been consummated as of the beginning of the period Revenue and earnings of the combined entity for the previous period, as if the acquisition had been consummated as of the beginning of the previous period. Inexplicably, IFRS does not require the third item, above. Therefore, inferences as to earnings trends of the combined entity from historical financial statements are defeated.

    The recent activities of the IASB, the high priests of IFRS, confirm that they are most definitely not the august body to which the future of U.S. financial accounting standards should be entrusted. To those who persist in practicing faith-based accounting, put IFRS's accounting for business combinations in your pipe and smoke it.

    --------------------------

    *Unlike statements of the FASB, IFRS publications are not freely available. Just thought you might want to know why I didn't provide a link.

    Bob Jensen's threads on goodwill accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#Impairment

    IFRS 3 on Business Combinations

    Contents paragraphs Introduction IN1–IN16 International Financial Reporting Standard 3 Business Combinations Objective 1 Scope 2–13 Identifying a business combination 4–9 Business combinations involving entities under common control 10–13 Method of accounting 14–15 Application of the purchase method 16–65 Identifying the acquirer 17–23 Cost of a business combination 24–35 Adjustments to the cost of a business combination contingent on future events 32–35 Allocating the cost of a business combination to the assets acquired and liabilities and contingent liabilities assumed 36–60 Acquiree's identifiable assets and liabilities 41–44 Acquiree's intangible assets 45–46 Acquiree's contingent liabilities 47–50 Goodwill 51–55 Excess of acquirer's interest in the net fair value of acquiree's identifiable assets, liabilities and contingent liabilities over cost 56–57 Business combination achieved in stages 58–60 Initial accounting determined provisionally 61–65 Adjustments after the initial accounting is complete 63–64 Recognition of deferred tax assets after the initial accounting is complete 65 Disclosure 66–77 Transitional provisions and Effective date 78–85 Previously recognised goodwill 79–80 Previously recognised negative goodwill 81 Previously recognised intangible assets 82 Equity accounted investments 83–84 Limited retrospective application 85 Withdrawal of Other Pronouncements 86–87 Appendices A Defined terms B Application supplement C Amendments to other IFRSs Approval of IFRS 3 by the Board Basis for Conclusions Dissenting opinions on IFRS 3 Illustrative Examples [Extracted from IFRS 3, Business Combinations. © IASC Foundation.]

     


    From The Wall Street Journal Accounting Educators' Review on Junly 30, 2004

    TITLE: FASB May Bite Into Overseas Profits 
    REPORTER: Lingling Wei 
    DATE: Jul 28, 2004 
    PAGE: C3 
    LINK: Print Only 
    TOPICS: Financial Accounting, Financial Accounting Standards Board, International Accounting Standards Board

    SUMMARY: The FASB has voted 4-3 to instruct the staff to examine "whether it is practical to require companies to book a liability for taxes they potentially owe on profits earned and held overseas."

    QUESTIONS: 
    1.) What was the vote undertaken at the Financial Accounting Standards Board (FASB)? Did this vote actually establish a new accounting requirement? Explain, commenting on the FASB's process for establishing a new accounting standard.

    2.) Why did the FASB undertake this step with respect to deferred taxes? How does it fit in with other work being undertaken in concert with the International Accounting Standards Board?

    3.) FASB member Michael Crooch comments that "there is a fair amount of opposition to the change" proposed by the FASB. Do you think such opposition is unusual or common for FASB proposals? Support your answer.

    4.) Define the term "deferred taxes". When must deferred taxes be recorded? Why do we bother to record them? That is, how does the process of reporting deferred taxes help to improve reporting in the balance sheet and income statement?

    5.) What taxes currently are recorded on foreign earnings? Why do companies currently not calculate deferred taxes for profits on foreign earnings? Why then would any change in this area result in "a major hit to earnings"?

    6.) Why do you think that companies might reconsider repatriating foreign earnings if they must begin to record deferred taxes on those amounts? What does your answer imply in regards to the economic consequences of accounting policies?

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


    From The Wall Street Journal Accounting Educators' Review on December 13, 2002

    TITLE: International Body to Suggest Tighter Merger Accounting 
    REPORTER: Silvia Ascarelli and Cassell Bryan-Low 
    DATE: Dec 05, 2002 
    PAGE: A2 
    LINK: http://online.wsj.com/article/0,,SB1039033389416080833.djm,00.html  
    TOPICS: Advanced Financial Accounting, Financial Accounting, Financial Statement Analysis, Goodwill, International Accounting, International Accounting Standards Board, Restructuring

    SUMMARY: The International Accounting Standards Board (IASB) is proposing a new standard for business combination accounting. The proposal prescribes accounting treatment that is more stringent than U.S. standards. For example, it disallows recording restructuring charges at the outset of a business combination; such charges must simply be recorded as incurred.

    QUESTIONS: 
    1.) Compare and contrast the standard for business combinations proposed by the IASB to the current U.S. standard. To investigate these differences directly from the source, access the IASB's web site at http://www.iasc.org.uk/cmt/0001.asp.

    2.) Why are U.S. companies expected to be concerned about recording restructuring charges as they are incurred in the process of implementing a business combination, rather than when these anticipated costs are identified at the outset of a business combination? Do these two accounting treatments result in differing amounts of expense being recorded for these restructuring charges? Will such U.S. companies be required to report according to this IAS, assuming it is implemented?

    3.) How are the goodwill disclosures proposed in the IAS expected to help financial statement analysis?

    4.) How are European companies expected to be impacted by this proposed IAS and future proposals currently planned in this area of accounting for business combinations? Provide your answer by considering not only the article under this review, but also by again accessing the IASB's web site referenced above.

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

    Program professors can search past editions of Educators' Reviews at http://ProfessorJournal.com.  
    Go to the Educators' Review section and click on "Search the Database." You can also change your discipline selection or remove yourself from the mailing list.

     

    Some intangible assets are booked and amortized.  Accounting guidance in this area dates back to APB 17.  Usually these are contractual or legal rights (patents, copyrights, etc.) and amortizations and write downs are to be based on the following provisions in Paragraph 27 of APB 17:

    The Board believes that the value of intangible assets at any one date eventually disappears and that the recorded costs of intangible assets should be amortized by systematic charges to income over the periods estimated to be benefited. Factors which should be considered in estimating the useful lives of intangible assets include:

    • Legal, regulatory, or contractual provisions may limit the maximum useful life.
    • Provisions for renewal or extension may alter a specified limit on useful life.
    • Effects of obsolescence, demand, competition, and other economic factors may reduce a useful life.
    • A useful life may parallel the service life expectancies of individuals or groups of employees.
    • Expected actions of competitors and others may restrict present competitive advantages.
    • An apparently unlimited useful life may in fact be indefinite and benefits cannot be reasonably projected.
    • An intangible asset may be a composite of many individual factors with varying effective lives.

    When a company purchases another company, the purchase price may soar way above the book value of the acquired firm.  The reason for the unbooked excess is the unbooked market values of booked and unbooked assets plus synergy increments  less negative value of unbooked liabilities. Paragraph 39 of FAS 141 requires the partitioning of the unbooked excess value into (1) separable versus (2) inseparable components of unbooked excess purchase value.  The inseparable portion is then booked as "goodwill."  This portion is then booked as goodwill and is carried forward as an asset subject to impairment tests of FAS 142.  Paragraph 39 of FAS 141 requires an intangible asset to be recognized as an asset apart from goodwill if it arises from:

    · contractual or other legal rights, regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations; or

    · separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged regardless of whether there is an intent to do so. An intangible asset is still considered separable if it can be sold transferred, licensed, rented, or exchanged in combination with a related contract, asset or liability.

    Paragraphs 10-28 of FAS 141 provides examples of intangible assets that are considered "separable" and are not to be confounded in the goodwill account. But the majority of the unbooked excess value is usually the inseparable goodwill arising from "knowledge capital" arising from the following components:

    Knowledge Capital Components

    • Spillover Knowledge (see above)
    • Human Resources (see above)
    • Structural Capital (see above)

    Knowledge capital arises generally from the conservatism concept that guides the FASB and other standard setters around the world.  For example, human resources are not owned, controlled, bought, and sold like tangible assets.  As a result, investment in training are expensed rather than capitalized.  Research and development expenditures are expensed rather than booked under the highly conservatism rulings in FAS 2.  This includes most R&D in database and software development except when impacted by FAS 86.

    Knowledge capital is often the major component of goodwill.  But "goodwill" as defined in FAS 141 and 142 is a hodgepodge of other positive and negative components that comprise the net excess value difference between the market value of total owners' equity and the value of the firm as a whole.  This is summarized below:

    Goodwill Components

    + Market value of Owners' Equity  ($10 billion)
    -     Book value of Owners' Equity  ($01 billion)
    = Market to book difference in value    ($09 billion)
    - Adjustment of booked items to fair value  ($04 billion)
    = Goodwill that includes the following components ($5 billion)
    • Unbooked synergy value of booked items (+$1 billion)
    • Unbooked knowledge capital value (+$04 billion)
    • Other unbooked  items (-$01 billion)
    • Joint effects, including other synergies (+$01 billion)

    The components of goodwill are not generally additive.  For example, a firm has just been purchased for $10 billion and has a book equity value of $1 billion.  The market to book ratio is therefore 10=$10/$1.  Suppose the value of the individual booked assets and liabilities sums to $5 billion even though the booked value on a historical cost basis is only $1 billion.  However, when combined as a bundle of booked items, assume there is a combined value of $6 billion, because the value of the combined booked items is worth more than the $5 billion sum of the parts.  For example, if an airline sells its booked airplanes and airport facilities, these many be worth more as a bundle than the sum of the values of all the pieces.  If there were no unbooked items, the value of the firm would be $6 billion, thereby, resulting in $1 billion in goodwill arising entirely from synergy of booked items. 

    However, the value of the equity is $10 billion rather than $6 billion.  This difference is due to the net value of the unbooked asset and liability items and the synergies they create in combination with one another.  For example, if an airline sells the entire business in addition to its airplanes and airport facilities, there is added value due to the intellectual capital components such as experienced mechanics, flight crews, computer systems, and ground crews.  There are also negative components such as unbooked operating lease obligations on airplanes not booked on the balance sheet.  

    The components of goodwill are not additve in value, but in combination they sum to the $5 billion in goodwill equal to the market value of the combined equity minus the sum of the market values of the booked items (without the $1 billion in unbooked synergy value).  When combined with the booked items, the unbooked knowledge capital takes on more value than $4 billion it can be sold for individually.  For example, if American Airlines sold its entire SABRE reservations system in one sale and the remainder of the company in another sale, the sum would probably be less than the combined value of the unbooked SABRE system plus all of the booked items belonging to American Airlines.  This is because there is synergy value between the booked and unbooked items.  One of the synergy items is leverage.  Values of booked debt and assets may be more additive in firms having low debt/equity ratios than in high leverage firms where there investors adjust added values for higher risk.

    If investors seek to extrapolate firm value from balance sheet value, they will discover that historical costs are useless and that adustments of booked items to fair value falls way short of total value.  The problem is that major components of value never appear on the balance sheets.  The unbooked knowledge capital components of firm value have become so enormous that it is not uncommon to find market to book values of equity way in excess of the ten to one ratio illustrated above. 

    Goodwill cannot be booked in the United States except when there is a combining of two companies that must now be accounted for as a purchase under FAS 141.  Goodwill is the purchase price less the current fair values of the booked items (not adjusted for synergy value).  No formal attempt is made to report the portion that is knowledge capital, although management may justify the business combination on some identified knowledge capital items.  For example, if Microsoft purchased PeopleSoft, Bill Gates would make a public explanation of why the value of PeopleSoft is almost entirely due to unbooked items relative to booked items in PeopleSoft's balance sheet.

    The main reason why goodwill cannot be booked, unless there is a business combination transaction, is that estimation of the value of the firm on an ongoing basis is too expensive and subject to enormous measurement error.  One common approach is to multiply the market price per share times the number of shares outstanding.  But this is usually far different from the price buyers are willing to pay for all of the shares outstanding.  This difference arises in part because acquiring control usually is far more valueable than the sum of the shares at current trading values.  This difference arises in part because current share prices are subject to transient market price movements of shares of all traded companies, whereas the value of the firm in a business combination deal is much more stable.

    From The Wall Street Journal Accounting Educators' Review on April 4, 2002

    TITLE: Why High-Fliers Built on Big Ideas, Are Such Fast Fallers 
    REPORTER: Greg Ip 
    DATE: Apr 04, 2002 
    PAGE: A1 
    LINK: http://online.wsj.com/article_print/0,4287,SB1017872963341079920,00.html  
    TOPICS: Intangible Assets, Electricity Markets, Goodwill, Managerial Accounting, Pharmaceutical Industry, Research & Development

    SUMMARY: Greg Ip reports on the perils of life-cycle differences based on products and services that are reliant on intangible rather than tangible assets. That value is created with either is undeniable, but significantly riskier when that value is supported by something intangible that may disappear entirely.

    QUESTIONS: 
    1.) What is a product life cycle? How many of the 5 basic stages of a product's life can you name? What has happened to the product life cycle that is heavily dependent on technological changes? What part does intangible assets have in this change? How could the $5 billion in assets of a firm sell for $42 million?

    2.) What does the author mean when he says "value today is increasingly derived from intangible assets - intellectual property, innovative technology, financial services or reputation"? Explain in terms of Alan Greenspan's statement "a firm is inherently fragile if its value-added emanates more from conceptual as distinct from physical assets."

    3.) The article relates the story of Polaroid, once a pioneer noted for its technological prowess. Its "technology" asset formed the basis of its early success. How did technology and innovation finally slay it?

    4.) Other industries are exposed to the same sorts of forces, including the pharmaceutical and fiber-optic industries. How have they fared?

    5.) Why have companies tried to cast off hard assets in favor of intangible assets? In 2000, Jeffrey Skilling said, " What's becoming clear is that there's nothing magic about hard assets. They don't generate cash. What does is a better solution for your customer. And increasingly that's intellectual, not physical assets, driven." Do you suppose he's changed his mind?

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

    A common mistake is to assume that "goodwill" is comprised only of unbooked assets such as knowledge capital.  Nothing could be further from the truth in terms of how goodwill is calculated under FAS 141 rules.  Goodwill also includes downward value adjustments for unbooked risk items such as off-balance sheet financing, pending and potential litigation losses, pending and possible adverse legislative and taxation actions, estimated environmental protection expenses, and various industry-specific liabilities such as unbooked frequent flyer certificate obligations.

    From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

    TITLE: Frequent-Flier Programs Get an Overhaul 
    REPORTER: Ron Lieber 
    DATE: Jun 18, 2002 
    PAGE: D1 LINK: http://online.wsj.com/article/0,,SB1024344325710894400.djm,00.html  
    TOPICS: Frequent-flier programs, Accounting

    SUMMARY: Many frequent-flier programs are offering alternative rewards in exchange for frequent-flier miles. Questions focus on accounting for frequent-flier programs and redemption of miles.

    QUESTIONS: 
    1.) What is a frequent-flier program? List three possible ways to account for frequent-flier miles awarded to customers in exchange for purchases. Discuss the advantages and disadvantages of each accounting method.

    2.) Why are companies offering alternative rewards in exchange for frequent-flier miles? How is the redemption of miles reported in the financial statements? Discuss accounting issues that arise if the miles are redeemed for awards that are less costly than originally anticipated.

    3.) The article states that the 'surge in unredeemed points is causing bookkeeping headaches.' Why would unredeemed points cause bookkeeping headaches? Would companies be better off if the points were never redeemed? If a company created a liability for awarded points, in what circumstances could the liability be removed from the balance sheet?

    4.) Refer to the related article. Describe Jet Blue's frequent-flier program. How does stipulating a one-year expiration on frequent-flier points change accounting for a frequent-flier program?

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

    --- RELATED ARTICLES --- 
    TITLE: JetBlue Joins the Fray But With Big Caveat: Miles Expire in a Year 
    REPORTER: Ron Lieber 
    PAGE: D1 
    ISSUE: Jun 18, 2002 
    LINK: http://online.wsj.com/article/0,,SB102434443936545600.djm,00.html 

     

    Liabilities and Equity of Microsoft Corporation

    The off-balance sheet liabilities of Microsoft dwarf the recorded liabilities.

    • The major risk of Microsoft is the ease with which its products can be duplicated elsewhere such as in China.  From a global perspective this gives rise to perhaps billions in lost revenues and enormous expenditures to protect copyrights.

    • There are enormous contingency risks and pending lawsuits, particularly government lawsuits alleging abuse of monopoly powers and civil lawsuits from companies claiming unfair marketing practices and copyright infringements.

     

     

    Entrenched Assets and Market Dominance

    • Microsoft Windows and MS Office
    • AMR Sabre
    • Oracle Databases
    • AOL 

    Market-to-Book (ratio of market value of net assets/book value of net assets) > 6.0

    Conservatism is Largely to Blame

    • R&D expensed under FASB, but only R expensed by IAS
    • Amazon.com's tremendous investment in systems, marketing, and distribution software
    • AOL's customer acquisition costs
    • Distrust of valuations that are highly subjective and subject to extreme volatility
    Managers and auditors "don't want to put anything on the balance sheet that may turn out to be worthless.  If they don't have to value intangible assets, such as AOL's customer acquisition costs, their legal liability is reduced."  Baruch Lev
    Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 --- http://equity.stern.nyu.edu/News/news/levbarrons1120.html
    Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

    Institutional Investors and Security Analysts Are Also At Fault

    Institutional investors and financial analysts are also quite happy with the current system because they think that they've go inside networks and proprietary information."  Baruch Lev
    Source: "The New Math," by Jonathan R. Laing, Barrons Online, November 20, 2000 --- http://equity.stern.nyu.edu/News/news/levbarrons1120.html
    Trinity students may go to J:\courses\acct5341\readings\levNov2000.htm

     

     

    Wages of factory workers are traced directly into finished goods inventories and are "capitalized" costs rather than expenses.  They are carried in the balance sheet as "tangible assets" until the inventory items are sold or perish.  Then these costs become "expenses" in the income statement and are written off to the Retained Earnings account.  Similarly, wages of construction workers on a building are capitalized into the Buildings asset account rather than expensed in the income statement.  These wages become expensed over time in periodic depreciation charges. Costs of labor and direct materials that can be traced to construction of tangible assets thereby become assets and are written off across future periods.  Even indirect labor and material charges may be capitalized as overhead applied to tangible assets.  Tangible assets depict "touchable" items that can be purchased and sold in established markets such as commodity markets, real estate markets, and equipment markets.  

    Wages and salaries of research workers can be traced to particular projects.  However, under most accounting standards worldwide, research costs, including all direct material, labor,  and overhead costs are expensed immediately rather than capitalized as assets even though the revenues from the projects may not commence until many years into the future.  Research projects are typically too unique and too uncertain to be traded in markets.  Accounting standard setters recognize that there are many "intangible" items having future benefits or losses that are not booked as assets or liabilities.  Outlays for development of intangibles are expensed rather than capitalized until they can be better matched with the revenues they generate.  Examples in include research for new or improved products.  Intangibles also include contractual items such as copyrights, advertising, product promotions, and public relations outlays.  When intangibles such as patents and copyrights are purchased, the outlays can be booked as intangible assets.  Costs are then amortized over time.  However, resources devoted to discovery and development of intangibles are generally not booked as assets.  They are expensed when incurred rather than capitalized.  Typical examples of intangible expenses include the following:

    • Research (including development of patent and copyright items)
    • Long-term development of patents, products, and copyrights
    • Advertising and trademarks
    • Employee training and development
    • Public relations

    When an entire firm is purchased, the difference between the total price and the current value of all intangibles is typically booked to a "Goodwill" asset account.  When purchased as a lump sum, goodwill can be carried as an asset until its value is deemed to be "impaired."  However, when developed internally, goodwill is not booked as an asset.  This creates all sorts of problems when comparing similar companies where one company purchased its goodwill and the other company developed it internally.  In the U.S., goodwill accounting must be treated under purchase rather than pooling methods that, in turn, result in booking of "purchased goodwill."  FAS 141 spells out the accounting standards for Goodwill.   

    One requirement under FAS 141 is that contractual items such as patents and copyrights that can be separated from goodwill must be valued separately and be immediately expensed.  This is an attempt in FAS 141 to make it easier to compare a firm that acquires R&D in a business combination with a firm that develops its own R&D.  However, implementation of FAS 141 rules in this regard becomes very murky.

    FAS 142 dictates that firms are no longer required to amortize capitalized goodwill costs.  Instead firms are required to run impairment tests and expense portions of goodwill that has been deemed "impaired."  FAS 142 does not alter standards for intangibles that are not acquired in a business combination.  Hence, standards such as FAS 2 (R&D), FAS 19 (Oil and Gas), FAS 50 (Recording Industry), and FAS 86 (Computer Software) remain intact in situations apart from business combinations.  Paragraph 39(b) of FAS 142 admits to the following:

    In some cases, the cost of generating an intangible asset internally 
    cannot be distinguished from the cost of maintaining or 
    enhancing ... internally generated goodwill.

    There is nothing new about the sad state of accounting for intangibles.   In a working paper entitled "The Measurement and Recognition of Intangible Assets:  Then and Now," Claire Eckstein from Fairleigh Dickinson University quotes the following footnote from 1928:

    The Gold Dust Corporation
    August 31, 1928

    In view of the available surplus, and in the fact that the corporation carries its most valuable asset, viz, its goodwill at $1, and also because of the uncertain market value of industrial plants, it was concluded that it would be entirely approprate for the corporation to carry its plants in a similar manner as its goodwill, viz, at the nominal value of $1.

    The FASB admits that accounting for intangibles is in a sad state in terms of providing relevant information to investors.  An agenda project has been created that is titled "Disclosure of Information about Intangible Assets not Recognized in Financial Statements."  Analysts bemoan the state of accounting for intangibles.  In April 2001, Fortune stated the following:

    In the Fortune 500 there are thousands upon thousands of statistics that reveal very little
    that's meaningful about the corporations they purportedly describe.  At least that's the
    verdict of a growing number of forward-thinking market watchdogs, academics, accountants,
    and others.  Convinced that accounting gives rotten information about the value of performance
    in modern knowledge-intensive companies, they are proposing changes that would be
    earthshaking to the profession.

    Because so much of the problem rests in "knowledge intensive companies," Baruch Lev and others have come to view unrecognized intangibles as being synonymous with unrecognized "knowledge capital."

    Measuring the Value of Intangibles and Valuation of the Firm

    Knowledge Capital Valuation Factors (terminology adapted from Baruch Lev's writings)
    Value Creators
    • Scalability
           Nonrivalry (e.g., the SABRE airline reservations system)
           Increasing Returns (due to initial fixed cost followed by low marginal cost)
    • Network Effects
           Positive Feedback ¨(customer discussion boards)
           Network Externalities (fast word of mouth)
           Industry Standard (Microsoft Windows)

    Value Destroyers

    • Partial Excludability (training of employees who cannot be indentured servants)
           Spillovers
           Fuzzy Property Rights
           Private vs. Social Returns (training that creates immense competition other nations)
    • Inherent Risk
           Sunk Cost
           Creative Destruction (Relational database and ERP destruction of COBOL systems)
           Volatility of value due to competition and technological change
           Risk Sharing (only a few products emerge as winners amidst a trail of road kill)
    • Non-tradability
           Contracting Problems
           Negligible Marginal Cost

    A few years ago a hardback set of the thirty-two volumes of the Britannica cost $1,600…In 1992 Microsoft decided to get into the encyclopedia business…[creating] a CD with some multimedia bells and whistles and a user friendly front end and sold it to end users for $49.95…Britannica started to see its market erode…The company's first move was to offer on-line access to libraries at a subscription rate of $2,000 per year…Britannica continued to lose market share…In 1996 the company offered a CD version for $200…Britannica now sells a CD for $89.99 that has the same content as the thirty-two volume print version that recently sold for $1,600.
    Shapiro and Varian (1999, pp. 19–20)

    On November 14, 2002 the following links were provided at http://pages.stern.nyu.edu/~blev/intangibles.html 

    1. Announcement: Lev's Book: Intangibles-Management, Measurement and Reporting has been published by the Brookings Institution Press. Get your copy now at book stores and retailers.
    2. Paper with Feng Gu: Intangible Assets, discussing Lev's methodology for measuring intangible assets.
    - intangible-assets.doc
    - intangibles-tables.ppt
    (Accompany Tables in Microsoft Powerpoint)
    3.

    Paper with Feng Gu: Markets in Intangibles: Patent Licensing,
    - patent-licensing.doc
    (Microsoft Word)
    - patent-licensing-tables.doc
    (Microsoft Word)

    4. April 16, 2001 - "Accounting Gets Radical" - Fortune
    5. April 2001 - "Knowledge Capital Scoreboard: Treasures Revealed" - CFO online
    6. May 10, 2001 - Interview with Baruch Lev - (in spanish)
    7. May 14, 2001 - "How Do We Guage Value of New Web Technologies?" - Wall Street Journal
    8. May 14, 2001 - "How do you value intangible assets?" - National Law Journal (No Online Version Available)
    9. June 18, 2001 - "Taking Stock of a Company's Most Valuable Assets" - Business Week

     

    There are all sorts of models for valuing an entire firm such that estimates of the value of unbooked items (goodwill) can be derived as the difference between the sum of the values of booked items and the entire value of the firm.  However, derivation of values of knowledge capital becomes confounded by the synergy effects. 

    The major problem is all valuation models is that they entail forecasting into the future based upon extrapolations from past history.  This is not always a bad thing when forecasting in relatively stable industries and economic conditions.  The problem in modern times is that there are very few stable industries and economic conditions.  Equity values and underlying values of intangibles are impacted by highly unstable shifts in investor confidence in equity markets, manipulations of accounting reports, terrorism, global crises such as the Asian debt crises, emergence of China in the world economy, and massive litigation unknowns such as lawsuits regarding mold in buildings.  Forecasting the future from the past is easy in most steady-state systems.  It is subject to enormous error in forecasting in systems that are far from being in steady states.

    The popular models for valuing entire firms include the following:

    • Valuation based upon analyst forecasts.  These alternatives have the advantages of being rooted in data outside what is reported under GAAP in financial statements.  Analysts may meet with top management and consider intangibles.  But there are also drawbacks such as the following:
    • The cart is in front of the horse.  When the purpose of accounting data is to help help investors and analysts set stock prices in securities markets, the forecasts of users (especially leading multiples) for valuation entails circular reasoning.
    • The recent scandals involving security analysts of virtually all major investment firms and brokerages makes us tend to doubt the objectivity and ability of analysts to make forecasts that are not self-serving.  See http://faculty.trinity.edu/rjensen/fraud.htm#Cleland 
    • Analyst forecasts tend to be highly subjective.  Comparing them may be like finding the mean between a banana and a lemon.
    • Valuation using stock price multiples (usually limited to comparing firms in a given industry and adjusted for leverage).  Multiples can be based upon price forecasts (leading multiples) or past price trends (trailing multiples).  In either case, the valuations are suspect for the following reasons:
    • The cart is in front of the horse.  When the purpose of the valuation exercise is to help help investors set stock prices in securities markets, the use of stock prices (especially leading multiples) for valuation entails circular reasoning.
    • Use of the current prices of small numbers of shares traded is not the same as the per-share value of all the shares acquired in a single transaction.  This difference arises in part because acquiring control usually i
    • s far more valuable than the sum of the shares at current trading values.  This difference arises in part because current share prices are subject to transient market price movements of shares of all traded companies, whereas the value of the firm in a business combination deal is much more stable.  For example, Microsoft share prices have declined about 40% between Year 2000 and Year 2002, but it is not at all clear that the value of the firm and/or its knowledge capital value has declined so steeply in the bear market of securities pricing in Year 2002.
    • Present value valuation based upon forecasted dividends (usually including a forecasted dividend growth rate). 
      The problem with forecasted dividends is that firms have dividend policies that do not reflect future value.  For example, many firms do not pay dividends at all or their payout ratios are too small to be reflective of firm value.  There may be enormous dividends decades into the future, but these are too uncertain to be realistic for valuation purposes.  Another problem is that forecasted dividend models generally require the estimation of a "terminal value" of the firm, and this usually entails grasping for straws.
    • Discounted abnormal earnings and returns valuation (including Edwards-Bell-Ohlson (EBO) and Steward's EVA Models)
      Abnormal earnings  and returns valuation models generally use forcasted after-tax operating profits discounted at the firm's current weighted average cost of capital.   There are variations of methods such as the abnormal returns method, the abnormal earnings method, and the free cash flow method of valuing returns to debt and equity.   

      One of the nicer summaries of the EBO versus EVA models can be found in "Measuring Wealth," by Charles Lee, CA Magazine, April 1996, pp. 32-37 --- http://www.cica.ca/cica/camagazine.nsf/e1996-Apr/TOC 

      The value of the firm depends on its ability to generate "abnormal earnings" above what can be earned in riskless or near-riskless investment alternatives.  There are immense problems in this valuation approach for the following reasons:
    • Empirical studies both before and after the Enron scandal indicate that earnings management is systemic and pervasive such that managers can manipulate abnormal earnings valuations with their earnings management policies (that are generally secret).
    • Earnings measures are subject to all the limitations of GAAP including the failure to expense employee stock options, inclusion of income on pension funds, write-off of R&D under FAS 2, and the expensing of expenditures for knowledge capital intended to benefit the future.  Actually, this problem is not as serious as it might seem at first blush since many of the accounting distortions wash themselves out over time if they are do to timing.  However, when the timing is long-term such as in the case of long-term R&D projects, distortions persist due to discounting.  For example, if a firm deducts $1 billion per year on a research project that may only start to pay off 15 or more years into the future, the conservatism badly distorts the discounted abnormal earnings and return valuation methods.
    • Abnormal earnings and returns valuation models implicitly assume firms that carry massive amounts of excess cash, beyond what is needed for year-to-year operations, distribute the excess cash as dividends to owners.  This just is not the case in some firms like Microsoft that carry huge cash reserves.  As a result, abnormal earnings and returns valuation methods must take this into account since abnormal earnings do not accrue to free cash reserves.
    MicrosoftAssets00.jpg (18291 bytes)
    • Real Options
      There are various valuation methods that are less widely used.  One of these is the Real Options approach that shows some promise even though it is still quite impractical.  See http://faculty.trinity.edu/rjensen/realopt.htm 

    • Market Transaction
      On rare occasion, a portion of a company's knowledge capital is sold in market transactions that give clues about total value.  The sale of a portion of the SABRE system by American Airlines is an excellent example of a clue to the immense value of this   unbooked asset on the balance sheet..  The problem with this is that market price of a portion of the SABRE system ignores the synergy values of the remaining portion still owned by AMR.

    In the final analysis, the most practical approach to date is to attempt to forecast the revenues and/or cost savings attributable to major components of intellectual capital.   This is much easier in the case of software and systems such as the SABRE system than it is in components like human resources where total future benefits are virtually impossible to drill down to present values at particular points in time.

    The valuation of intangibles will probably always be subject to enormous margins of error and risk.

    One way to help financial statement users analyze intangibles would be to expand upon the interactive spreadsheet/database approach currently used by Microsoft Corporation for making forecasts.  Although this approach is not currently used by Microsoft for detailed analysis of intangibles, we can envision how knowledge capital components might be expanded upon in a way that financial statement users themselves can make assumptions and then analyze the aggregative impacts of those assumptions.  Click on the Following from http://www.microsoft.com/msft/ 

    FY 2003 Microsoft "What-if?" (193 KB) Do your own forecasting for Microsoft’s FY 2003 income statements based on your assumptions with this Excel projection tool --- http://www.microsoft.com/msft/download/PivotTables/What_If.xls 

    Pivot tables might also be useful for slicing and dicing information about intangibles.  Although Microsoft does not employ this specifically for analysis of intangibles, the approach used at the following link might be extended for such purposes:

    Financial History PivotTable (122 KB) Allows you to view and analyze historical Microsoft financial data.  For example, you can look at income statement line items dating back to 1985 --- http://www.microsoft.com/msft/download/PivotTables/historypivot.xls 

    Click here to view references on intangibles 


    FAS 141 and the Question of Value By PricewaterhouseCoopers CFOdirect Network Newsdesk, January 16, 2003 --- http://www.cfodirect.com/cfopublic.nsf/vContentPrint/CA13B226B214A04085256CB000512D34?OpenDocument 

    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  

     


    Intangibles:  An Accounting Paradox

     

    Teaching Case on Accounting for Private Companies
    From The Wall Street Journal Accounting Weekly Review on January 9, 2015
    Private companies just got a break in their reporting of intangible assets.

    FASB Issues Guidance for Private Companies
    by: John Kester
    Dec 25, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: FASB, Intangible Assets

    SUMMARY: The Financial Accounting Standards Board, tasked with setting U.S. private sector financial standards, released guidance that lets private companies consolidate their reporting of some intangible assets. FASB's alternative allows some companies to lump noncompetition agreements and some "customer-related intangible assets" such as the value of having an existing customer base, into goodwill items. However, some customer-related intangible assets would continue to be recognized separately, such as mortgage servicing rights, commodity supply con­tracts, core deposits, and customer information such as names and contact information.

    CLASSROOM APPLICATION: This is an update to the rules for accounting for intangible assets.

    QUESTIONS: 
    1. (Introductory) What are intangible assets? Why are they classified separately from other assets?

    2. (Introductory) What is FASB? What is its purpose? What are the details of its new guidance for reporting intangible assets?

    3. (Advanced) What is the reason for the new rule? How are companies benefited? How are users of the financial statements benefited? Will the change have a negative impact on any of these parties?

    4. (Advanced) What intangible assets must be recognized separately? Why? Does this take away any value of the new rule? Is it an appropriate exception to the new rule?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "FASB Issues Guidance for Private Companies," by John Kester, The Wall Street Journal, December 25, 2014 ---
    http://blogs.wsj.com/cfo/2014/12/25/fasb-issues-guidance-for-private-companies/?mod=djem_jiewr_AC_domainid

    Private companies just got a break in their reporting of intangible assets.

    The Financial Accounting Standards Board, tasked with setting U.S. private sector financial standards, today released guidance that lets private companies consolidate their reporting of some intangible assets.

    The new guidance is an effort to “avoid…unnecessary costs and complexity,” said Russell Golden, FASB’s chairman. It responds to feedback from FASB’s Private Company Council, which modifies accounting standards for private companies.

    FASB’s alternative lets companies lump noncompetition agreements and some “customer-related intangible assets” such as the value of having an existing customer base, into goodwill items.

    Private businesses must decide whether or not to use FASB’s alternative with their next transaction in its scope.

    However, some customer-related intangible assets would continue to be recognized separately, such as mortgage servicing rights, commodity supply con­tracts, core deposits, and cus­tomer information such as names and contact information, said Daryl Buck, a FASB member.

    Companies can sell or buy some intangible assets, including customer information or commodity supply contracts, but noncompetition agreements and the existence of a customer base can be more difficult to value.

    Importantly, public companies and not-for-profit companies must still report intangible assets as they previously did. FASB however plans to consider offering the alternative for public companies and not-for-profits.

     

     


    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

     

     


    An Accounting Paradox

    If you are following the accounting saga following the implosion of Enron and Andersen, I strongly recommend the Summer 2002, Volume 21, Number 2 of the Journal of Accounting and Public Policy --- http://www.elsevier.nl/inca/publications/store/5/0/5/7/2/1/ 

    Enron:  An Accounting Perspective

    • Reforming corporate governance post Enron: Shareholders' Board of Trustees and the auditor 97 -- 103 
      A.R. Abdel-khalik
    • Enron: what happened and what we can learn from it pp. 105 -- 127 
      G.J. Benston, A.L. Hartgraves
    • Enron et al.--a comment pp.129 -- 130 
      J.S. Demski
    • Where have all of Enron's intangibles gone? pp.131 -- 135 
      Baruch Lev
    • Enron: sad but inevitable pp.137 -- 145 
      L. Revsine
    • Regulatory competition for low cost-of-capital accounting rules pp.147 -- 149 
      S. Sunder

    Regular Paper

    • How are loss contingency accruals affected by alternative reporting criteria and incentives? pp. 151 -- 167 
      V.B. Hoffman, J.M. Patton

     

    Question:
    Where were Enron's intangible assets?  In particular, what was its main intangible asset that has been overlooked in terms of accounting for intangibles?

     

    Answer by Baruch Lev:

    Baruch Lev Quote from Page 131 from the  Summer 2002, Volume 21, Number 2 of the Journal of Accounting and Public Policy --- http://www.elsevier.nl/inca/publications/store/5/0/5/7/2/1/ 

    On December 31, 2000, Enron's market value was $75.2 billion, while its book value (balance sheet equity) was $11.5 billion.  The market-to-book gap of almost $64 billion, while not equal to the value of intangibles (it reflects, among other things, differences between current and historical-cost values of physical assets), appears to indicate that Enron had substantial intangibles just half a year before it started its quick slide to extinction.  This naturally raises the questions: Where are Enron's intangibles now?  And even more troubling: Why did not those intangibles--a hallmark of modern corporations--prevent the firm's implosion?  In intangibles are "so good", as many believe, why is Enron's situation "so bad"?

    Baruch Lev Quite beginning on Page 133 (from the reference above)

    So the answer to the question posed at the opening of this note--where have Enron's intangible gone?--is a simple one: Nowhere.  Enron did not have substantial intangibles, that is, if hype, glib, and earnings manipulation did not count as intangibles.  Which, of course, also answers the second question--why did not the intangibles prevent Enron's implosion.

    Back to Greenspan's comment about the fragility of intangibles: "A physical asset, whether an office building or an automotive assembly plant, has the capability of producing goods even if the reputation of the managers of such facilities falls under a cloud.  The rapidity of Enron's decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation."  Intangibles are indeed fragile, more on this later, but "true" intangibles are not totally dependent on managers' reputation.  IBMs management during the 1980s and early 1990s drove the company close to bankruptcy, and was completely discredited (though not ethically, as Enron's).  But IBMs intangibles--innovation capabilities and outstanding services personnel--were not seriously harmed.  Indeed, under Lou Gerster's management (commencing in 1993), IBM made an astounding comeback.  Hypothetically, would a tarnished reputation of Microsoft, Pfizer, or DuPont's management destroy the ability of these similarly innovative companies to continuously introduce new products and services and maintain dominant competitive positions?  Of course not.  Even when companies collapse, valuable patents, brands, R&D laboratories, trained employees, and unique information systems will find eager buyers.  Once more, Enron imploded, and its trading activities "acquired" for change not because its intangibles were tied to management's reputation, but partly, because it did not have any valuable intangibles--unique factors of production--that could be used by successor managers to resuscitate the company and create value.

    Finally, to the fragility of intangibles.  As I elaborate elsewhere,3 along with the ability of intangible assets to create value and growth, comes vulnerability, which emanates from the unique attributes of these factors of production:

    Partial excludability (spillover): The inability of owners of intangible assets to completely appropriate (prevent non-owners from enjoying) the benefits of the assets.  Patents can be "invented around", and ultimately expire; trained employees often move to competitors, and unique organizational structures (e.g., just-in-time production) are imitated by competitors.

    Inherently high risk: Certain intangible investments (e.g., basic research, franchise building for new products) are riskier than most physical and financial assets.  The majority of drugs under development do not make it to the market, and most of the billions of dollars spent by the dotcoms in the late 1990s to build franchise (customer base) were essentially lost.

    Nonmarketability: Market in intangibles are in infancy, and lack transparency (there are lots of patent licensing deals, for example, but no details released to the public).  Consequently, the valuation of intangible-intensive enterprises is very difficult (no "comparables"), and their management challenging.

    Intangibles are indeed different than tangible assets, and in some sense more vulnerable, due to their unique attributes.  Their unusual ability to create value and growth comes at a cost, at both the corporate and macroeconomy level, as stated by Chairman Greenspan: "The difficulty of valuing firms that deal primarily with concepts and the growing size and importance of these firms may make our economy more susceptible to this type of contagion".  Indeed, intangible-intensive firms are "growing in size and importance", a fact that makes the study of the measurement, management, and reporting of intangible assets so relevant and exciting, irrespective of Enron the intangibles-challenged sorry affair.

     

    Answer by Bob Jensen

    I have to disagree with Professor Lev with respect his statement:  " Enron did not have substantial intangibles."  I think Enron, like many other large multinational corporations, invested in a type of intangible asset that has never been mentioned to my knowledge in the accounting literature.  Enron invested enormously in the intangible asset of political power and favors.  There are really two types of investments of this nature for U.S. based corporations:

    1. Investments in bribes and political contributions allowed under U.S. law, including the Foreign Corrupt Practices Act (FCPA)

    2. Investments in bribes and political contributions not allowed under U.S. law, including the Foreign Corrupt Practices Act (FCPA)

    I contend that large corporate investment in political power is sometimes the main intangible asset of the company.  This varies by industry, but political favors are essential in agribusiness, pharmaceuticals, energy, and various other industries subject to government regulation and subsidies.  Enron took this type of investment to an extreme in both the U.S. and in many foreign nations.  Many of Enron's investments in political favors appear to violate the FCPA, but the FCPA is so poorly enforced that it seldom prevents huge bribes and other types of investments in political intangibles.

    I provide you with several examples below.

    Two Examples of Enron's Lost Millions in Political Intangibles
    India and Mozambique:  Enron Invests in U.S. Government Threats to Cut Off  Foreign Aid

    SHAMELESS:
    1995'S 10 WORST
    CORPORATIONS


    by Russell Mokhiber and Andrew Wheat
    http://www.essential.org/monitor/hyper/mm1295.04.html 

     

    The module about Enron in 1995 reads as follows:

    Enron's Political Profit Pipeline

    In early 1995, the world's biggest natural gas company began clearing ground 100 miles south of Bombay, India for a $2.8 billion, gas-fired power plant -- the largest single foreign investment in India.

    Villagers claimed that the power plant was overpriced and that its effluent would destroy their fisheries and coconut and mango trees. One villager opposing Enron put it succinctly, "Why not remove them before they remove us?"

    As Pratap Chatterjee reported ["Enron Deal Blows a Fuse," Multinational Monitor, July/August 1995], hundreds of villagers stormed the site that was being prepared for Enron's 2,015-megawatt plant in May 1995, injuring numerous construction workers and three foreign advisers.

    After winning Maharashtra state elections, the conservative nationalistic Bharatiya Janata Party canceled the deal, sending shock waves through Western businesses with investments in India.

    Maharashtra officials said they acted to prevent the Houston, Texas-based company from making huge profits off "the backs of India's poor." New Delhi's Hindustan Times editorialized in June 1995, "It is time the West realized that India is not a banana republic which has to dance to the tune of multinationals."

    Enron officials are not so sure. Hoping to convert the cancellation into a temporary setback, the company launched an all-out campaign to get the deal back on track. In late November 1995, the campaign was showing signs of success, although progress was taking a toll on the handsome rate of return that Enron landed in the first deal. In India, Enron is now being scrutinized by the public, which is demanding contracts reflecting market rates. But it's a big world.

    In November 1995, the company announced that it has signed a $700 million deal to build a gas pipeline from Mozambique to South Africa. The pipeline will service Mozambique's Pande gas field, which will produce an estimated two trillion cubic feet of gas.

    The deal, in which Enron beat out South Africa's state petroleum company Sasol, sparked controversy in Africa following reports that the Clinton administration, including the U.S. Agency for International Development, the U.S. Embassy and even National Security adviser Anthony Lake, lobbied Mozambique on behalf of Enron.

    "There were outright threats to withhold development funds if we didn't sign, and sign soon," John Kachamila, Mozambique's natural resources minister, told the Houston Chronicle. Enron spokesperson Diane Bazelides declined to comment on the these allegations, but said that the U.S. government had been "helpful as it always is with American companies." Spokesperson Carol Hensley declined to respond to a hypothetical question about whether or not Enron would approve of U.S. government threats to cut off aid to a developing nation if the country did not sign an Enron deal.

    Enron has been repeatedly criticized for relying on political clout rather than low bids to win contracts. Political heavyweights that Enron has engaged on its behalf include former U.S. Secretary of State James Baker, former U.S. Commerce Secretary Robert Mosbacher and retired General Thomas Kelly, U.S. chief of operations in the 1990 Gulf War. Enron's Board includes former Commodities Futures Trading Commission Chair Wendy Gramm (wife of presidential hopeful Senator Phil Gramm, R-Texas), former U.S. Deputy Treasury Secretary Charles Walker and John Wakeham, leader of the House of Lords and former U.K. Energy Secretary.

     

    United States Deregulation of Energy That Needed a Change in the Law:  Enron's Investment in Wendy Gramm

    Forwarded by Dick Haar on February 11, 2002

    Senator Joseph Leiberman 
    706 Hart Senate Office Building 
    Washington, D.C. 20510

    RE: Enron Investigation

    Dear Senator Leiberman,

    I watched your Sunday morning appearance on Face the Nation with intense interest. Inasmuch as I own a fair amount of Enron stock in my SEP/IRA, I'm sure you can understand my curiosity relative to your investigation.

    Knowing you to be an honorable man, I feel secure that you will diligently pursue the below listed matters in an effort to determine what part, if any, these matters contributed to the collapse of Enron.

    1. Government records reveal the awarding of seats to Enron executives and Ken Lay on four Energy Department trade missions and seven Commerce Department trade trips during the Clinton administration's eight years.

    a. From January 13, 1995 through June 1996, Clinton Commerce Secretary Ron Brown and White House Counsel Mack McLarty assisted Ken Lay in closing a $3 billion dollar power plant deal with India. Four days before India gave final approval to the deal, Enron gave $100,000 to the DNC. Any quid pro quo?

    b. Clinton National Security Advisor, Anthony Lake, threatened to withhold aid to Mozambique if it didn't approve an Enron pipeline project. Subsequent to Mr. Lake's threats, Mozambique approved the project, which resulted in a further $770 million dollar electric power contract with Enron. Perhaps, if NSA Advisor Lake had not been so busy strong-arming for Enron, he might have been focused on something obliquely related to national security like, say, Mr. Bin Laden? Could it be that a different, somewhat related, investigation is warranted?

    c. In 1999, Clinton Energy Secretary Bill Richardson traveled to Nigeria and helped arrange a joint, varied, energy development program which resulted in $882 million in power contracts for Enron from Nigeria. Perhaps if Energy Scretary Richardson had been more focused on domestic energy, we might have avoided:

    i. The severe loss of nuclear secrets to China and concurrently ii. developed more domestic sources of energy.

    d. Subsequent to leaving Clinton White House employ, Enron hired Mack McLarty (White House Counsel), Betsy Moler (Deputy Energy Secretary) and Linda Robertson (Treasury Official). Even a person without a high school diploma (no disrespect to airline security screeners) can see that this looks like Enron paying off political favors with fat-cat corporate jobs, at the expense of stockholders and Enron pension employees.

    e. Democratic Mayor Lee P. Brown of Houston (Enron headquarter city), received $250,000 just before Enron filed Chapter 11 bankruptcy. Isn't that an awful lot of money to throw away right before bankruptcy?

    The Democratic National Committee was the recipient of hundreds of thousands of dollars from 1990 through 2000. The above matters appear to be very troubling and look like, smack of, reek of, political favors for campaign payoffs. I know you will find out.

    2. Recently, former Clinton Treasury Secretary Robert Rubin called a top U. S. Treasury official, asking on Enron's behalf, for government help with credit agencies. As you well know, Rubin is the chairman of executive committee at Citigroup, which just coincidentally, is Enron's largest unsecured creditor at an estimated $3 billion dollars.

    3. As you well know, Mr. Leiberman, Citigroup is Senator Tom Daschle's largest contributor ($50,000) in addition to being your single largest contributor ($112,546). This fact brings to mind some disturbing questions I feel you must answer.

    a. Have you, any member of your staff, any Senate or House colleagues, any relatives or any friends of yours, been asked by Citigroup to intercede on their behalf, in an effort to recover part or all of Citigroup's $3 billion, at the expense of Enron's shareholders, employees and or Enron pensioners?

    b. Did your largest contributor, Citigroup, have anything to do with the collapse of Enron?

    c. Enron has tens of thousands of employees, stockholders and pensioners who have lost their life savings. How will you answer their most obvious question? Do you represent Citigroup, your largest contributor, or do you represent the Enron employees, et al, who stand to lose if Citigroup recovers any of its $3 billion?

    During Sunday's Face the Nation, both you and Senator McCain praised Attorney General Ashcroft for recusing himself from the Justice Department investigation because he had once received a contribution from Enron. I know in my heart, that, being the honest gentleman you are, you will now recuse yourself because of the glaring conflict of interest described above. I also know that you will pass this letter to your successor for his or her attention.

    Very truly yours,

    Robert Theodore Knalur


    Also see:  "Where Was Enron Getting a Return for Its Political Bribes?" at http://faculty.trinity.edu/rjensen/fraud.htm#bribes 

    The extent to which Enron's investments and alleged investments in current and future political favors actually resulted in political favors will never be known.  Clearly, Enron invested in some enormous projects such as the $3 billion power plant in India knowing full well that the investment would be a total loss without Indian taxpayer subsidies.  Industry in India just could not pay the forward contract gas rates needed to run the plant.  

    Enron executives intended that purchased political influence would make it one of the largest and most profitable companies in the world.  In the case of India, the power plant became a total loss, because the tragedy of the September 11 terror made the U.S. dependent upon India in its war against the Taliban.  Even if the White House leaders had been inclined to muscle the Indian government to subsidize power generated from the new Enron plant in India, the September 11 tragedy destroyed  Enron's investment in political intangibles and its hopes to fire up its $3 billion gas-fired power plant in India.  The White House had greater immediate need for India's full support in the war against the Taliban.

    The point here is not whether Enron money spent for political favors did or did not actually result in favors.  The point is that to the extent that any company or wealthy employees invest heavily for future political favors, they have invested in an intangible asset and have taken on the intangible risk of loss of reputation and money if some of these investments become discovered and publicized in the media.  In fact, discovery and disclosure will set government officials scurrying to avoid being linked to political payoffs.

    Enron is a prime example of a major corporation focused almost entirely upon turning political favors into revenues, especially in the areas of energy trading and foreign power plant construction.  As such, these investments are extremely high risk.  

    It is doubtful that political intangibles will ever be disclosed or accounted for except in the case of bankruptcy or other media frenzies like the Enron media frenzies.  

    Question:
    Accountants and auditors face an enormous task of disclosing and accounting for political intangibles.

    Answer:
    Because disclosures and accounting of political intangibles will likely destroy their value.  Generally, accounting for assets does not destroy those assets.  This is not the case for many types of political intangibles that cost millions upon millions of dollars in corporations.


    August 28, 2002 reply from Craig Polhemus [Joedpo@AOL.COM

    -----Original Message----- 
    From: Craig Polhemus [mailto:Joedpo@AOL.COM]  
    Sent: Wednesday, August 28, 2002 1:55 AM 
    To: AECM@LISTSERV.LOYOLA.EDU  
    Subject: Re: An Accounting Paradox: When will accounting for an asset destroy the asset?

    Bob Jensen writes:

    <<Question: Accountants and auditors face an enormous task of disclosing and accounting for political intangibles.

    Answer: Because disclosures and accounting of political intangibles will likely destroy their value. Generally, accounting for assets does not destroy those assets. This is not the case for many types of political intangibles that cost millions upon millions of dollars in corporations.>>

    Interesting. There are many instances where the reverse is true -- the marketing value to a lobbying firm of having made large contributions to the winning candidates (of whatever party) is greatest where it is well known. This applies regardless whether the contributions came from individual partners or (at least in those states where it's legal for state and local elections) from the firm itself.

    Even on a local level, if you're in a jurisdiction where judges are elected, would you prefer to go to a lawyer who contributed to the successful judge or to one who did not? I have a friend who asks this question directly whenever he's seeking local counsel. And if you're that lawyer, do you want that contribution to be secret or as public as possible? Maybe even exaggerated?

    Dita Beard is a classic example -- her initial "puffery" [whether truthful, partially truthful, or entirely false] about getting the IT&T antitrust case dropped based on a pledge of IT&T funding to support moving the 1972 Republican National Convention to Miami was a marketing aid to her ONLY if she let it be known, at least to her clients and potential clients.

    Similarly, Ed Rollins writes of a foreign "contributor" who apparently passed a million in cash to a middleman and thought it made it to the Reagan re-election campaign. Rollins believes the middleman (an unnamed Washington lawyer, by the way) held on to it all but the "contributor" felt he'd purchased access, and certainly the middleman benefited not just financially but also from the contributor's belief that the middleman had provided direct access to the campaign and hence the Administration.

    I express no opinion on how such things should be recorded in financial statements -- I'm just pointing out that publicity about large political contributions to successful candidates (whether within or exceeding legal limits) can be positive for some businesses, such as lobbying firms.

    Craig [Craig Polhemus, 
    Association Vitality International]


    August 28, 2002 reply from Bob Jensen

    Great to hear from you Craig.

    I agree that sometimes the accounting and/or media disclosure of investments in political favors may increase the value of those investments. Or it may have a neutral effect in some industries like agribusiness and oil where the public has come to expect that members of Congress and/or the Senate are heavily dependent upon those industries for election to office and maintenance of their power.

    On the other hand, it is unlikely that accounting and media disclosure of the Enron investments in political favors, including the favors of linking foreign aid payments to Enron's business deals, would have either a positive or neutral impact upon the expected value of those political favors to Enron.

    It is most certain that accounting and media disclosure political investments that are likely to violate the Foreign Corrupt Practices Act would deal a severe blow to the value of those intangible assets.

    Thanks,

    Bob Jensen


    August 28 reply from mark-eckman@att.net 

    I think companies have invested a great deal in political intangibles outside the arena of government. Consider the current discussions on the importance of expensing stock option expensing as an example. Views are strong and vary widely on the issue but clearly, these positions exist only to gain visibility and increase political pressure.

    On the side that believes CPA stands for 'can't prove anything' we find the speech to the Stanford Director's College on June 3, 2002 by T. J. Rodgers, CEO of Cypress. Mr. Rodgers refers to expensing options as "...the next mistake..." and refers to "...accounting theology vs. business reality...." He opposes the Levin- McCain proposal and recounts the story you have on your website of the 1994 political storm in Silicon Valley when the FASB proposed expensing options. He believes that the free market will eliminate any abuse of option accounting. Contrast that with the opposition represented in the July 24, 2002 letter to CEOs from John Biggs at TIAA-CREF. Mr. Biggs also derides the profession by labeling APB 25 as an "...archaic method..." and that its use has the effect of “…eroding the quality of earnings…” by encouraging “…the use of one form of compensation.” Mr. Biggs completes his letter by equating option expensing to management credibility. Both of these men have made political investments with their comments, drawing lines in the sand. While the remarks were not made directly to any political body, and there is no tangible cost involved, this is still political pressure. It is also interesting both men focus on the accounting profession as the root cause rather than the value of the political intangibles that exist only in market capitalization.

    Consider how companies build political intangibles with analysts, institutional shareholders and others. ADP had an extended string of increased quarterly earnings – over 100 consecutive quarters. The PE multiple for the stock has been high for some time, due in no small part to the consistency of this trend. ADP management reminded shareholders with every quarter how long they had provided shareholders with higher earnings. When that streak recently ended, the stock dropped like a stone. Closing price moved down from $41.35 on July 17, 2002 to $31.60 the next day. The volume associated with that change was almost nine times the July 16 trading volume. How would anyone explain this event other than a reversal of political intangibles that did not exist on the financial statements?

    Power and politics are always with us. We just have to be smart enough to know which is for show and which is for $$$. (By the way, if you have a way to tell them apart, let me know.)


    August 28 reply from E. Scribner [escribne@NMSU.EDU

    Hi, Bob and Craig! 
    You've discovered an accounting application of Heisenberg's uncertainty principle, which originated with the notion that to "see" an electron's position we have to "illuminate" it, which causes it to shift its position so it's not "there" any more. To quote from the American Insitutute of Physics ( http://www.aip.org/history/heisenberg/p08b.htm ), "At the moment the light is diffracted by the electron into the microscope lens, the electron is thrust to the right."

    When we "illuminate" political intangibles by disclosing them, they are not "there" any more.

    Ed Scribner 
    New Mexico State University
     Las Cruces, NM, USA ---
    --

    August 28, 2002 Reply from Bob Jensen
    Heisenberg's Theory Song
    "My get up and go got up an went." http://www.eakles.com/get_up_go.html  

     August 28, 2002 reply from Richard C. Sansing [Richard.C.Sansing@DARTMOUTH.EDU

    There is an extensive literature on the economics of information. The Analytics of Uncertainty and Information by Jack Hirshleifer and John Riley is a good survey. Chapters 6 (The economics of emergent public information) and 7 (Research and invention) address the issues of the value of private information and the effects of disclosure on its value.

    Heisenberg's uncertainty principle both "originated" and (for practical purposes) terminated with the behavior of electrons and other sub-atomic particles. It applies to the joint indeterminacy of the position and momentum of electrons. It is only significant at the atomic level because Planck's constant is so small.

    Richard C. Sansing 
    Associate Professor of Business Administration 
    Tuck School of Business at Dartmouth 
    email: Richard.C.Sansing@dartmouth.edu 

     

    June 12, 2009 message from Bob Jensen

  • Hi Pat,

    Control is part and parcel to the definition of an asset and liability.

    Intangibles are very ambiguous with respect to “control.” For example, intangible goodwill can be an asset or a liability as positive or negative goodwill. By definition it is the total in excess of the values of identifiable assets and liabilities. The key word is “identifiable.”

    If you can’t identify something it’s pretty hard to prove you control it. Goodwill at best is only partly influenced with things like trade name advertising but for the most part its value is comprised of factors outside the control of the company. For example, the value of goodwill might be greatly impacted by legislation.

    Control of course is not part of any definition of love to my knowledge. But then control is not part of the definition of an intangible asset if you can’t identify that which you claim to control. In fact, goodwill impairment tests cover situations where goodwill value plunges due to events outside of a company’s control.

    I think that Andrew’s original message suggested that an owner/manager’s love for a company can add intangible value. In places like Germany (but not in the U.S.) home grown evolving goodwill can valued and added to the balance sheet. Conceivably evolving love for a company can add to its booked intangible value in Germany. The booking of homegrown goodwill is a very recent change in German accounting standards as I pointed out in a previous message on the AECM.

    I was only being half serious when I suggested that love could also be an intangible liability. However, the serious half of my comment suggests that love for a company can become a liability if it is in some way dysfunctional such as when a manager/owner refuses to take risks that are often important to success in business.

    Or an owner in 1940 might’ve loved his buggy whip subsidiary so much that he refused to close a factory that was only selling ten units of product per year with a labor force of 50 workers. Now that is love that truly is an intangible liability.

    Bob Jensen


    Teaching Case on the Special Problems of Accounting for Intangibles in a Company that is Mostly Human Resources and Intangible Assets
    From The Wall Street Journal Accounting Weekly Review on May 24, 2013

    Yahoo Deal Shows Power Shift
    by: Joann Lublin, Amir Efrati and Spencer Ante
    May 20, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Intangible Assets, Mergers and Acquisitions

    SUMMARY: "Valuations placed on social media sites like Tumblr make little sense under typical financial analysis' concludes the authors in this piece on Yahoo's biggest acquisition under Chief Executive Marissa Mayer. Yahoo has faced challenges in competing against Google, Facebook, and other Internet companies as the market of online activities--that its founders essentially developed--has grown and matured. Tumblr's value to Yahoo may be its appeal to a younger audience and the value to be obtained by Yahoo, which will produce needed financial results, is clearly discussed in the related video.

    CLASSROOM APPLICATION: The article may be used to introduce strategic reasons for business combinations or accounting for intangible assets.

    QUESTIONS: 
    1. (Introductory) Based on the description in the article, what are the strategic reasons for Yahoo to acquire Tumblr? The related video available on one of the top tabs to the online article is also helpful to answer this question.

    2. (Introductory) Why is consumer attention focused on social media important for profitability of Internet based companies? Explain the importance of advertising in this scenario.

    3. (Introductory) Why is it valuable for Yahoo to acquire Tumblr when the management of Tumblr will not change?

    4. (Introductory) Yahoo is paying a premium to acquire Tumblr for $1 billion. How is that premium measured?

    5. (Advanced) Explain how the funding invested in Tumblr by the venture-capital firm in 2011 must have been based on some "typical financial analysis" model.

    6. (Advanced) Despite what the author concludes, how must the price paid by Yahoo be determined at least partly on the basis of a financial model?

    7. (Advanced) How will the model determining the price paid for Tumblr lead to the accounting for this $1 billion by Yahoo when this acquisition eventually closes? What types of assets are most likely to be recorded from this transaction?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Yahoo Deal Shows Power Shift," by Joann Lublin, Amir Efrati and Spencer Ante, The Wall Street Journal, May 20, 2013 ---
    http://online.wsj.com/article/SB10001424127887324787004578493130789235150.html?mod=djem_jiewr_AC_domainid

    Yahoo Inc. YHOO -1.00% has agreed to pay $1.1 billion for Tumblr, a six-year-old company with more than 100 million users but very little revenue, a deal that highlights the shifting balance of power in the technology business.

    Veterans like Yahoo have shown they have staying power—and they have cash to spend. But companies like Yahoo's target, a blogging site, have something valuable as well: the rapt attention of fast-growing communities of users. That has pushed up the price tags as more established companies fear getting left behind as people's online habits evolve.

    Yahoo and Tumblr announced the agreement on Monday. Tumblr will be independently operated as a separate business, "per the agreement and our promise not to screw it up," the companies said. CEO and founder David Karp will stay on as chief executive. More on Tumblr

    In a 2012 interview, Tumblr's David Karp spoke to the Wall Street Journal about how he started the company and where he's headed with it. Read the interview.

    MoneyBeat: Yahoo Promises 'Not to Screw It Up' Heard on the Street: Tumblr of Opportunity ATD: Board Approves Deal as Expected Earlier: Will Yahoo Try to Get Its 'Cool Again' Why Yahoo Is Sweet on Tumblr Yahoo Wants Out of Microsoft Deal (5/7/2013) Yahoo Scraps Deal for French Video Site (4/30/2013) Yahoo's Ad Struggles Persist (4/16/2013) Yahoo, Apple Discuss Deeper iPhone Partnership (4/9/2013)

    Timeline: A Changing Internet Pioneer

    See key dates in the history of Yahoo, which helped to revolutionize the Web.

    View Graphics

    More photos and interactive graphics

    The transaction adds Yahoo to the list of established Internet companies, including Google Inc. GOOG -1.47% and Facebook Inc., FB -3.24% that have spent $1 billion or more apiece to buy startup companies in hopes of gaining an edge in growth. Facebook, for instance, last year paid cash and stock initially valued at about $1 billion to buy revenue-free Instagram, a popular photo-sharing service.

    Google famously paid $1.65 billion in stock seven years ago for YouTube, the online-video behemoth. In a smaller deal, in dollar terms, but one that reflects the appetite among old-line Internet companies for fresh blood, AOL bought Huffington Post for $315 million in 2011.

    Yahoo Chief Executive Marissa Mayer's deal for Tumblr gives Yahoo, one of the original big Internet companies, a fast-growing Web service that could fill one of its many holes—namely, the lack of a thriving social-networking and communications hub. Tumblr is popular with many younger adults, in contrast with Yahoo's older customer base. Tumblr is also growing more quickly on smartphones than Yahoo.

    "You only do an acquisition of this size and scale if you find an exceptional company, which Tumblr is," Ms. Mayer said Monday.

    Some Tumblr users will take time to migrate to Yahoo's core websites and might never join the fold of its parent, Ms. Mayer said. At the same time, the blogging service offers several advantages Yahoo executives said could benefit Yahoo, like a successful track record snagging users on mobile devices.

    "Part of our strategy here is to let Tumblr be Tumblr," Ms. Mayer said.

    Yahoo is paying a premium for the company. When Tumblr last raised money, in late 2011, the $85 million venture-capital investment it received valued the company at $800 million.

    Yahoo already has plans to generate more revenue from some Tumblr features like its top-of-site "dashboard" by possibly including some extra ads. Ms. Mayer credited the company for its already rich base of big-brand advertisers, which include all of the major film studios.

    The deal is a big win for Mr. Karp, who remains a large shareholder, and the site's early venture investors, which include Union Square Ventures, Spark Capital and Sequoia Capital.

    Ms. Mayer praised Mr. Karp for his enthusiasm for entertaining and compelling ads on other media, like TV, that can be "every bit as good as the content" when pitching products like cars.

    "Where are the ads that are like that, where are the ads that are aspirational?" she asked. "We want that kind of richness in the online atmosphere."

    The acquisition is a big bet for Yahoo, given Tumblr's financial performance so far. But Yahoo needs the growth. Its annual revenue has been stuck for years around $5 billion, and the company's big presence on personal computers hasn't translated well to mobile devices, where it lacks the advantage of Apple Inc.'s AAPL +0.81% coveted hardware or Google's ubiquitous smartphone operating software, Android.

    Yahoo Chief Financial Officer Ken Goldman said Yahoo expects its acquisition to add "relatively modest" revenue to its top line in the second half, when the deal is expected to close, with its contribution ramping up next year.

    Bob Jensen's threads on accounting for intangibles ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Paradox

     

     

     


  • Accounting for Options to Buy Real Estate

    From The Wall Street Journal Accounting Weekly Review on July 14, 2006

    TITLE: Land-Value Erosion Seen As a Problem for Builders
    REPORTER: by Michael Corkery and Ian McDonald
    DATE: Jul 06, 2006
    PAGE: C1
    LINK: http://online.wsj.com/article/SB115214204821498941.html 
    TOPICS: Accounting, Advanced Financial Accounting, Impairment, Investments

    SUMMARY: "Land values are becoming a flash point for investors and analysts who watch the builders sector. Bears say the companies' land might not be worth what they paid for it, which could lead to painful write-downs. If they are right, it will be a blow to the already battered sector." Questions relate to the classification of land on building companies' balance sheets and the treatment of the write-down of the value of land.

    QUESTIONS:
    1.) As an example of the type of building company discussed in this article, view the quarterly financial statements for Toll Brothers in their 10-Q filing with the SEC dated July 6, 2006. You may go directly through the following link or may access through the WSJ article on-line by clicking on Toll Brothers on the right-hand side of the page then SEC filings. http://www.sec.gov/Archives/edgar/data/794170/000112528206003278/p413541-10q.htm  In what account does Toll Brothers classify Land on its balance sheet? Why is the Land classified this way?

    2.) Refer again to the Toll Brothers financial statements. By how much did Toll Brothers write down the values of land during the 6-month and 3-month periods ended on April 30, 2006 and 2005? Describe in words, the pattern of write-downs that you observe and compare it to the discussion given in the article.

    3.) How will adjustments to reflect decline in land values affect reported income and balance sheets of companies such as Toll Brothers, which hold land as inventory and a major component of their operations? How might these adjustments affect the company's stock price? Refer to information in the article in providing your answer.

    4.) Compare and contrast the accounting for land and recent decline in the market value of land described in question 2 above, to accounting by a company, such as a manufacturer or service entity, which owns land only in the location of its principal place of business (that is, as part of property, plant, and equipment).

    5.) Explain why the accounting differs under the two answers given to questions 2 and 3 above.

    6.) What are options? What type of option contracts do builders enter into? How much has Toll Brothers paid to enter into such contracts?

    7.) What is the book value of net assets? How is that measure used by analysts of companies in the building industry? How might the recent decline in land values affect the usefulness of book value for analyzing financial statements?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Land-Value Erosion Seen As a Problem for Builders," by Michael Corkery and Ian McDonald, The Wall Street Journal, July 6, 2006; Page C1 --- http://online.wsj.com/article/SB115214204821498941.html

    Already reeling from slowing housing sales and worries about the economy, shares of home builders face another issue: the value of the land on their books.

    Land values are becoming a flash point for investors and analysts who watch the builders sector. Bears say the companies' land might not be worth what they paid for it, which could lead to painful write-downs.

    If they are right, it will be a blow to the already battered sector. After a 28% average fall so far this year, many stocks of home builders trade close to -- or even at -- their "book value,'' which makes them tantalizing to bargain hunters. Book value is a company's assets minus its liabilities and is often seen as a rough approximation of how a business would be valued if liquidated.

    But if some land on builders' books is overvalued, their shares might also be overvalued.

    "People are looking at book value as a possible floor for the stock prices. The question is 'should that be a floor?' There could be some risk to that book value from land recently acquired or put under option contract," says Banc of America Securities analyst Daniel Oppenheim, whose firm does business with several builders.

    The debate is lively because the true extent of the land risk is tough to quantify. Many builders use options, where they put a deposit on a parcel to be purchased at a later date. Builders say options minimize their losses because they let them walk away from overpriced land, sacrificing typically no more than a 5% to 10% deposit.

    So far, the damage has been limited. In its last quarter, Centex Corp., a large builder based in Dallas, reduced its earnings by 14 cents a share in connection with walking away from option deposits and pre-acquisition costs in Washington, D.C., Sacramento, Calif., and San Diego. Last month, Hovnanian Enterprises Inc., based in Red Bank, N.J., said it plans to take $5 million in write-offs on land deposits, a small percentage of its total, and luxury home builder Toll Brothers Inc. in suburban Philadelphia wrote down roughly $12 million, mainly from land that it owned in the sluggish Detroit market. Builders say they often adjust their land values to the market, even in boom times, but some analysts expect charges to increase.

    Write-downs are "starting to happen,'' says Credit Suisse analyst Ivy Zelman, a longtime bear on the sector whose firm does business with several builders. "I don't think you can define what [the scope] is today and capture the risk."

    Parcels are valued at their purchase price on companies' books, so there isn't any way of determining the land's true market value until they sell houses on it. Older purchases are likely worth far more than their listed value on balance sheets, but newer land buys are probably worth less. Many builders say land prices are still fairly static, but Jeff Barcy, chief executive of Hearthstone, a large land investor based in San Rafael, Calif., says prices are declining in certain markets.

    "We expect the softening to continue for a while," Mr. Barcy says. "In the hottest markets you could see a 20% to 30% price decline."

    Ms. Zelman estimates that many companies are building houses on land that they bought or optioned a few years ago when land was less expensive. But some analysts say many companies purchased large amounts of land in 2005, at the height of the boom, and that could come back to hurt them if the housing market doesn't improve in a year or so.

    Some think these worries are overblown and creating an opportunity. Bulls acknowledge there may be scattered write-downs, but say undervalued land on company books likely outweighs any overpriced recent buys. They add that the sector's worries, from property values to job growth, are reflected in the stocks' prices. And they say home prices have to drop significantly to sink land values. Fans of the builder stocks also point to a flurry of recent share repurchases, indicating that insiders believe the stocks are cheap. NVR Inc., for example, has reduced its shares outstanding by more than 20% over the past five years, according to researcher CapitalIQ.

    Shares of the nation's five biggest home builders trade at about 1.3 times the their book value, compared with two times book on average over the past five years, according to Chicago researcher Morningstar Inc. The average U.S. stock trades at more than four times its book value.

    Pulte Homes Inc. and Beazer Homes USA Inc. trade at about 1.2 times book, while shares of M.D.C. Holdings Inc. trade at 1.1 times and shares of Standard Pacific Corp. trade at about book value.

    Home builders always have had a hard time getting respect on Wall Street, where investors often take a short-term view of the sector's performance potential. "The adage has been 'buy them at book value and sell when they get to two times book value,'" says Arthur Oduma, a senior stock analyst who covers the home builders at Morningstar. "So, that would tell you it's time to buy."

    And some are doing so. Henry Ramallo, a portfolio manager at Neuberger Berman, a Lehman Brothers company, with $116 billion under management, says he likes Toll Brothers because it takes the company about five years, on average, to develop land from the time the builder puts it under option. By the time Toll is ready to build on the land it optioned or bought in the past year, the housing market should have improved, Mr. Ramallo says. His firm has recently bought shares of Toll, which is trading at about 1.3 times book value.


     

     

     

    The Controversy over Accounting for Securitizations and Loan Guarantees

    Accounting for Loan Guarantees

    FASB Issues Accounting Guidance to Improve Disclosure Requirements for Guarantees --- http://www.fasb.org/news/nr112502.shtml 

    Accounting and Auditing Policy Committee Credit Reform Task Force --- http://www.fasab.gov/aapc/cdreform/98CR01Recpts.pdf 

    The new FAS 146 Interpretation 46 deals with loan guarantees of Variable Interest (Special Purpose) Entities --- at: http://www.fasb.org/interp46.pdf.


    From The Wall Street Journal Accounting Educators' Review on November 15, 2002

    TITLE: H&R Block's Mortgage-Lending Business Could Be Taxing 
    REPORTER: Joseph T. Hallinan 
    DATE: Nov 12, 2002 
    PAGE: C1 
    LINK:  http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html 
    TOPICS: Accounting, Bad Debts, Cash Flow, Debt, Loan Loss Allowance, Securitization, Valuations

    SUMMARY: H&R Block's pretax income from mortgage operations grew by 146% during the fiscal year ending April 30, 2002. However, the accounting treatment for the securitization of these mortgages is being questioned.

    QUESTIONS: 
    1.) Describe the accounting treatment used by H&R Block for the sale of mortgages. Why is this accounting treatment controversial?

    2.) What alternative accounting methods are available to record H&R Block's sale of mortgages? Discuss the advantages and disadvantages of each accounting treatment. Which accounting method is most conservative?

    3.) Why do companies, such as H&R Block, sell mortgages? Why does H&R Block retain the risks of non-payment? How could the sale be structured to transfer the risks of non-payment to the purchaser of the mortgages? How would this change the selling price of the mortgages? Support your answer.

    4.) How do economic conditions change the expected losses that will result from non-payment? How does the credit worthiness of borrowers change the expected losses that will result from non-payment? Support your answers.

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


    "H&R Block Faces Issues With Mortgage Business," by Joseph T. Hallinan, The Wall Street Journal,  November 12, 2002, Page C1 ---- http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html

    Famous for its tax-preparation service, H&R Block Inc. last year prepared 16.9 million individual income-tax returns, or about 14% of all individual returns filed with the Internal Revenue Service.

    But the fastest-growing money maker for the Kansas City, Mo., company these days is its mortgage business, which last year originated nearly $11.5 billion in loans. The business, which caters to poor credit risks, has been growing much faster than its U.S. tax business. In the fiscal year ended April 30, Block's pretax income from mortgage operations grew 146% over the year before. The tax business, while still the largest in the U.S., grew just 23%.

    If those rates remain unchanged, the mortgage business will this year for the first time provide most of Block's pretax income. In the most-recent fiscal year, mortgage operations accounted for 47.3% of Block's pretax income.

    As Block's mortgage business has soared, so has its stock price, topping $53 a share earlier this year from less than $15 two years ago, though it has dropped in recent months as investors have fretted about the cost of lawsuits in federal court in Chicago and state court in Texas on behalf of tax clients who received refund-anticipation loans. But now, some investors and analysts are raising questions about the foundation beneath Block's mortgage earnings. "The game is up if interest rates rise and shut off the refinancing boom," says Avalon Research Group Inc., of Boca Raton, Fla., which has a "sell" rating on Block's shares.

    On Monday, the shares were up $1.53, or 4.8%, to $33.63 in 4 p.m. New York Stock Exchange composite trading -- a partial snapback from a $3.25, or 11%, drop on Friday in reaction to the litigation in Texas over fees H&R Block collected from customers in that state.

    The company dismisses concerns about its mortgage results. "We think it's a great time for our business right now," says Robert Dubrish, president and CEO of Block's mortgage unit, Option One Mortgage Corp.

    Much of Block's mortgage growth has come because the company uses a fairly common but controversial accounting treatment that allows it to accelerate revenue, and thus income. This treatment, known as gain-on-sale accounting, has come back to haunt other lenders, including Conseco Inc. and AmeriCredit Corp. At Block, gains from sales of mortgage loans accounted for 62% of revenue at the mortgage unit last year.

    In essence, under gain-on-sale accounting, lenders post upfront the estimated profit from a securitization transaction, which is the sale to investors of a pool of loans. Specifically, the company selling the loans records profit for the excess of the sales price and the present value of the estimated interest income that is expected to be received on the loans above the amounts funded on the loans and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.

    But if the expected income stream is cut short -- say, because more borrowers refinance their loans than expected when the profit was calculated -- the company essentially has to reverse some of the gain, taking a charge.

    That is what happened at Conseco. The Carmel, Ind., mobile-home lender was forced to take a $350 million charge in 1998 after many of its loans were paid off early. It stopped using gain-on-sale accounting the following year, saying that the "clear preference" of investors was traditional loan accounting. AmeriCredit in Fort Worth, Texas, which lends money to car buyers with poor credit histories, abandoned the practice in September in the midst of a meltdown of its stock price.

    But Block says it faces nowhere near the downside faced by AmeriCredit and Conseco, which it says had different business models. Big Block holders seem to agree. "Block doesn't have anywhere near the scale of exposure [to gain on sale] that the other companies had," says Henry Berghoef, co-manager of the Oakmark Select mutual fund, which owns 7.7 million, or about 4.3%, of Block's shares.

    Another potential problem for Block is the way it treats what is left after it sells its loans. The bits and pieces that it keeps are known as residual interests. Block securitizes most of these residual interests, allowing it to accelerate a significant portion of the cash flow it expects to receive rather than taking it over the life of the underlying loans. The fair value of these interests is calculated by Block considering a number of factors, such as expected losses on its loans. If Block guesses wrong, it could be forced to take a charge down the road.

    Block says its assumptions underlying the valuation of these interests are appropriately conservative. It estimates lifetime losses on its loan pools at roughly 5%, which it says is one percentage point higher than the 4% turned in by its worst-performing pool of loans. (Comparable industry figures aren't available.) So Block says the odds of a write-up are much greater than those of a write-down and would, in a worst-case scenario that it terms "remote," probably not exceed $500 million. Block's net income for the fiscal year ended April 30 was $434.4 million, or $2.31 a share, on revenue of $3.32 billion.

    Block spokeswoman Linda McDougall says gain-on-sale provides an "insignificant" part of the company's revenue. She notes that Option One, Block's mortgage unit, recently increased the value of its residual interest by $57 million. She also says that the company's underwriting standards are typical of lenders who deal with borrowers lacking pristine credit histories.

    Bears contend that Block has limited experience in the mortgage business. It bought Option One in 1997, and Option One in Irvine, Calif., has itself been in business only since 1993. So its track record doesn't extend to the last recession of 1990 to 1991.

    On top of that, Block lends to some of the least creditworthy people, known in the trade as "subprime" borrowers. There is no commonly accepted definition of what constitutes a subprime borrower. One shorthand measure is available from credit-reports firm Fair, Isaac & Co. It produces so-called FICO scores that range from 300 to 850, with 850 being perfect. Anything less than 660 is usually considered subprime. Securities and Exchange Commission documents filed by Block's mortgage unit show its borrowers typically score around 600. Moreover, according to the filings, hundreds of recent Block customers, representing about 4% of borrowers, have FICO scores of 500 or less, or no score at all. A score below 500 would place an applicant among the bottom 5% of all U.S. consumers scored by Fair Isaac.

    Mr. Dubrish says Block stopped lending to people with FICO scores below 500 some two years ago and says he is puzzled as to why those with scores below 500 still appear in the company's loan pools.

    Block says its loans typically don't meet the credit standards set by Fannie Mae or Freddie Mac, which are the lending industry's norms. Block's customers may qualify for loans even if they have experienced a bankruptcy in the previous 12 months, according to underwriting guidelines it lists in the SEC documents.

    In many cases, according to Block's SEC filings, an applicant's income isn't verified but is instead taken as stated on the loan application. In other cases, an applicant with a poor credit rating may receive an upgraded rating, depending on factors including "pride of ownership." Most Block mortgages are for single-family detached homes, but Block also makes mobile-home loans, according to the filings.

    "We are doing a lot to help people own houses who wouldn't have the chance to do it otherwise," Mr. Dubrish says. "We think we're doing something that's good for the economy and good for our borrowers."

    A key figure in the mortgage business is the ratio of loan size to value of the property being mortgaged. Loans with LTV rates above 80% are thought to present a greater risk of loss. The LTV on many of Block's mortgages is just under 80%, according to the SEC filings. The value of these properties can be important if Block is forced to foreclose on the loans and resell the properties. Nationwide, roughly 4.17% of subprime mortgage loans are in foreclosure, according to LoanPerformance, a research firm in San Francisco. As of June 30, only 3.52% of Block's loans, on a dollar basis, were in foreclosure, even though its foreclosure ratio more than tripled between Dec. 31, 1999, and June 30.


     

    The Controversy Over Pro Forma Non-GAAP Reporting and HFV

     

    Pro Forma --- https://en.wikipedia.org/wiki/Pro_forma

    EY:  Pro forma financial information A guide for applying Article 11 of Regulation S-X (over 100 pages) ---
    http://www.ey.com/Publication/vwLUAssetsAL/ProForma_06549-171US_30November2017/$FILE/ProForma_06549-171US_30November2017.pdf

    Aggressive use of non-GAAP numbers is creating a crisis in how investors, analysts, and the media report financial performance and value companies ---
    https://www.cfo.com/gaap-ifrs/2019/09/has-non-gaap-reporting-become-an-accounting-chasm/

    Bob Jensen's theads on non-GAAP measures --- See Below

     

    Majority of Companies Produce Unreliable Financial Forecast, Potentially Hurting Share Prices

    The KPMG study of 544 global executives found that 78 percent of the companies surveyed reported forecasting errors of more than 5 percent. Although other factors are undoubtedly at play, companies with unreliable and inaccurate forecasting had a six percent drop on average in share price over the past three years, according to the survey findings. Similarly, the survey also found that companies that kept forecast fluctuations below the five percent mark realized a 46 percent rise in share price over the same three-year period, compared to a 34 percent increase among the companies that had more than a five percent margin of error in their forecasts.
    SmartPros, December 14, 2007 --- http://accounting.smartpros.com/x60077.xml

    Private equity tricks mask mounting debt: 'I’m 5 foot 8 inches, but I change the scale and make myself 6 foot 2 inches on a pro forma basis' ---
    https://www.businessinsider.com/private-equity-debt-a-worry-says-jonathan-lavine-at-bain-capital-2019-4


    From the CFO Journal's Morning Ledger on October 21, 2019

    Companies’ Non-GAAP Adjustments to Net Income Have Soared

    Companies’ reliance on disclosing adjusted earnings or other figures not consistent with generally accepted accounting principles has made it more difficult for investors to forecast performance, new academic research shows.

    Companies say that such tailor-made metrics are a way for investors to better understand their business. As a result, the rise of earnings adjustments over the past 20 years has been dramatic, CFO Journal’s Mark Maurer reports.

    Non-GAAP adjustments related to net income increased 33% from 1998 to 2017, according to the research, which was conducted by accounting professors from the Harvard Business School and the Massachusetts Institute of Technology’s Sloan School of Management.

    SEC:  Petition for Rulemaking Regarding Disclosures on Use of Non-GAAP Financials in Proxy Statement CD&As ---
    https://www.sec.gov/rules/petitions/2019/petn4-745.pdf

    Journal of Accounting and Economics:  The effect of voluntary clawback adoption on non-GAAP reporting ---
    https://www.sciencedirect.com/science/article/pii/S0165410118301071

    Use of non-GAAP financial metrics increases in executive comp—will the SEC increase its scrutiny?
    https://cooleypubco.com/2019/06/20/ngfms-in-executive-comp/

    SEC:  Non-GAAP Financial Measures --- https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm

    CFO:  Has Non-GAAP Reporting Become an Accounting Chasm?
    https://www.cfo.com/gaap-ifrs/2019/09/has-non-gaap-reporting-become-an-accounting-chasm/

    The CPA Journal:  Recent Trends in Reporting Non-GAAP Income ---
    https://www.cpajournal.com/2017/07/05/recent-trends-reporting-non-gaap-income/

    Journal of Accounting and Economics:  The effect of voluntary clawback adoption on non-GAAP reporting ---
    https://www.sciencedirect.com/science/article/pii/S0165410118301071


    WeWork --- https://en.wikipedia.org/wiki/WeWork

    Read 58 pages of letters revealing how WeWork convinced securities regulators to let it use an accounting measure that painted a rosy picture ---
    https://www.businessinsider.com/wework-sec-letters-about-contribution-margin-2020-1

    ·         Business Insider obtained 58 pages of correspondence between the SEC and WeWork about the coworking company's IPO filing and questions or concerns the agency had about the document.

     

    ·         One crucial piece of the back-and-forth centered on the company's use of a non-GAAP financial metric.

     

    ·         The SEC originally asked WeWork to "remove disclosure of this measure throughout your registration statement."

     

    ·         After pushback from WeWork's lawyers, including a former chief of the same SEC division asking the company to scrap the metric, the agency relented and allowed the company to continue using the metric after it made some changes. 

     

    When WeWork first released the documents for its initial-public-offering filing in mid-August, investors, analysts, and journalists zeroed in on a creative financial metric the company was using to show the performance of each location. 

    Dubbed the contribution margin after an earlier and quite similar metric called community-adjusted EBITDA was universally panned, it departed from general accepted accounting principles (GAAP, in accounting speak) in how it accounted for lease costs.

    The metric was intended to reflect the true timing of revenue and costs associated with the real-estate leases, according to the company. The figure was positive when key GAAP numbers were in the red. 

    It turns out the Securities and Exchange Commission had concerns about the metric. In a nine-page letter to then-CEO Adam Neumann dated August 30, the SEC's division of corporation finance raised numerous issues and concluded one section with the words: "Please remove disclosure of this measure throughout your registration statement."

    Continued in article

     


    Teaching Case From The Wall Street Journal Weekly Accounting Review on October 11, 2019

    Minding the GAAP Matters to Investors

    By Lauren Silva Laughlin | October 8, 2019

    Topics: GAAP , Ebitda , Non-GAAP Reporting

    Summary: The article discusses concerns with recent proliferation in the use of non-GAAP measures in financial reporting. As noted by the author, “the tech industry is among the biggest offenders and, not coincidentally, sector participants are highly unlikely to have positive net income according to normal accounting rules.”

    Classroom Application: The article may be used in a financial reporting class to discuss non-GAAP measures. Note that SEC Regulation G, contains the definition of non-GAAP measures. It is available at https://www.federalregister.gov/documents/2003/01/30/03-1977/conditions-for-use-of-non-gaap-financial-measures Compliance & Disclosure Interpretations ("C&DIs") comprise the Division's interpretations of the rules and regulations on the use of non-GAAP financial measures. They are available at https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm

    Questions:

    ·         What are non-GAAP measures? Cite your source for this definition.

    ·         How do these measures compare to those provided by “normal accounting rules”? In your answer, define “normal accounting rules” in the U.S.

    ·         How many firms publicly traded in the U.S. use non-GAAP measures in their financial reporting? How has that trend changed over the last 20 years?

    ·         What is EBITDA? Is this a non-GAAP measure? Support your answer.

    ·         Zion Research Group “recently calculated EBITDA in four different, but often used ways for companies in the S&P 500 by sector.” What was the result?

    Read the Article

    Reviewed By: Judy Beckman, Ph.D., CPA, University Of Rhode Island (Uri)

     

    "Minding the GAAP Matters to Investors, by Lauren Silva Laughlin, The Wall Street Journal, October 8, 2019
    https://www.wsj.com/articles/minding-the-gaap-matters-to-investors-11570468261

    Investors have reason to worry as creative accounting metrics have become more prevalent

    What’s in an Ebitda? It is anyone’s guess nowadays.

    Financial accounting metrics at companies ranging from Uber Technologies to Beyond Meat to We Co. have gotten creative, going far beyond the guidelines that fall under generally accepted accounting principles.

    Companies claim the made-up metrics are a way for investors to better understand their business, but they create greater discrepancies between the valuations of publicly traded companies. As We’s recently pulled public listing shows, they also can erode investor trust.

    The tech industry is among the biggest offenders and, not coincidentally, sector participants are highly unlikely to have positive net income according to normal accounting rules. Some companies tweak their top lines as well as their bottom lines. Uber, for example, uses non-GAAP “core platform adjusted net revenue,” which attempts to strip out recurring costs it incurs to grow in competitive markets.

    Beyond Meat is slightly more conservative, though it messes with an already alternate measure of profits—earnings before interest, taxes, depreciation, and amortization—by adjusting it further. WeWork’s parent took creativity to a whole new level with new-age sounding but also much ridiculed financial metric “community adjusted Ebitda,” which it later amended to “contribution margin excluding noncash GAAP straight-line lease cost.”

    The number of companies reporting non-GAAP numbers has proliferated. In 1996, only 59% of filers used non-GAAP figures according to firm Audit Analytics. By 2017, that had grown to 97%. A gander at the wide range of valuations that non-GAAP creativity implies shows just how dangerous creative accounting can be for investors, too. Zion Research Group recently calculated Ebitda in four different, but often used, ways for companies in the S&P 500 by sector. The communications sector produced the widest range between the lowest and highest figures—a difference of $25 billion for the sector as a whole between the most and least flattering techniques.

    Companies have reason to reconsider their markings on their own accord. Earlier this year a report from Wachtell, Lipton, Rosen & Katz warned that the Securities and Exchange Commission was increasing its scrutiny over non-GAAP numbers.

    Investors may beat regulators to it. Investor skepticism about We’s pulled listing initially arose because of concern about creative measures. Sticking to GAAP could translate into greater investor acceptance, too.

    Corrections & Amplifications
    Uber Technologies uses a non-GAAP metric called “core platform adjusted net revenue” which attempts to strip out recurring costs it incurs to grow in competitive markets. An earlier version of this article misstated the name of the metric. (Oct. 8, 2019)

    Continued in article

     


    Non-GAAP Earnings Management at Kraft Heinz Co.
    From the CFO Journal's Morning Ledger on March 6, 2019 --- Going Concern Justification

     The problems Kraft Heinz Co. disclosed last month are shining a light on a growing concern: the company’s tailored financial metrics that help make its results look better.

    You say tomato, I say $6 billion. Since the 2015 merger that created Kraft Heinz, the packaged-food company has reported adjusted operating earnings totaling more than $24 billion. But reported cash flow from operations under standard accounting rules for that same period was only about $6 billion.

    Mind the GAAP. The gap in cash flow tallies underscores the need for investors to be cautious when relying on nonstandard metrics, rather than those that governed by U.S. Generally Accepted Accounting Principles. The relatively low operating cash flow might have been a tipoff to investors that Kraft Heinz was faltering. Last month it announced a big write-down and a decline in the value of several key brands.

    Caveat emptor. Companies are allowed to report tailored financial metrics, but they must provide detailed disclosures and can’t feature them more prominently than official measures. In recent years, the U.S. Securities and Exchange Commission has criticized many companies over the way they feature adjusted measures.


    Non‐GAAP Earnings and the Earnings Quality Trade‐Off

    Abacus, Vol. 55, Issue 1, pp. 6-41, 2019

    SSRN
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3358529
    36 Pages Posted: 22 Mar 2019

    Andrea Ribeiro

    NSW New South Wales (Government) - NSW Treasury

    Yaowen Shan

    University of Technology Sydney (UTS) - School of Accounting; Financial Research Network (FIRN)

    Stephen L. Taylor

    University of Technology Sydney; Financial Research Network (FIRN); Centre for International Finance and Regulation (CIFR)

    Multiple version iconThere are 2 versions of this paper

    Date Written: March 2019

    Abstract

    Using a large sample of earnings press releases by Australian firms, we compare multiple attributes of non‐GAAP earnings measures with their closest GAAP equivalent. We find that, on average, non‐GAAP earnings are more persistent, smoother, more value relevant, and have higher predictive power than their closest GAAP equivalent. However, the same set of non‐GAAP earnings disclosures are also less conservative and less timely than their closest GAAP equivalent. The results are consistent with non‐GAAP earnings measures reflecting a reversal of the trade‐off between the valuation and stewardship roles of accounting inherent in accounting standards and the way they are applied. We also find that differences in several of these attributes between GAAP and non‐GAAP earnings are more evident in larger firms, firms with lower market‐to‐book ratios, firms with a higher proportion of independent directors, and firms that report profits rather than losses. Our evidence is consistent with the argument that accounting standards impose significant amounts of conditional conservatism at some cost to the valuation role of accounting information. Non‐GAAP earnings measures can therefore be seen as a response to the challenges faced by a single GAAP performance measure in satisfying the competing demands of value relevance and stewardship.

     

    Keywords: Non‐GAAP disclosures, Earnings quality


    Tesla's Really Unprofessional Non-GAAP Metrics

    From the CFO Journal's Morning Ledger on November 29, 2016

    Not every motor runs
    Tesla Motors Inc. has come under fire from the SEC for using prohibited accounting metrics and sharing that information with investors, according to regulatory correspondence. The SEC said Tesla in its August earnings release used “individually tailored” measurements when the electric-vehicle maker added back certain costs to revenue calculated under generally accepted accounting principles. While the SEC allows the use of some non-GAAP metrics, certain figures that adjust revenue are prohibited. The exchange between the SEC and Tesla includes four letters uploaded by the regulator from mid-September to mid-October, Tatyana Shumsky reports.


    Francine:  Remarks at New York University Forum on Non-GAAP Metrics ---
    http://retheauditors.com/2016/11/09/remarks-at-new-york-university-forum-on-non-gaap-metrics/

    Teaching Case from The Wall Street Journal Accounting Weekly Review on October 21, 2016 ---

    Buyout-Loan Strategy Questioned
    by: Liz Hoffman and Matt Wirz
    Oct 17, 2016
    Click here to view the full article on WSJ.com

    TOPICS: Non-GAAP Reporting

    SUMMARY: Bank regulatory requirements "discourage banks from lending more than six times a company's earning before interest, taxes, depreciation and amortization, or EBITDA." However, companies looking for financing adjust the amounts used to determine that ratio in "potentially aggressive or unsupported" ways similar to concerns about non-GAAP reporting of earnings in earnings releases by publicly-traded firms. "The warnings come amid annual reviews in which regulators expressed concerns that banks and their clients are being liberal with adjustments to earnings to justify more borrowing...."

    CLASSROOM APPLICATION: The article may be used in a class on financial reporting to cover non-GAAP reporting or debt issuance.

    QUESTIONS: 
    1. (Introductory) What are "leveraged loans"? Why are they of particular interest now?

    2. (Introductory) Why do federal banking regulators examine buyout transactions such as the purchase of Ultimate Fighting Championship (UFC) by William Morris Endeavor? Include in your answer a description of bank loan portion of the transaction.

    3. (Advanced) What benefit is obtained by limiting loan amounts to 6 times EBITDA?

    4. (Advanced) What are the reporting requirements when publicly traded companies disclose non-GAAP information in earnings releases? How are regulators requiring similar information for mergers and acquisitions that are financed with bank lending?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Buyout-Loan Strategy Questioned," by Liz Hoffman and Matt Wirz, The Wall Street Journal, October 17, 2016 ---
    http://www.wsj.com/articles/the-ultimate-earnings-fighting-championship-1476615601?tesla=y?mod=djem_jiewr_AC_domainid

    Sale of UFC and other buyout deals are raising concerns among regulators that banks and clients are being too liberal with adjustments to earnings to justify more borrowing for transactions

    When the Ultimate Fighting Championship put itself up for sale this year, the mixed-martial-arts organization showed one measure of earnings of about $170 million, according to people familiar with the deal.

    But with a few tweaks, the figure presented to debt investors helping finance the sale climbed to $300 million, the people said.

    The higher number allowed the buyer, talent agency William Morris Endeavor, to borrow $1.8 billion for the deal without exceeding a regulatory “leverage” guideline. That discourages banks from lending more than six times a company’s earnings before interest, taxes, depreciation and amortization, or Ebitda.

    Banking regulators have shown increasing concern about such moves in the $900 billion-a-year leveraged-loan market, in which banks lend to risky companies, often during a takeover, and then sell the debt in pieces to investors. In 2013, the Federal Reserve and Office of the Comptroller of the Currency started guiding banks to stay away from heavily leveraged deals.

    In recent weeks, Fed examiners have notified William Morris Endeavor’s lenders, Goldman Sachs Group Inc. and  AG, that the way the UFC loans stayed under the Ebitda guideline could be problematic, according to people familiar with the matter.

    Regulators in recent months have also flagged at least two other buyouts—those of software companies Cventand SolarWinds Inc.—for potentially aggressive or unsupported adjustments to Ebitda, some of the people said.

    The warnings come amid annual reviews in which regulators expressed concerns that banks and their clients are being liberal with adjustments to earnings to justify more borrowing, the people said.

    Goldman Sachs and Deutsche Bank declined to comment.

    Concerns about companies massaging their financial figures in the debt markets echo worries in stock markets. The Securities and Exchange Commission has criticized companies’ increasing use of measures that don’t comply with standard accounting rules.

    The adjustments often exclude charges for things like stock-based compensation or restructuring expenses. In and of themselves, the adjustments aren’t improper. Companies have said that the tweaks provide a truer picture of their business. The fear is that they also provide an overly rosy view of profits.

    Continued in article


    Preliminary statistical data show the difference between operating (pro forma) earnings and net income under generally accepted accounting principles reached an all-time high in 2001. These statistics cover the largest U.S. public companies, collectively known as the Standard & Poor's 500. A timely analysis by TheStreet.Com shows why investors should be concerned. http://www.accountingweb.com/item/70533 


    Sharpe Point: Risk Gauge Is Misused
    Past average experience may be a terrible predictor of future performance

    The so-called Sharpe Ratio has become a cornerstone of modern finance, as investors have used it to help select money managers and mutual funds. Now, many academics -- including Sharpe himself -- say the gauge is being misused . . . The ratio is commonly used -- "misused," Dr. Sharpe says -- for promotional purposes by hedge funds. Bayou Management LLC, the Connecticut hedge-fund firm under investigation for what authorities suspect may have been a massive fraud, touted its Sharpe Ratio in marketing material. Investment consultants and companies that compile hedge-fund data also use it, as does a new annual contest for the best hedge funds in Asia, by a newsletter called AsiaHedge. "That is very disturbing," says the 71-year-old Dr. Sharpe. Hedge funds, loosely regulated private investment pools, often use complex strategies that are vulnerable to surprise events and elude any simple formula for measuring risk. "Past average experience may be a terrible predictor of future performance," Dr. Sharpe says.
    Ianthe Jeanne Dugan, "Sharpe Point: Risk Gauge Is Misused," The Wall Street Journal, August 31, 2005; Page C1--- http://online.wsj.com/article/0,,SB112545496905527510,00.html?mod=todays_us_money_and_investing


    2002 Message from Ron Huefner [rhuefner@ACSU.BUFFALO.EDU

    For those needing a break from Enron, the SEC today issued its first enforcement action in the area of pro-forma earnings. AAER 1499, regarding Trump Hotels and Casino Resorts, Inc., may be found at

    http://www.sec.gov/news/headlines/trumphotels.htm 

    Ron Huefner

    "SEC Brings First Pro Forma Financial Reporting Case Trump Hotels Charged With Issuing Misleading Earnings Release,"  FOR IMMEDIATE RELEASE 2002-6 --- http://www.sec.gov/news/headlines/trumphotels.htm 

    Washington, D.C., January 16, 2002 — In its first pro forma financial reporting case, the Securities and Exchange Commission instituted cease-and-desist proceedings against Trump Hotels & Casino Resorts Inc. for making misleading statements in the company's third-quarter 1999 earnings release. The Commission found that the release cited pro forma figures to tout the Company's purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual one-time gain rather than to operations.

    "This is the first Commission enforcement action addressing the abuse of pro forma earnings figures," said Stephen M. Cutler, Director of the Commission's Division of Enforcement. "In this case, the method of presenting the pro forma numbers and the positive spin the Company put on them were materially misleading. The case starkly illustrates how pro forma numbers can be used deceptively and the mischief that they can cause."

    Trump Hotels consented to the issuance of the Commission's order without admitting or denying the Commission's findings. The Commission also found that Trump Hotels, through the conduct of its chief executive officer, its chief financial officer and its treasurer, violated the antifraud provisions of the Securities Exchange Act by knowingly or recklessly issuing a materially misleading press release.

    "This case demonstrates the risks involved in mishandling pro forma reporting," said Wayne M. Carlin, Regional Director of the Commission's Northeast Regional Office. "Enforcement action can result if a company fails to disclose information necessary to assure that investors will not be misled by the pro forma numbers."

    Specifically, as set forth in the Order, which is available on the Commission's website, the Commission found that:

    • On Oct. 25, 1999, Trump Hotels issued a press release announcing its quarterly results. The release used net income and earnings-per-share (EPS) figures that differed from net income and EPS calculated in conformity with generally accepted accounting principles (GAAP), in that the figures expressly excluded a one-time charge. The earnings release was fraudulent because it created the false and misleading impression that the Company had exceeded earnings expectations primarily through operational improvements, when in fact it had not.
       
    • The release expressly stated that net income and EPS figures excluded a $81.4 million one-time charge. Although neither the earnings release nor the accompanying financial data used the term pro forma, the net income and EPS figures used in the release were pro forma numbers because they differed from such figures calculated in conformity with GAAP by excluding the one-time charge. By stating that this one-time charge was excluded from its stated net income, the Company implied that no other significant one-time items were included in that figure.
       
    • Contrary to the implication in the release, however, the stated net income included an undisclosed one-time gain of $17.2 million. The gain was the result of the termination, in September 1999, of the All Star Café's lease of restaurant space at the Trump Taj Mahal Casino Resort in Atlantic City. Trump Hotels, through various subsidiaries, owns and operates the Taj Mahal and other casino resorts. The Company's executive offices are in New York City, and its business and financial operations are centered in Atlantic City.
       
      • Not only was there no mention of the one-time gain in the text of the release, but the financial data included in the release gave no indication of it, because all revenue items were reflected in a single line item.
         
    • The misleading impression created by the reference to the exclusion of the one-time charge and the undisclosed inclusion of the one-time gain was reinforced by the comparison in the earnings release of the stated earnings-per-share figure with analysts' earnings estimates and by statements in the release that the Company been successful in improving its operating performance. Using the non-GAAP, pro forma figures, the release announced that the Company's quarterly earnings exceeded analysts' expectations, stating:

       

      Net income increased to $ 14.0 million, or $ 0.63 per share, before a one-time Trump World's Fair charge, compared to $ 5.3 million or $ 0.24 per share in 1998. [Trump Hotels'] earnings per share of $ 0.63 exceeded First Call estimates of $ 0.54.

       

      In addition, the release quoted Trump Hotels' chief executive officer as attributing the stated positive results and improvement from third-quarter 1998 to improvements in the Company's operations.
       
    • In fact, had the one-time gain been excluded from the quarterly pro forma results as well as the one-time charge, those results would have reflected a decline in revenues and net income and would have failed to meet analysts' expectations. The undisclosed one-time gain was thus material, because it represented the difference between positive trends in revenues and earnings and negative trends in revenues and earnings, and the difference between exceeding analysts' expectations and falling short of them.
       
    • On Oct. 25, the day the earnings release was issued, the price of the Company's stock rose 7.8 percent; subsequently, analysts learned of the one-time gain. On Oct. 28, the day on which an analysts' report and a news article revealing the impact of the one-time gain were published, the stock price fell approximately 6 percent.

    The Commission found that Trump Hotels violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The Company was ordered to cease and desist from violating those provisions.

    For information about the use and interpretation of pro forma financial information, see the cautionary advice for companies and their advisors at http://www.sec.gov/news/headlines/proforma-fin.htm and the investor alert recently issued by the Commission at http://www.sec.gov/investor/pubs/proforma12-4.htm.

    Contact:   Wayne M. Carlin  tel.: (646) 428-1510

    Additional Materials

       * Order re: Trump Hotels & Casino Resorts, Inc.
       * SEC Caution Regarding "Pro Forma" Financials
       * Investor Alert Regarding "Pro Forma" Financials

     


    From the Wall Street Journal Accounting Weekly Review on May 27, 2016

    SEC Reviewed Valeant's Use of 'Non-GAAP' Financial Measures
    by: Michael Rapoport
    May 25, 2016
    Click here to view the full article on WSJ.com

    TOPICS: Financial Accounting, Financial Reporting, GAAP, Non-GAAP Reporting, SEC

    SUMMARY: The Securities and Exchange Commission reviewed Valeant Pharmaceuticals International Inc.'s use of adjusted "non-GAAP" financial measures and criticized Valeant's disclosures at one point as "potentially misleading. The SEC took issue with Valeant's practice of stripping out acquisition-related costs from its customized non-GAAP measures given that the Canadian drug company's business strategy was heavily dependent on acquisitions. The commission also questioned Valeant's disclosure of the tax effects of the costs it stripped out of its non-GAAP measures.

    CLASSROOM APPLICATION: This article offers a case study which applies the recent concerns regarding non-GAAP reporting to a company's situation. It is appropriate for discussing non-GAAP financial reporting in financial accounting classes.

    QUESTIONS: 
    1. (Introductory) What are the facts surrounding Valeant Pharmaceuticals International Inc.'s current financial situation?

    2. (Introductory) What is GAAP? How is it determined? What entities use GAAP?

    3. (Advanced) What is non-GAAP reporting? Why do companies engage in non-GAAP reporting? What are the benefits of this type of reporting?

    4. (Advanced) What is the SEC? What is its area of authority? Why has the SEC chosen to get involved with non-GAAP reporting? What is the agency planning to do?

    5. (Advanced) What are the SEC's criticisms of Valeant's recent actions? What was Valeant doing? Why did the company choose to do these actions? Why is the SEC concerned?

    6. (Advanced) How did Valeant's management respond the SEC's criticisms? What changes will the company make?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "SEC Reviewed Valeant's Use of 'Non-GAAP' Financial Measures," by Michael Rapoport, The Accounting Review, May 25, 2016 ---
    http://www.wsj.com/articles/sec-reviewing-valeants-use-of-non-gaap-financial-measures-1464112332?mod=djem_jiewr_AC_domainid

    Valeant defended practice, but has told SEC it would make changes in its disclosures

    The Securities and Exchange Commission reviewed Valeant Pharmaceuticals International Inc.’s use of adjusted “non-GAAP” financial measures and criticized Valeant’s disclosures at one point as “potentially misleading,” according to newly public correspondence between the SEC and the company.

    The SEC took issue with Valeant’s practice of stripping out acquisition-related costs from its customized non-GAAP measures given that the Canadian drug company’s business strategy was heavily dependent on acquisitions, according to comment letters the SEC sent to the company starting in December. The commission also questioned Valeant’s disclosure of the tax effects of the costs it stripped out of its non-GAAP measures.

    SEC staff members are “concerned with your overall format and presentation of the non-GAAP measures and believe revisions to your future earnings releases and investor materials are appropriate,” the SEC’s corporation-finance division wrote to Valeant in a Dec. 4 letter.

    In responses to the SEC letters, Valeant defended its use of non-GAAP measures but said it would make changes in its disclosures. A Valeant spokeswoman said in a statement Tuesday that the company “believes that its disclosures were in accordance with applicable SEC rules.”

    The SEC has recently stepped up criticism of non-GAAP metrics—unofficial measures of corporate earnings that don’t follow generally accepted accounting principles, or GAAP. These measures strip out non-cash and one-time items to present what companies say is a clearer picture of their true performance, but critics contend the companies are taking out expenses they shouldn’t and making themselves appear stronger than they really are.

    Valeant had a GAAP loss of $291.7 million in 2015 versus an adjusted profit of $2.84 billion, after stripping out items like restructuring and acquisition costs, impairment charges and amortization of intangible assets.

    The comments came as part of a regular SEC review of Valeant’s filings, which the commission said in an April 26 letter it had completed. They don’t result in any penalty for the company.

    The correspondence shows the SEC’s “lack of comfort” with Valeant’s reporting, said Wells Fargo & Co. analyst David Maris, who has often been critical of Valeant. It “could add gravity” to the various regulatory investigations of the company, he said, including the SEC’s own probe into Valeant’s ties to a mail-order pharmacy which helped the company get insurance reimbursements for its often high-priced drugs. Valeant earlier this year restated earnings with regard to $58 million of revenue in connection with the pharmacy.

    Valeant is trying to move forward after months of questions about its accounting and business practices. The company has replaced its chief executive and much of its board, filed its belated annual report and vowed to curb the dramatic drug-price increases that drew political backlash.

    Valeant’s stock slipped 0.4% Tuesday to close at $26.11. The company’s shares have lost about 90% of their value since hitting their high last August.

    In the comment letters, the SEC asked Valeant to justify “why you remove the impact of acquisition-related expenses” and questioned the company’s reference to its “core” operating results, since its operations were so reliant on large, frequent acquisitions. Valeant stripped out $400 million in “restructuring, integration, acquisition-related and other costs” from its non-GAAP earnings in 2015, and nearly $1.3 billion in the last three years.

    Valeant replied that acquisition expenses were “not related to the company’s core operating performance,” and said that the volume and size of its acquisitions had varied over time. But the company agreed to stop referring to “core” results.

    In addition, the non-GAAP numbers seem to assume a low tax rate, the SEC said in a March 18 comment letter, giving the impression Valeant could generate big pre-tax profits without paying any significant amount of taxes. “We find this presentation to be potentially misleading,” the SEC said.

    Valeant responded that it believed its approach had been “reasonable” but said it would address the SEC’s concerns. In March, the company said it would change the tax reporting it uses when calculating its non-GAAP metrics.

    Among other issues, the SEC questioned whether Valeant was giving “equal prominence” to its GAAP results when it reported non-GAAP metrics, and criticized Valeant’s name of “cash earnings per share” for its adjusted metric, arguing that the name could be confusing since it doesn’t measure cash flows. Valeant agreed to give equal prominence to GAAP and to retitle cash EPS as “adjusted earnings per share,” a change the company told investors about in December.

    The SEC has become more critical of non-GAAP measures as evidence has mounted that they portray companies’ performance in a much more favorable light than standard GAAP measures. Earnings of S&P 500 companies fell 0.5% on a non-GAAP basis in 2015 compared with the previous year, but GAAP earnings fell 15.4%, according to data from Thomson Reuters and S&P Dow Jones Indices.

    Continued in article

     


    From The Wall Street Journal Weekly Accounting Review on April 1, 2015

    Valuing Intangibles Doable, Despite Resistance
    by: Vipal Monga
    Mar 23, 2016
    Click here to view the full article on WSJ.com

    TOPICS: Financial Accounting, Intangible Assets, Valuation

    SUMMARY: Company executives and investors say that recording values for intangible assets like brand names and customer data is time consuming and difficult. That's why many resist the idea of having to bring them onto their balance sheets. But valuing such items is doable. There are well-established methods used by companies when they need to calculate values for assets such as trademarks. Under current accounting rules, U.S. companies don't record those items on their books as assets, leaving a growing gap in how balance sheets and income statements reflect the inner-workings of business. Companies do put values on intangibles in acquisitions and during restructurings.

    CLASSROOM APPLICATION: This article is good for coverage of how intangible assets appear on the financial statements and how they can be valued.

    QUESTIONS: 
    1. (Introductory) What are intangible assets? How do they differ from other types of assets?

    2. (Advanced) How do current accounting rules treat intangible assets? When they appear on the financial statements? How are they presented?

    3. (Advanced) What is valuation of assets? When must companies place a value on intangible assets?

    4. (Advanced) Why do some people think it is challenging to value intangible assets?

    5. (Advanced) What are some of valuation methods? Which methods are best for what types of situations?

    6. (Advanced) Should intangible assets be included in the financial statements? Why or why not? What value would that information add? How can the value of reporting be limited?

    Reviewed By: Linda Christiansen, Indiana University Southeast

    RELATED ARTICLES: 
    Accounting's 21st Century Challenge: How to Value Intangible Assets
    by Vipal Monga
    Mar 22, 2016
    Online Exclusive

    "Valuing Intangibles Doable, Despite Resistance," by Vipal Monga, The Wall Street Journal, March 23, 2016 ---
    http://blogs.wsj.com/cfo/2016/03/23/valuing-intangibles-doable-despite-resistance/?mod=djem_jiewr_AC_domainid

    Company executives and investors say that recording values for intangible assets like brand names and customer data is time consuming and difficult. That’s why many resist the idea of having to bring them onto their balance sheets.

    But valuing such items is doable. There are well-established methods used by companies when they need to calculate values for assets such as trademarks.

    Under current accounting rules, U.S. companies don’t record those items on their books as assets, leaving a growing gap in how balance sheets and income statements reflect the inner-workings of business.

    Companies do put values on intangibles in acquisitions and during restructurings.

    Valuation experts such as PJ Patel, co-chief executive of Valuation Research Corporation, use a “discounted cash flow” model to help companies come up with values during those instances. That involves estimating the amount of cash produced annually by the intangible and then projecting the cash flow out for many years. The firm then discounts the number to determine the present-day value of the future cash flows.

    The method isn’t as precise as it would be for estimating the value of commodities such as copper, where there are well-established markets that set prices. “There’s still subjectivity involved,” said Mr. Patel. But he added that it’s becoming more commonplace to get values for intangibles.

    Companies in distress or restructuring almost always get their intangible assets valued, especially those related to the Internet, said Holly Etlin, a managing director at consulting firm AlixPartners LLP.

    “All of it has value to potential buyers,” said Ms. Etlin. She advised defunct book seller Borders Group Inc. on its bankruptcy in 2011. She also acted as interim chief financial officer for RadioShack Corp. before it filed for bankruptcy protection last year.

    While getting values on such assets takes time, it’s not always expensive.

    The consultancy fee for initial valuations for companies involved in mergers can run as low as in the five figures for middle-market companies, said Anthony Alfonso, head of the valuation and the business analytics department of accounting and consulting firm BDO USA LLP. He added that similar work for large, multinational companies, could run into the millions, but that the number would be small compared to the market capitalization of such corporations.

    It’s unclear, however, whether investors are clamoring for the values. Putting more information onto the balance sheet would only have limited worth, say investors.

    For fund managers the balance sheets or earnings aren’t the most important financial statements; many prefer to look at cash flow to see how companies are really doing, said Jason Tauber, senior research analyst with Neuberger Berman. There are too many variables and assumptions that go into earnings statements, which can color the numbers, he explained.

    “Earnings are a story, but cash is a fact,” he said.

    Continued in article

    Bob Jensen's threads on pro forma accounting ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

     


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on June 19, 2015

    Tech Startups Woo Investors With Unconventional Financial Terms - but Do Numbers Add Up?
    by: Telis Demos, Shira Ovide, and Susan Pulliam
    Jun 10, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Financial Reporting, GAAP

    SUMMARY: As young technology companies jostle for investors who will pour money into the firms as they try to make it big and strike it rich, some companies are using unconventional financial terms. Instead of revenue, these privately held firms tout "bookings," "annual recurring revenue" or other numbers that often far exceed actual revenue. The practice is perfectly legal and doesn't violate securities rules because the companies haven't sold shares in an initial public offering. Public companies can use "non-GAAP" financial terms but must explain them and disclose how they differ from measurements that follow strict accounting rules.

    CLASSROOM APPLICATION: This is a very interesting article about the use of nontraditional - "non-GAAP" - information by startups when they report to investors.

    QUESTIONS: 
    1. (Introductory) What is GAAP? What purpose does it serve? Why do companies and outside parties use it?

    2. (Advanced) What is the trend regarding providing "non-GAAP" financial information? Who is doing this? To whom are they providing it? What is their reasoning for doing this?

    3. (Advanced) In what situations would non-GAAP be acceptable reporting? In what situations would it not be allowed?

    4. (Advanced) What additional value does non-GAAP reporting add to other parties' decision-making processes? Would these parties also want GAAP information, or is the non-GAAP information sufficient?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Blowing the Froth Off Tech Earnings
    by Miriam Gottfried
    May 19, 2015
    Online Exclusive

    "Tech Startups Woo Investors With Unconventional Financial Terms - but Do Numbers Add Up?," by Telis Demos, Shira Ovide, and Susan Pulliam, The Wall Street Journal, June 10, 2015 ---
    http://www.wsj.com/articles/how-tech-startups-play-the-numbers-game-1433903883?mod=djem_jiewr_AC_domainid

    Hortonworks Inc. Chief Executive Rob Bearden forecast in March 2014 that the software firm would have a “strong $100 million run rate” by year-end. But the number looked a lot smaller after Hortonworks went public and then reported financial results: just $46 million in revenue last year.

    It turns out that Mr. Bearden wasn’t talking about revenue, though he didn’t say so at the time. The Santa Clara, Calif., company now says the $100 million target was for “billings,” a gauge of future business that isn’t part of generally accepted accounting principles. Mr. Bearden declines to comment.

    As young technology companies jostle for investors who will pour money into the firms as they try to make it big and strike it rich, some companies are using unconventional financial terms.

    Instead of revenue, these privately held firms tout “bookings,” “annual recurring revenue” or other numbers that often far exceed actual revenue.

    The practice is perfectly legal and doesn’t violate securities rules because the companies haven’t sold shares in an initial public offering. Public companies can use “non-GAAP” financial terms but must explain them and disclose how they differ from measurements that follow strict accounting rules.

    Continued in article

    "Tech Companies Fly High on Fantasy Accounting," The New York Times, June 18, 2015 ---
    http://www.nytimes.com/2015/06/21/business/high-tech-fantasy-accounting.html?mwrsm=Email&_r=0

    Jensen Comment
    It's not clear that the companies are in violation of FASB accounting standards. For example, they would be in violation of FAS 123r if they did not book employee vested stock options as expenses ---
    https://en.wikipedia.org/wiki/Stock_option_expensing 

    Restricted Stock --- https://en.wikipedia.org/wiki/Restricted_stock

    . . .

    Executive compensation practices came under increased congressional scrutiny in the United States when abuses at corporations such as Enron became public. The American Jobs Creation Act of 2004, P.L. 108-357, added Sec. 409A, which accelerates income to employees who participate in certain nonqualified deferred compensation plans (including stock option plans). Later in 2004, FASB issued Statement no. 123(R), Share-Based Payment, which requires expense treatment for stock options for annual periods beginning in 2005. (Statement no. 123(R) is now incorporated in FASB Accounting Standards Codification Topic 718, Compensation—Stock Compensation.)

    Prior to 2006, stock options were a popular form of employee compensation because it was possible to record the cost of compensation as zero so long as the exercise price was equal to the fair market value of the stock at the time of granting. Under the same accounting standards, awards of restricted stock would result in recognizing compensation cost equal to the fair market value of the restricted stock. However, changes to generally accepted accounting principles (GAAP) which became effective in 2006 led to restricted stock becoming a more popular form of compensation.[4] Microsoft switched from stock options to restricted stock in 2003, and by May 2004 about two-thirds of all companies surveyed by HR consultancy Mercer had reported changing their equity compensation programs to reflect the impact of the new option expensing rules.[5]

    The median number of stock options (per company) granted by Fortune 1000 firms declined by 40% between 2003 and 2005, and the median number of restricted stock awards increased by nearly 41% over the same period (“Expensing Rule Drives Stock Awards,” Compliance Week, March 27, 2007). From 2004 through 2010, the number of restricted stock holdings of all reporting executives in the S&P 500 increased by 88%.[

    Continued in article.

    FASB rules for stock compensation are set out in ASC 718, Compensation—Stock Compensation ---
    http://www.pwc.com/en_US/us/cfodirect/assets/pdf/accounting-guides/pwc_stock_based_2013.pdf 

    It would seem unlikely that auditors of companies using stock awards would allow violations of ASC 718.

    My point is that it is unlikely that "Fantasy Accounting" by tech companies are outright violations of FASB accounting standards. In the 1990s the tech industry was notoriously creative in writing contracts for creative accounting for increasing revenue and decreasing expenses. It became like a game to invent creative accounting followed by new EITFs to restrain the creative accounting.
    http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 

    The article ["Tech Companies Fly High on Fantasy Accounting,"] cited above in  The New York Times, June 18, 2015] is not specific enough to allow us to judge whether the companies and auditors put themselves in jeopardy of huge lawsuits by blatantly violating FASB standards in a fantasy land. It would be interesting to learn more of the specifics, however, about how they are skating on the edge of FASB standards with tacit approval of their auditors. What the article does suggest is that some of the tech company transactions (such as acquisition transactions) are so complex that the FASB has not yet caught up with creative accounting. This most certainly has been the case of the new revenue recognition standard that keeps being delayed and delayed and delayed presumably because of costs of implementation.

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    "Hollywood Creative Accounting: The Success Rate of Major Motion Pictures," by Sergio Sparviero (University of Salzburg), SSRN, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2617170

    Abstract:     
     
    Academic, trade, and popular publications commonly assert that 80 percent of motion pictures fail to make a net profit, suggesting also that the main players of the motion picture industry operate in highly volatile market conditions. More importantly, major film companies use this argument to negotiate for better terms with their production and distribution partners, to lobby for stricter copyright protections, and to argue in favor of media conglomeration as a hedge against adverse market conditions. This article disputes these assertions by calculating the full range of income that major motion pictures derive from their primary and secondary markets. It demonstrates that a large share of studio films are ultimately profitable, therefore challenging the arguments that conglomerates make with industry partners and government policy makers.

    June 21, 2015 reply from Tom Selling

    No good deed goes unpunished. The SEC tried to limit the use of non-GAAP financial measures by publishing pretty strict requirements prior to their use (See Reg. G and Item 10(e) of Regulation S-K. But issuers could now be assured that if they complied with the letter of the rules, then they wouldn’t have to revise their filings.

    Previously (may 12 years ago?), whether a non-GAAP measure was misleading was subject to the judgment of the Division of Corporation Finance, which reviewed disclosures only very selectively. As a result of the new rules, the use of non-GAAP measures exploded.

    Best,
    Tom

    Jensen Note
    Pro forma statements must be reconciled with traditional GAAP financial statements. Hence, investors and analysts who take the time and trouble can evaluate the extent of pro forma distortions.

    Bob Jensen's threads on Pro Forma Reporting --- http://faculty.trinity.edu/rjensen/Theory02.htm#ProForma

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     


    GAAP versus Non-GAAP Accounting for IPOs
    From the CFO Journal's Morning Ledger on January 8, 2015

    Forty companies went public last year reporting losses under traditional accounting rules but showing profits under their own tailor-made measures, the WSJ’s Michael Rapoport reports. That is 18% of all U.S. IPOs for the year. Some IPO market observers have raised fears that companies’ increased use of nonstandard earnings measures could confuse or mislead investors.

    Companies that use the non-GAAP measures insist that they give investors a better picture of the company. But that worries some experts, and hasn’t stopped the SEC from demanding that some of the companies revise their filings, saying that they give too much prominence to the specialty calculations over more standard measures.

    Nonstandard metrics give investors “the best measure” of continuing performance, said Jason Morgan, chief financial officer of Zoe’s Kitchen Inc., one of the firms that had to revise its filings at the request of the SEC. Do you feel that you need to look beyond GAAP to tell the full story of your company’s performance? Send us a note to let us know or tell us in the comments

    "Tailored Accounting at IPOs Raises Flags Critics Say:  Companies’ Increased Use of Customized Earnings Measures Could Confuse Investors," by Michael Rapoport, The Wall Street Journal," January 7, 2015 ---
    http://www.wsj.com/articles/tailored-accounting-at-ipos-raises-flags-1420677431

    Zoe's Kitchen Inc. is serving up profits—but only after leaving some of its expenses off the menu.

    Zoe’s, a chain of 125-plus Mediterranean-theme restaurants that went public in April, reported an adjusted profit of $13.2 million for the first nine months of 2014 under its own accounting treatments that strip out a variety of expenses.

    Including those expenses, as is required under standard accounting rules, Zoe’s reported a loss of $8.4 million.

    It is far from an isolated example. Forty companies went public in 2014 reporting losses under traditional accounting rules but showing profits under their own tailor-made measures. That is 18% of all U.S. initial public offerings for the year, according to consulting firm Audit Analytics, the highest level since at least 2009. Of 2014’s 10 biggest IPOs, nine used nonstandard earnings measures alongside the official accounting treatment to some degree.

    Many companies prefer highlighting their own customized measures, saying they give investors a better picture of the company. That worries some experts, and the Securities and Exchange Commission has written letters to Zoe’s and other companies telling them the bespoke figures they use are given too much prominence in regulatory filings and asking for revisions.

    Nonstandard metrics give investors “the best measure” of continuing performance, said Jason Morgan, chief financial officer of Zoe’s, who added that the SEC’s concerns were addressed in the company’s case by revising its prospectus.

    But as the IPO market heated up last year, observers have raised fears that companies’ increased use of these nonstandard measures could confuse or mislead investors at a time when they are forming their first impression of a company.

    “I think it’s a sign of frothiness” in the IPO market, said Brandon Rees, deputy director of the AFL-CIO’s Office of Investment. “Why investors tolerate it, I don’t know.”

    Some say the costs that companies strip out of their nonstandard measures are increasingly things that should be counted in earnings calculations, such as executive bonuses, fees for stock offerings and acquisition expenses.

    “I was just astounded at the wide variety of elements that people thought were appropriate to exclude,” said Curtis Verschoor, a DePaul University emeritus professor of accountancy. Investors should be aware that a company’s nonstandard numbers “are more likely to be slanted rather than balanced,” he said.

    Companies must still prominently disclose their earnings under generally accepted accounting principles, the standard set of U.S. accounting rules, even if they also spotlight their earnings under “non-GAAP” measures.

    “It’s knee-jerk to say that’s a place where companies put bad stuff,” said Mike Guthrie, chief financial officer of TrueCar Inc., an auto-buying-and-selling platform that went public in May.

    For the first nine months of 2014, TrueCar had a $38.6 million loss under standard rules but a $6.6 million profit under “adjusted Ebitda”—earnings before interest, taxes, depreciation and amortization, modified further to exclude other costs, such as an $803,000 expense to acquire rights to the company’s stock symbol.

    Mr. Guthrie said it would be more misleading for the companies not to present adjusted measures; the stock-symbol cost, for instance, was a one-time expense that won’t affect TrueCar’s future results. TrueCar closed Wednesday at $20.94 a share, up 133% from its IPO price of $9.

    According to Audit Analytics data, 59% of the companies that filed for an IPO since 2012 have used nonstandard metrics, compared with 48% in 2010 and 2011.

    Many go beyond the items that companies most frequently strip out of their preferred measures, such as employee stock compensation and foreign-exchange gains and losses. A PricewaterhouseCoopers LLP survey found 80% of IPO companies that made adjustments to their Ebitda from 2010 to 2013 had at least one adjustment beyond the more-common strip-outs, though PwC said it couldn’t comment on individual companies.

    The growth in such reporting by IPO companies comes in part because more technology and service-based companies are coming public. Those companies are more likely to use accounting estimates and subjective measures when compared with traditional bricks-and-mortar companies, said Jay Ritter, a University of Florida finance professor who tracks IPOs.

    The SEC has expressed concern in the past about companies’ non-GAAP metrics, notably with regard to daily-deals company Groupon Inc. Before Groupon’s 2011 IPO, the SEC raised questions about its use of “adjusted consolidated segment operating income,” a metric that excluded Groupon’s marketing costs to land new subscribers. Groupon scaled back its use of the metric in response to the SEC concerns. Groupon couldn’t be reached for comment.

    In the past two years, the commission has sent comment letters to more than 30 companies, both pre-IPO companies and those already public, criticizing them for giving nonstandard earnings measures “undue prominence” in their securities filings.

    Zoe’s received such a letter in January 2014.

    Zoe’s had mentioned its adjusted Ebitda first in the “management’s discussion and analysis” section of its prospectus, four pages before providing an earnings table that followed standard accounting rules. The SEC also questioned Zoe’s exclusion of some cash expenses from its adjusted Ebitda, such as the costs of opening new restaurants and management and consulting fees.

    Usually With the Blessings of Their Audit Firms:  The PCAOB concludes that all large audit firms frequently conduct deficient audits)
    "Big Companies Can’t Stop Cooking Their Books," The Economist, December 13, 2014 ---
    http://www.businessinsider.com/why-big-companies-cant-stop-cooking-their-books-2014-12

    No endorsement carries more weight than an investment by Warren Buffett. He became the world's second-richest man by buying safe, reliable businesses and holding them for ever. So when his company increased its stake in Tesco to 5% in 2012, it sent a strong message that the giant British grocer would rebound from its disastrous attempt to compete in America.

    But it turned out that even the Oracle of Omaha can fall victim to dodgy accounting. On September 22nd Tesco announced that its profit guidance for the first half of 2014 was £250m ($408m) too high, because it had overstated the rebate income it would receive from suppliers. Britain's Serious Fraud Office has begun a criminal investigation into the errors. The company's fortunes have worsened since then: on December 9th it cut its profit forecast by 30%, partly because its new boss said it would stop "artificially" improving results by reducing service near the end of a quarter. Mr Buffett, whose firm has lost $750m on Tesco, now calls the trade a "huge mistake".

    No sooner did the news break than the spotlight fell on PricewaterhouseCoopers (PwC), one of the "Big Four" global accounting networks (the others are Deloitte, Ernst & Young (EY) and KPMG). Tesco had paid the firm £10.4m to sign off on its 2013 financial statements. PwC mentioned the suspect rebates as an area of heightened scrutiny, but still gave a clean audit.

    PwC's failure to detect the problem is hardly an isolated case. If accounting scandals no longer dominate headlines as they did when Enron and WorldCom imploded in 2001-02, that is not because they have vanished but because they have become routine. On December 4th a Spanish court reported that Bankia had mis-stated its finances when it went public in 2011, ten months before it was nationalised. In 2012 Hewlett-Packard wrote off 80% of its $10.3 billion purchase of Autonomy, a software company, after accusing the firm of counting forecast subscriptions as current sales (Autonomy pleads innocence). The previous year Olympus, a Japanese optical-device maker, revealed it had hidden billions of dollars in losses. In each case, Big Four auditors had given their blessing.

    And although accountants have largely avoided blame for the financial crisis of 2008, at the very least they failed to raise the alarm. America's Federal Deposit Insurance Corporation is suing PwC for $1 billion for not detecting fraud at Colonial Bank, which failed in 2009. (PwC denies wrongdoing and says the bank deceived the firm.) This June two KPMG auditors received suspensions for failing to scrutinise loan-loss reserves at TierOne, another failed bank. Just eight months before Lehman Brothers' demise, EY's audit kept mum about the repurchase transactions that disguised the bank's leverage.

    The situation is graver still in emerging markets. In 2009 Satyam, an Indian technology company, admitted it had faked over $1 billion of cash on its books. North American exchanges have de-listed more than 100 Chinese firms in recent years because of accounting problems. In 2010 Jon Carnes, a short seller, sent a cameraman to a biodiesel factory that China Integrated Energy (a KPMG client) said was producing at full blast, and found it had been dormant for months. The next year Muddy Waters, a research firm, discovered that much of the timber Sino-Forest (audited by EY) claimed to own did not exist. Both companies lost over 95% of their value.

    Of course, no police force can hope to prevent every crime. But such frequent scandals call into question whether this is the best the Big Four can do--and if so, whether their efforts are worth the $50 billion a year they collect in audit fees. In popular imagination, auditors are there to sniff out fraud. But because the profession was historically allowed to self-regulate despite enjoying a government-guaranteed franchise, it has set the bar so low--formally, auditors merely opine on whether financial statements meet accounting standards--that it is all but impossible for them to fail at their jobs, as they define them. In recent years this yawning "expectations gap" has led to a pattern in which investors disregard auditors and make little effort to learn about their work, value securities as if audited financial statements were the gospel truth, and then erupt in righteous fury when the inevitable downward revisions cost them their shirts.

    The stakes are high. If investors stop trusting financial statements, they will charge a higher cost of capital to honest and deceitful companies alike, reducing funds available for investment and slowing growth. Only substantial reform of the auditors' perverse business model can end this cycle of disappointment. Born with the railways

    Auditors perform a central role in modern capitalism. Ever since the invention of the joint-stock corporation, shareholders have been plagued by the mismatch between the interests of a firm's owners and those of its managers. Because a company's executives know far more about its operations than its investors do, they have every incentive to line their pockets and hide its true condition. In turn, the markets will withhold capital from firms whose managers they distrust. Auditors arose to resolve this "information asymmetry".

    Early joint-stock firms like the Dutch East India Company designated a handful of investors to make sure the books added up, though these primitive auditors generally lacked the time or expertise to provide an effective check on management. By the mid-1800s, British lenders to capital-hungry American railway companies deployed chartered accountants--the first modern auditors--to investigate every aspect of the railroads' businesses. These Anglophone roots have proved durable: 150 years later, the Big Four global networks are still essentially controlled by their branches in the United States and Britain. Their current bosses are all American.

    As the number of investors in companies grew, so did the inefficiency of each of them sending separate sleuths to keep management in line. Moreover, companies hoping to cut financing costs realised they could extract better terms by getting an auditor to vouch for them. Those accountants in turn had an incentive to evaluate their clients fairly, in order to command the trust of the markets. By the 1920s, 80% of companies on the New York Stock Exchange voluntarily hired an auditor.

    Unfortunately, Jazz Age investors did not distinguish between audited companies and their less scrupulous peers. Among the miscreants was Swedish Match, a European firm whose skill at securing state-sanctioned monopolies was surpassed only by the aggression of its accounting. After its boss, Ivar Kreuger, died in 1932 the company collapsed, costing American investors the equivalent of $4.33 billion in current dollars. Soon after this the Democratic Congress, cleaning up the markets after the Great Depression, instituted a rule that all publicly held firms had to issue audited financial statements. Britain had already brought in a similar policy.

    Read more: http://www.businessinsider.com/why-big-companies-cant-stop-cooking-their-books-2014-12#ixzz3LsJuCymz

    Bob Jensen's Recipes for Book Cooking ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's threads on creative earnings management ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation


    Pro Forma Misguidance

    To accounting experts, however, it is another in a long line of “pro forma” figures that companies have trotted out over the years to show their business in a better light than possible under generally accepted accounting principles.
    "How Big Is GE Capital? It Depends," by Ted Mann, The Wall Street Journal, June 9, 2015 ---
    http://www.wsj.com/articles/ge-uses-own-metric-to-value-its-finance-arms-assets-1433842205?mod=djemCFO_h

    . . .

    To accounting experts, however, it is another in a long line of “pro forma” figures that companies have trotted out over the years to show their business in a better light than possible under generally accepted accounting principles.

    GE does report total assets as well. But in slides, investor discussions and forecasts, it consistently refers to ENI.

    “We disclose ENI in addition to total assets so that our investors can better assess our total capital invested in financial services,” GE spokesman Seth Martin said.

    Pro forma reporting really took off in the 1990s, and after dropping off in the wake of the dot-com bust, is back on the upswing, according to Ben Whipple, an assistant professor of accounting at the University of Georgia who has researched the subject.

    Mr. Whipple and several collaborators went through nearly 130,000 earnings announcements filed with the Securities and Exchange Commission from 2003 through 2013. They found that nearly 50% of those announcements used a pro forma earnings per share metric in 2013, up from about 20% in 2003. The research didn’t track other kinds of pro forma figures, such as GE’s ENI number.

    In the best case, pro forma metrics can reveal details that might be lost in official figures, he said. Consumer products companies, for instance, regularly report sales excluding currency effects to show the strength of underlying demand. But the problem for investors is that, by definition, there aren’t any rules for coming up with pro forma data.

    “The discretionary nature of non-GAAP reporting might allow some firms to simply use metrics that portray firm performance in a more favorable light and that are not necessarily better measures of performance,” Mr. Whipple said in an email.

    To come up with ENI, GE counts up the assets in its lending businesses, then subtracts liabilities that don’t require it to pay interest, like accounts payable or insurance reserves. GE says that provides a better measure of the positions on its books that it has to fund, whether with deposits or with money borrowed in the market.

    Continued in article

    Bob Jensen's threads on pro forma scandals ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

     


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on October 11, 2013

    Company Directors Say Auditors Shouldn't Be Forced to Disclose More
    by: Michael Rapoport
    Oct 08, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Annual Report, Auditing, Financial Accounting, PCAOB

    SUMMARY: Big changes may be coming to the auditor's report: that letter in every company's annual report in which the company's auditor blesses its financial statements. But lots of corporate directors don't think the changes are such a good idea. Only 27% of public-company board members believe the proposed changes to the report will improve its usefulness. A larger portion of those surveyed, 45%, say the changes won't improve the report, while 28% aren't sure. The Public Company Accounting Oversight Board, the government's audit-industry regulator, proposed the changes. If they are enacted, auditors would have to disclose more information to investors in the auditor's report: currently a boilerplate, pass-fail document that critics say doesn't tell investors much about a company's financial health. Among other changes proposed by the PCAOB, audit firms would have to tell investors more about any "critical audit matters," the parts of the audit in which the auditor had to make its toughest decisions. They also would have to evaluate other information in the annual report beyond the financial statements, and tell investors how long the audit firm has worked for the company.

    CLASSROOM APPLICATION: This article addresses the contents of the annual report and it can be used in auditing and financial accounting classes. You can use it for a discussion or assignment regarding what is included in the annual report and the proposed changes. I found it interesting that the auditor's report has not changed since the 1940s. The related articles help to flesh out the topic and will serve nicely as a case study, if you choose.

    QUESTIONS: 
    1. (Introductory) What are the changes proposed for the auditor's report? How are directors of public companies reacting to these proposals?

    2. (Advanced) Why do you think directors have these views regarding each of the proposed changes? What changes are acceptable to more directors? Which of the changes are less appealing to directors? Why?

    3. (Advanced) What is the PCAOB? Why is it involved in the composition of annual reports?

    4. (Advanced) How long have the current requirement been in place? Why are changes being proposed at this time? Are you surprised that the current format has not been changed? Why might it have stayed unchanged for so many years?
     

    Reviewed By: Judy Beckman, University of Rhode Island
    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    RELATED ARTICLES: 
    Fear & Cheer Over Litigation Risk From New PCAOB Standard
    by Gregory J. Millman
    Aug 27, 2013
    Online Exclusive

    New Rules Expected for Annual Audit Reports
    by Michael Rapoport
    Aug 12, 2013
    Online Exclusive

    What You Need to Know About the Audit-Report Changes
    by Michael Rapoport
    Aug 13, 2013
    Online Exclusive

    "Company Directors Say Auditors Shouldn't Be Forced to Disclose More," by Michael Rapoport, The Wall Street Jounral, October 8, 2013 ---
    http://blogs.wsj.com/moneybeat/2013/10/08/companies-say-auditors-shouldnt-be-forced-to-disclose-more/?mod=djem_jiewr_AC_domainid

    Big changes may be coming to the auditor’s reportthat letter in every company’s annual report in which the company’s auditor blesses its financial statements. But lots of corporate directors don’t think the changes are such a good idea, according to a survey to be released Tuesday.

    Only 27% of public-company board members believe the proposed changes to the report will improve its usefulness, according to the survey by accounting firm BDO USA LLP. A larger portion of those surveyed, 45%, say the changes won’t improve the report, while 28% aren’t sure.

    The Public Company Accounting Oversight Board, the government’s audit-industry regulator, proposed the changes in August. If they are enacted, auditors would have to disclose more information to investors in the auditor’s report – currently a boilerplate, pass-fail document that critics say doesn’t tell investors much about a company’s financial health.

    Among other changes proposed by the PCAOB, audit firms would have to tell investors more about any “critical audit matters,” the parts of the audit in which the auditor had to make its toughest decisions. They also would have to evaluate other information in the annual report beyond the financial statements, and tell investors how long the audit firm has worked for the company.

    Of the 74 public-company directors surveyed by BDO in September, 52% are opposed to the proposal that auditors should discuss critical audit matters, and 67% are opposed to requiring auditors evaluate information beyond the financial statements. But 78% were in favor of disclosing the length of the auditor’s tenure – a move prompted by concerns that a long-tenured auditor might grow too cozy with a company to conduct a tough audit.

    The auditor’s report hasn’t been significantly changed since the 1940s, and “when you make changes to something that has been done the same way for more than 70 years, there is bound to be some pushback,” Lee Graul, a partner in BDO’s corporate governance practice, said in a statement. Corporate directors “aren’t sold on the usefulness of the PCAOB’s proposal,” he said.

    Continued in article

    Bob Jensen's threads on pro forma reporting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ProForma


    Teaching Case on How More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
    From The Wall Street Journal Accounting Weekly Review on March 7, 2014

    Some Firms Alter the Bonus Playbook
    by: Michael Rapoport
    Feb 27, 2014
    Click here to view the full article on WSJ.com
    Click here to view the video on WSJ.com WSJ Video
     

    TOPICS: Corporate Governance, Executive Compensation, Financial Accounting, GAAP, Goodwill

    SUMMARY: From 2009 to 2013, the number of companies using non-GAAP financial measures to determine compensation grew from 249 to 542, 28% of the 1,957 firms with at least $700 million of stock held outside the company's control. In the related video, author Michael Rapoport focuses on McKesson Corp. The company reports non-GAAP metrics in announcements to shareholders and then further adjusts earnings measures for determining executive bonuses. "Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures."

    CLASSROOM APPLICATION: The article and related video provide an excellent discussion for use in financial accounting classes covering non-GAAP earnings, executive compensation, and or goodwill accounting.

    QUESTIONS: 
    1. (Introductory) What is corporate governance?

    2. (Advanced) Last year, McKesson's shareholders voted against the company's executive compensation pay package. Why then is the company still using this package? How does that situation reflect on the company's corporate governance?

    3. (Introductory) What is incentive compensation?

    4. (Advanced) Focus on the paragraphs about Trex Co. How did the company adjust its determination of income used as the basis for CEO Ronald W. Kaplan's incentive compensation? What was the reasoning for this treatment? Do you agree with this approach?

    5. (Introductory) What is a goodwill write down?

    6. (Advanced) Consider the Boston Scientific Corp. exclusion of goodwill writedowns from determining its CEO's incentive compensation. How might this adjustment set an improper incentive for the CEO?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Some Firms Alter the Bonus Playbook," by Michael Rapoport, The Wall Street Journal, March 27, 2014 ---
    http://online.wsj.com/news/articles/SB10001424052702304834704579405411156046356?mod=djem_jiewr_AC_domainid

    More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
    Graphs not quoted here

    U.S. companies increasingly are using unconventional earnings measures in determining bonuses, making it easier for them to appear more profitable when they reward executives with big paydays.

    Last year, 542 companies said they determine compensation using financial measurements that differ from U.S. accounting standards, according to an analysis performed by consultant Audit Analytics for The Wall Street Journal. That is more than double the 249 companies that did so in 2009. The practice can be controversial because it strips out various costs—from employee stock payments to asset write-downs—that can depress profits.

    Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures. The commission declined to comment on their use in executive-pay decisions.

    "Everything you can think of to manipulate this has been done," said Gary Hewitt, head of research at GMI Ratings, a corporate-governance research firm.

    U.S. companies report quarterly results based on generally accepted accounting principles, or GAAP, but regulators also allow them to provide non-GAAP adjusted measures as long as they provide proper disclosure. Some companies use the non-GAAP measures as the basis for the profit targets they must hit to award incentive bonuses to executives.

    Companies are allowed to use nonstandard measures in setting executive pay, and some observers said they better represent a company's health and its executives' performances by excluding items the companies don't see as relevant to their core operations. Others disagree.

    "We're very frustrated with that," said Michael Pryce-Jones, a senior governance analyst at CtW Investment Group, which works with union pension funds on shareholder initiatives. When companies use such customized measures, he said, investors "are being given the upside, but they're not being given the downside."

    For its analysis, Audit Analytics examined public firms with $700 million or more in stock not under the company's control. The results showed the use of nonstandard measures for executive pay has risen steadily each year since 2009. The 542 companies represent 28% of the 1,957 firms examined by Audit Analytics for 2013.

    One example cited by some corporate-governance advocates: medical-products distributor McKesson Corp. MCK +0.34% , which awarded Chief Executive John Hammergren $51.7 million in compensation for fiscal 2013.

    To help determine the $3.7 million he received in short-term incentive pay, McKesson used a measure of its earnings it adjusted not once but twice. It took the nonstandard earnings measures it disclosed to investors in its earnings reports, which already had stripped out a variety of expenses, to boost the year's earnings by 74 cents a share, to $6.33, and then stripped out more costs to increase earnings an additional 88 cents, to $7.21.

    Activist shareholders have complained about McKesson's pay structure, including its use of handpicked metrics. Shareholders voted "no" by more than a 3-to-1 margin last year on a nonbinding resolution to approve the company's executive-compensation package.

    "This is something we're absolutely focusing on, looking at adjustments being made in bonus plans," said Mr. Pryce-Jones of CtW Investment Group, which was active in the campaign against McKesson.

    McKesson said its board "exercises great discipline" in deciding on pay, and its modifications are representative of its recurring performance and match how Wall Street views its profits.

    Some others think the non-GAAP use is justified. "I really don't see the sort of blatant attempt to jigger the numbers so that someone gets more compensation than they're entitled to," said Charles Vaughn, a lawyer at Nelson Mullins Riley & Scarborough LLP in Atlanta who advises boards on compensation.

    But other observers think some companies exclude some expenses from nonstandard measures that really shouldn't be excluded, like stock compensation, which they contend is a legitimate cost.

    Continued in article


    "Pro Forma Earnings:  What's Wrong With GAAP?" Stanford Graduate School of Business, August 20, 2010 ---
    http://www.gsb.stanford.edu/cldr/cgrp/documents/CGRP09-GAAP.pdf

    Jensen Comment
    I think what went wrong with pro forma statements is that business firms abused the intent ---

    September 16, 2010 reply from Tom Selling [tom.selling@GROVESITE.COM]

  • If anybody is looking for official literature, the SEC’s rules are to be found in Regulation G (“non-GAAP measures” used outside of SEC filings) and Item 10 of Regulation S-K (non-GAAP measures used in SEC filings). 

    There is also additional interpretive guidance on use of non-GAAP measures in MD&A (can’t provide cites off the top of my head), and an interesting pre-SOX enforcement release that makes for pretty light and enjoyable (if you’re into Schadenfreude) reading – Trump Hotels (AAER No. 1499 – available at www.sec.gov/litigation/admin/34-45287.htm.)

    Best,
    Tom


  • Question
    Can you trust your pro forma accountant?

    Answer
    Definitely not unless you check up on what she/he is assuming.

    "Fair Value for the S&P 500? Tell Me Lies, Sweet Little Lies," Seeking Alpha, July 28, 2009 ---
    http://seekingalpha.com/article/151795-fair-value-for-the-s-p-500-tell-me-lies-sweet-little-lies

    So in valuing equities moving forward, what concept of earnings should we use? Pick a number, any number. Looking at 2010 earnings estimates yield an incredibly broad range of forecasts. If you believe the crack-smoking bottom-up guys who strip out everything that could be construed as a "loss", you get a resounding $74 per share. Not bad!

    Taking the same approach (stripping out the quarterly "one-offs"), but from a top-down framework, yields a substantially less rosy result: earnings of just $46 per share. And actually counting all the turds for what they are on a top-down basis yields 2010 EPS of just $37 per share.


    Source: S&P Remarkable!

    On this basis, equities are either pretty darn cheap, or bum-clenchingly expensive based on 2010 earnings. Gee, thanks. Now obviously, trusting analysts' forecasts is a treacherous endeavour at the best of times, but it's small wonder that you have some people screaming "buy buy buy buy buy!!!!" whole others mutter "you guys are frickin' morons" under their breath (or not, as the case may be.)

    The chart below shows the appropriate valuation for the SPX based on a) the 3 sets of earnings estimates listed above and b) a range of multiples, none of which is completely unbelievable.

    Continued in article

    Bob Jensen's threads on pro forma controversies are at
    http://faculty.trinity.edu/rjensen/theory01.htm#ProForma


    Up Up and Away in My Beautiful Pro Forma

    "Creative Accounting Leads to Fuzzy Earns," SmartPros, December 27, 2005 --- http://accounting.smartpros.com/x51147.xml

    Dec. 27, 2005 (Associated Press) — If it weren't for some pesky accounting rules, telecom-equipment company Ciena Corp. would have lost a mere 2 cents a share in the fourth quarter. With those accounting rules, it lost 44 cents a share.

    The disparity is "the GAAP Gap" - the difference between "pro forma" earnings and earnings prepared according to Generally Accepted Accounting Principles, or GAAP.

    GAAP is the nation's accounting standard. Pro forma earnings, by contrast, are governed by no fixed standard. Companies can toss out one-time charges, options expenses, goodwill write-downs - anything that looks bad. One-time windfalls, however, usually manage to stay in.

    Merrill Lynch's U.S. Strategist Richard Bernstein did the math on 1,600 stocks and found total earnings for their third calendar quarter grew 22 percent on a GAAP basis, but 31 percent on a pro forma basis.

    The gap was greater when the companies were subdivided by Standard & Poor's quality rankings. S&P grades stocks on their annual sales and dividend growth and actual earnings over a 10-year period. A company with very stable growth would rank "A+," while a company in bankruptcy would be a "D."

    "Lower quality companies are dramatically overstating their growth rates by using pro forma earnings," Bernstein wrote in a December 19 research report.

    Companies with a B- ranking have a GAAP growth rate of 1 percent, but a pro forma growth rate of 38 percent, according to Bernstein. B+ companies are more than doubling their growth rate: GAAP growth is 13 percent, but pro forma growth is 27 percent.

    Part of the problem, according to Bernstein, is that most post-bubble regulations focus on the quality of formal financial reporting, but "there appears to be no regulation" covering earnings conference calls and press releases.

    "Although the newer regulation is laudable, stocks trade on press releases and conference calls, and not on the formal financial statements that are released weeks after the announcement and call," he wrote. "We think regulation regarding company press releases and conference calls is sorely needed because of the significant deterioration in the quality of announced earnings."

    He calls for an end to pro forma earnings, saying they have made U.S. corporate earnings perhaps the most opaque they've been in his 23 years in the business.

    Continued in article


    "EBITDA: WARTS AND ALL," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, March 5, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/542

    With the earnings season upon us, discussions in recent weeks sometimes have focused on pro forma numbers, especially with respect to several IPOs.  Some pro forma numbers are better than others.  Most, however, are inferior to GAAP (generally accepted accounting principles) numbers.

    What these pro forma constructs have in common is that they are non-GAAP numbers, which means that their definition and measurement are not standardized by any agency, and more importantly that corporate disclosures about them are not audited.  By itself, this does not disqualify them from use, but should alert the user to apply caution.

    One particularly good pro forma number is free cash flow.  The variable is supported by economic theory, and its components (cash generated by operating activities and capital expenditures) are found in GAAP financial statements, which means they are audited numbers.

    Continued (with links) in article

    Bob Jensen's threads on earnings management ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     


    Compilation and Review Standards Change
    As opposed to a formal audit, many accountants perform compilation and review services to generate unaudited financial statements for a client.  There is a new standard for these two services.

    According to SSARS, compilations and reviews are restricted to historical financial statements, even though clients often ask their accountants to provide financial statement elements and pro forma financial information. Michael Glynn, technical manager at the AICPA, reports on newly adopted standards allowing accountants to report on those financial statement elements or pro forma financial information under SSARS.
    "Compilations & Reviews New Standards," SmartPros, October 2005 --- http://education.smartpros.com/main1/extcoursedetail.asp?PartnerRed=accountingnet&CatalogNumber=APP515

     

    GAAP vs. Non-GAAP Earnings
    "Investors Applaud Oracle’s Non-GAAP Earnings," AccountingWeb, July 1. 2005 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=101064

    SOX Regulation G, which went into effect in March 2003, defines non-GAAP (Generally Accepted Accounting Principles) financial measures and creates disclosure standards for them. According to Strategic Finance magazine, the guidelines for non-GAAP financial measures stipulate that they may not:

    “The rapid integration of PeopleSoft into our business contributed to the strong growth in both applications sales and profits that we saw in the quarter,” Oracle President Safra Catz said in a written statement. “The combination of increased organic growth plus a carefully targeted acquisition strategy have pushed Oracle’s revenue and profits to record levels.”


    A Teaching Case Featuring an Article by NYU Accounting Professor Baruch Lev

    From The Wall Street Journal Accounting Weekly Review on March 2, 2012

    The Case for Guidance
    by: Baruch Lev
    Feb 27, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Earnings Forecasts, Earnings Management

    SUMMARY: This is the first of three articles in the WSJ's Section on Leadership in Corporate Finance published on Monday, February 27, 2012. Baruch Lev, the Philip Bardes Professor of Accounting and Finance at NYU's Stern School of Business offers arguments in favor of publicly traded companies' managements issuing earnings guidance. He has recently published a book entitled "Winning Investors Over."

    CLASSROOM APPLICATION: The article is useful for any financial reporting class to introduce the notions of management earnings guidance, analyst earnings forecasts, and the arguments for and against this information dissemination process. It is as well useful to highlight the usefulness of academic research in finance and accounting.

    QUESTIONS: 
    1. (Introductory) What is management guidance? To whom is it directed?

    2. (Introductory) What is the trend regarding the number of publicly traded U.S. firms providing management guidance?

    3. (Advanced) What is the difference between annual guidance and quarterly guidance? What are the trends in regarding the numbers of companies providing each of these?

    4. (Introductory) What are the arguments often presented against companies providing annual earnings guidance?

    5. (Introductory) What are the author's counterarguments to those points?

    6. (Introductory) What does Dr. Lev say about management's need for the information that is used to develop and present management earnings guidance?

    7. (Advanced) Who is Dr. Baruch Lev?

    8. (Introductory) What is the source for Dr. Lev's information in writing this article for The Wall Street Journal?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "The Case for Guidance," by Baruch Lev, The Wall Street Journal, February 7, 2012 ---
    http://online.wsj.com/article/SB10001424052970203391104577124243623258110.html?mod=djem_jiewr_AC_domainid

    Alot of prominent people don't like the idea of giving the market an early heads-up.

    Critics, who include Warren Buffett, Al Gore and groups like the Chamber of Commerce, have blasted the practice of issuing "guidance"—advance notices about earnings and other matters. They argue that it wastes managers' time and encourages short-term thinking, and may even drive companies to seek capital overseas instead of in the U.S.

    But a host of research—mine and others'—shows that those arguments don't hold up. Guidance benefits investors, companies and managers in a number of ways, such as cutting down shareholder lawsuits and giving the market better data to work with. Indeed, research recently published in the Journal of Accounting and Economics documents a significant stock-price drop for companies that announced they were stopping guidance. Far from a waste of time, guidance is a crucial part of an executive's job.

    That said, companies should do it smartly. For one thing, they should issue guidance only when they can predict performance better than analysts—and they should make it part of a broader practice of disclosure that gives investors insight into the company's plans and progress. A Vital Component

    Let's start with the most basic argument against guidance: It takes too much time. Critics say executives must set up elaborate and costly forecasting processes, and then answer endless rounds of questions about the numbers they issue. And that prevents them from undertaking other productive activities.

    ut guidance requires a negligible investment of time. A CEO who doesn't readily have short- and medium-term performance forecasts shouldn't guide, and shouldn't manage. Guidance also increases the circle of analysts following the firm, since guidance data makes it much easier to do their job. And having lots of analysts on board comes in handy in stock issues and proxy contests.

    More broadly, managers gain credibility when they have a track record of issuing accurate guidance. There's also evidence that guidance helps keep management honest. A study from University of Georgia researchers finds that companies that issue guidance are less likely to put out dishonest earnings reports than companies that don't guide.

    Critics also say that guidance encourages a futile short-term earnings game. Companies, the argument goes, slash R&D or other long-term initiatives to meet earnings estimates—sacrificing future growth.

    But the argument misses a crucial point: Most guidance isn't short-term. It forecasts several quarters ahead, giving companies a chance to fill in details that wouldn't show up in regular financial reports.

    For instance, reported earnings don't reflect the progress of the product-development process of innovative companies, such as in biotech. They also ignore recent business initiatives and new contracts signed or canceled, as well as the impact of economic developments—like the European recession—on future performance.

    In fact, I further argue that critics are wrong even when companies are providing short-term guidance. For one thing, the game of trying to beat expectations plays out with or without guidance. Doesn't Google, the famous nonguider, aim to beat the consensus? Reducing Uncertainty

    More broadly, getting more information out helps everyone involved—shareholders, analysts and companies. By sharing information with the market, companies reduce investor uncertainty and prevent stock prices from swinging wildly upon unexpected bad news. My research shows that managers' quarterly earnings guidance is more accurate than the current analysts' consensus forecast in 70% of cases. Analysts know this and are quick to revise their forecasts upon the release of guidance.

    But warning investors about potential disappointments doesn't just help protect them from losses—it helps protects companies, too. Guidance released prior to weak earnings is considered a mitigating factor in shareholder lawsuits, and was shown in a study published in 1997 to reduce settlement figures. (Most shareholder lawsuits are settled.)

    There's one more argument the critics often make against guidance: It puts so much pressure on companies that they abandon the U.S. equities market and seek out private equity or foreign listings. But I haven't found a single example of a company taken private or listed abroad whose managers claimed that the "pressure to guide" was a major reason. Besides, isn't it easier just to abstain from guidance? Two-thirds of public companies do just that.

    All that said, there are right and wrong ways to do guidance. Here's a look at some basic principles companies should follow.

    • Guide when you are a better prognosticator than analysts. For the past three to five years, compare your internal quarterly earnings forecasts with analysts' public forecasts, relative to the subsequently released earnings. If you beat analysts, chalk one up for guidance. If not, how come outsiders know more about your company's future than you do?

    • If most of your industry peers release guidance regularly, you don't want to stand out as a refusenik. Investors will suspect that you have something to hide or that you aren't on top of things.

    Continued in article

    Jensen Comment
    Baruch has done a considerable amount of previous accountics research on how to measure and report intangibles and contingency items. I'm sorry to say that over the years I've been mostly critical of that research ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    "Little Bitty Cisco," by Jesse Eisinger, The Wall Street Journal, November 6, 2003 --- http://online.wsj.com/article/0,,SB106806983279057200,00.html?mod=technology%255Ffeatured%255Fstories%255Fhs 

    The way Wall Street eyes these things, including the liberal use of the words "pro forma," Cisco had an impressive fiscal first quarter.

    Revenue came in better than expected and grew 5.3% compared with a year ago, topping expectations of a flat top-line thanks in part to spending from the federal government (see article). How impressive is this? Well, the country's economy grew at 7.2%, and business spending on equipment and software rose 15%. Microsoft had revenue growth of 6%, IBM 8.6%, and Dell is estimated to come in at 15% growth. So Cisco Systems, one of the big tech dogs, looks like the runt of that particular litter. Is networking a growth industry anymore, or is it doomed to be troubled by overcapacity and a lack of business demand? The next few quarters are crucial.

    Earnings per share -- that is, pro forma earnings per share -- easily surpassed estimates, logging in at 17 cents a share, compared with the expectation of 15 cents a share and last year's 14 cents.

    The company's shareholder equity fell in the quarter to $27.4 billion from $28 billion a year ago. Cash flow from operations fell to $973 million from $1.1 billion a year earlier. Cash on hand and investments fell from $20.7 billion to $19.7 billion, which is still mountainous but lower year-over-year, nevertheless.

    Then there is the gross-margin story. Cisco has had Himalayan gross margins throughout the slowdown, because it was able to squeeze suppliers and find efficiencies. But now that revenue is finally increasing, gross margins fell. Product gross margins came in at 69%, down from 71% in the fourth quarter. Cisco is selling less profitable products, including some from its recent acquisition of Linksys. It also has outsourced much of its production. How much operating leverage does Cisco now have? That is the reason it sports its high valuation, after all.

    Then there is the outlook. Deferred revenue and backlog were down. Cisco's book-to-bill ratio, a measure that reflects order momentum, was below one. When book-to-bill is below one, orders are lower than billings, suggesting a slowdown, not acceleration. True, Cisco put out a forecast for modestly higher revenue for the second quarter compared with the first. But some questions should linger.


    Question:  How does former Enron CEO Jeff Skilling define HFV?
    Home Video Uncovered by the Houston Chronicle, December 19, 2002
    Skits for Enron ex-executive funny then, but full of irony now --- http://www.chron.com/cs/CDA/story.hts/metropolitan/1703624 
    (The above link includes a "See it Now" link to download the video itself which played well for me.)

    The tape, made for the January 1997 going-away party for former Enron President Rich Kinder, features nearly 30 minutes of absurd skits, songs and testimonials by company executives and prominent Houstonians. The collection is all meant in good fun, but some of the comments are ironic in the current climate of corporate scandal.

    In one skit, former administrative executive Peggy Menchaca plays the part of Kinder as he receives a budget report from then-President Jeff Skilling, who plays himself, and financial planning executive Tod Lindholm. When the pretend Kinder expresses doubt that Skilling can pull off 600 percent revenue growth for the coming year, Skilling reveals how it will be done.

    "We're going to move from mark-to-market accounting to something I call HFV, or hypothetical future value accounting," Skilling jokes as he reads from a script. "If we do that, we can add a kazillion dollars to the bottom line."

    Richard Causey, the former chief accounting officer who was embroiled in many of the business deals named in the indictments of other Enron executives, makes an unfortunate joke later on the tape.

    "I've been on the job for a week managing earnings, and it's easier than I thought it would be," Causey says, referring to a practice that is frowned upon by securities regulators. "I can't even count fast enough with the earnings rolling in."

    Texas' political elite also take part in the tribute, with then-Gov. George W. Bush pleading with Kinder: "Don't leave Texas. You're too good a man."

    Former President George Bush also offers a send-off to Kinder, thanking him for helping his son reach the Governor's Mansion.

    "You have been fantastic to the Bush family," he says. "I don't think anybody did more than you did to support George."

    As far as partying accountants go, let's never forget Rich Kinder's Enron Departure Party before the meltdown of Enron (it features Jeff Skilling in the flesh speaking about Hypothetical Future Value Accounting) --- http://www.cs.trinity.edu/~rjensen/video/windowsmedia/enron3.wmv
    PS
    Rich Kinder left Enron before the scandal broke and went on to become a self-made billionaire.
    See Question 2 at http://faculty.trinity.edu/rjensen/FraudEnronQuiz.htm


    "Bubble Redux," by Andrew Bary, Barron's, April 14, 2003, Page 17.

    Amazon's valuation is the most egregious of the 'Net trio.  It trades for 80 times projected "pro forma" 2003 profit of 32 cents a share.  Amazon's pro forma definition of profit, moreover, is dubious because it excludes re-structuring charges and, more important, the restricted stock that Amazon now is issuing to employees in lieu of stock options.  Amazon's reported profit this year under generally accepted accounting principles (which include restricted-stock costs) could be just 10 cents to 15 cents a share, meaning that Amazon's true P/E arguably is closer to 200.

    Yahoo, meanwhile, now commands 70 times estimated 2003 net of 35 cents a share, and eBay fetches 65 times projected 2003 net of $1.35 a share.

    What's fair value?  By our calculations, Amazon is worth, at best, roughly 90% of its projected 2003 revenue of $4.6 billion. That translates into $10 a share, or $4.1 billion.  This estimate is charitable because the country's two most successful brick-and-mortar retailers, Wal-Mart Stores and Home Depot, also trade for about 90% of 2003 sales.

    Yahoo ought to trade closer to 15.  That's a stiff 43 times projected 2003 earnings and gives the company credit for its strong balance sheet, featuring over $2 a share in cash and another $3 a share for its stake in Yahoo Japan, which has become that country's eBay.

    Sure, eBay undoubtedly is the most successful Internet company and the only one that has lived up to the growth projections made during the Bubble.  As the dominant online marketplace in the U.S. and Europe, eBay saw its earnings surge to 87 cents a share last year from three cents in 1998, when it went public at a split-adjusted $3.00 a share.

    Why would eBay be more fairly valued around 60, its price just several months ago?  At 60, eBay would trade at 44 times projected 2003 profit of $1.35 a share and 22 times an optimistic 2005 estimate of $2.75.  So confident are analysts about eBay's outlook that they're comfortable valuing the stock on a 2005 earnings estimate.

    Fans of eBay believe its profit can rise at a 35% annual clip in the next five years, a difficult rate for any company to maintain, even one, such as eBay, with a "scalable" business model that allows it to easily accommodate more transactions while maintaining its enviable gross margins of 80%.  If the company earns $5 a share in 2007--nearly six times last year's profit--it would still trade at 18 times that very optimistic profit level.

    Continued in the article.


    The New York Yankees today released their 4th Quarter 2001 pro forma results. Although generally accepted scorekeeping principles (GASP) indicate that the Yankees lost Games 1 and 2 of the 2001 World Series, their pro forma figures show that these reported losses were the result of nonrecurring items, specifically extraordinary pitching performances by Arizona Diamondbacks personnel Kurt Schilling and Randy Johnson. Games 3 and 4 results, already indicating Yankee wins, were not restated on a pro forma basis.
    Ed Scribner, New Mexico State

    Until recently, pro forma reporting was seen as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. Today it finds itself in bad odour. 
    "Pro forma lingo Does the use of controversial non-GAAP reporting by some companies confuse or enlighten?," by Michael Lewis, CA Magazine, March 2002 --- http://www.cica.ca/cica/camagazine.nsf/e2002-mar/Features 

    For fans of JDS Uniphase Corp., the fibre-optics manufacturer with headquarters in Ottawa and San Jose, Calif., the report for fiscal 2001 provided the icing on a very delicious cake: following an uninterrupted series of positive quarterly earnings results, the corporate giant announced it was set to deliver US$67 million in pro forma profit.

    There was only one fly in the ointment. Like all such calculations, JDS's pro forma numbers were not prepared in accordance with generally accepted accounting principles (GAAP), and as such they excluded goodwill, merger-related and stock-option charges, and losses on investments. Once those items were added back into the accounting mix, JDS suddenly showed a staggering US$50.6 billion in red ink - a US corporate record. Even so, many investors remained loyal, placing their trust in the boom-market philosophy that views onetime charges as largely irrelevant. The mantra was simple - operating results rule.

    "That was the view at the time," says Jim Hall, a Calgary portfolio manager with Mawer Canadian Equity Fund. "It just goes to show how wrong people can be."

    Since then, of course, the spectacular flameout of Houston's Enron Corp. has done much to change that point of view (though it's not a pro forma issue). Once the world's largest energy trader, the company now holds the title for the largest bankruptcy case in US history. The Chapter 11 filing in December came after Enron had to restate US$586 million in earnings because of apparent accounting irregularities. In its submission, the company admitted it had hidden assets and related debt charges since 1997 in order to inflate consolidated earnings. Enron's auditor, accounting firm Arthur Andersen LLP, later acknowledged that it had made "an [honest] error in judgement" regarding Enron's financial statements.

    While the Enron saga will continue in various courtrooms for many months to come, regulators on either side of the border have responded to the collapse with uncharacteristic swiftness. Both the Securities and Exchange Commission (SEC) in the United States and the Canadian Securities Administrators (CSA) issued new guidelines on financial reporting just a few weeks after the Enron bust. In each instance, investors were reminded to redirect their focus to financial statements prepared in accordance with GAAP, paying special attention to cash flow, liquidity and the intrinsic value of acquisitions. At the same time, issuers were warned to reduce their reliance on pro forma results and to explain to investors why they were not using GAAP in their reporting.

    SEC chairman Harvey Pitt moved furthest and fastest. In mid-January he announced plans to establish a private watchdog to discipline accountants and review company audits. Working with the largest accounting firms and professional organizations such as the American Institute of Certified Public Accountants (AICPA), the SEC wants the new body to be able to punish accountants for incompetence and ethics violations. As Pitt emphasized, "The commission cannot, and in any event will not, tolerate this pattern of growing re-statements, audit failures, corporate failures and investor losses."

    The sheer scale of the Enron debacle has brought pro forma accounting under public scrutiny as never before, and, observers say, will provide a powerful impetus for financial reporting reform. "This will send a message to companies and accountants to cut back on some of the games they've been playing," says former SEC general counsel Harvey Goldschmid.

    Meanwhile, the CSA (the forum for the 13 securities regulators of Canada's provinces and territories) expressed its concern over the proliferation of non-standard measures, warning that they improve the appearance of a company's financial health, gloss over risks and make it exceedingly difficult for investors to compare issuers.

    "Investors should be cautious when looking at non-GAAP measures," says John Carchrae, chair of the CSA Chief Accountants Committee, when the guidelines were released in January. "These measures present only part of the picture and may selectively omit certain expenses, resulting in a more positive portrayal of a company's performance."

    As a result, Canadian issuers will now be expected to provide GAAP figures alongside non-standard earnings measures, explain how pro forma numbers are calculated, and detail why they exclude certain items required by GAAP. So far, the CSA has provided guidance rather than rules, but the committee cautions it could take regulatory action if issuers publish earnings reports deemed to be misleading to investors.

    Carchrae, who is also chief accountant of the Ontario Securities Commission (OSC), believes "moral suasion" is a good place to start. Nonetheless, he adds, the OSC intends to track press releases, cross-reference them to statutory earnings filings and supplemental information on websites, and monitor continuous disclosure to ensure a company meets its requirements under the securities act.

    Although pro forma reporting finds itself in bad odour, until recently it was regarded as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. In cases involving a merger or acquisition, for example, where a company has made enormous expenditures that generate significant non-cash expenses on the income statement, pro forma can be used as a clarifying document, enabling investors to view economic performance outside of such onetime events. Over the years, however, the pro forma route has increasingly involved the selective use of press releases, websites, and other reports to put a favourable spin on earnings, often leading to a spike in the value of a firm's stock. Like management discussion and analysis, such communications are not within the ambit of GAAP, falling somewhere between the cracks of current accounting standards.

    "Obviously, this issue is of concern to everyone who uses financial statements," says Paul Cherry, chairman of the Canadian Institute of Chartered Accountants' Accounting Standards Board. "Our worry as standard-setters is whether these non-GAAP, pro forma items confuse or enlighten."

    Regulators and standard-setters have agonized over this issue ever since the reporting lexicon began to expand with the rise of the dot-com sector in the late 1990s, a sector with little in the way of earnings that concentrated on revenue growth as a more meaningful performance indicator. New measures, such as "run-through rates" or "burn rates," were deemed welcome additions to traditional methodology because they helped determine how much financing a technology company might require during its risky startup phase.

    Critics, however, argued such terms were usurping easily understood language as part of a corporate scheme to hoodwink unwary investors. Important numbers were hidden or left out under a deluge of new and ever-more complex terminology. The new measurements, they warned, fell short of adequate financial disclosure.

    An OSC report published in February 2001 appears to support these claims. According to the report, Canadian technology companies have not provided investors with adequate information about how they disclose revenue, a shortcoming that may require some of them to restate their financial results.

    "Initial results of the review suggest a need for significant improvement in the nature and extent of disclosure," the report states, adding that the OSC wants more specific notes on accounting policy attached to financial statements. The report also observes that revenue is often recognized when goods are shipped, not when they are sold, despite the fact that the company may be exposed to returns.

    David Wright, a software analyst at BMO Nesbitt Burns in Toronto, says dealing with how technology companies record revenue is a perennial issue. The issue has gained greater prominence with the rise of vendor financing, a practice whereby companies act as a bank to buyers, lending customers the cash to complete purchase orders. If the customer is unable to pay for the goods or services subsequent to signing the sales agreement, the seller's revenue can be drastically overstated.

    But pro forma still has plenty of advocates - particularly when it comes to earnings before interest, taxes, depreciation and amortization (EBITDA). Such a measure, it is often argued, can provide a pure, meaningful and reliable diagnostic tool, albeit one that should be considered along with figures that accommodate charges to a balance sheet.

    Ron Blunn, head of investor relations firm Blunn & Co. Inc. in Toronto and chairperson of the issues committee of the Canadian Investor Relations Institute, says adjusted earnings can serve a legitimate purpose and are particularly helpful to analysts and money managers who must gauge the financial well-being of technology startups.

    The debate shows no signs of burning out anytime soon. On the one hand, the philosophy among Canadian and US standard-setters in recent years has appeared to favour removing constraints, rather than imposing them. New rules to apply to Canadian banks this year, for example, will no longer require the amortization of goodwill in earnings figures. On the other hand, it has become abundantly clear that companies will emphasize the reporting method that puts the best gloss on their operations. And while the use of pro forma accounting has remained most prevalent among technology companies, the movement to embrace more and varied language has spread to "old economy" companies such as Enron, gaining steam as the economy stumbled. Blunn theorizes the proliferation of nontraditional reporting and the increasing reliance on supplemental filings simply reflect the state of the North American economy.

    Carchrae has a slightly different diagnosis. When asked why pro forma reporting has mushroomed in recent years, he points to investors' slavish devotion to business box scores - that is, a company's ability to meet sales and earnings expectations as set out by equity analysts. Since companies can be severely punished for falling short of the Street's consensus forecast, there is intense pressure, especially in a bear market, to conjure up earnings that appear to satisfy forecasts.

    As a result, pro forma terminology has blossomed over the Canadian corporate landscape. Montreal-based telephone utility BCE Inc., for example, coined the term "cash baseline earnings" to describe its operating performance. Not to be outdone, Robert McFarlane, chief financial officer of Telus Corp., Canada's second-largest telecommunications company, cited a "revenue revision" and "EBITDA deficiency" to explain the drop in the Burnaby, BC-based phone service firm's "core baseline earnings" for its third quarter ended September 30, 2001. (According to company literature, core baseline earnings refers to common share income before discontinued operations, amortization of acquired intangible assets net of tax, restructuring and nonrecurring refinancing costs net of tax, revaluation of future tax assets and liabilities and goodwill amortization.)

    Meanwhile, IBM Corp. spinoff Celestica Inc. of Toronto neglected to mention the elimination of more than 8,700 jobs from a global workforce of 30,000, alluding to the cuts in its fiscal 2001 third-quarter report through references to "realignment" charges during the period.

    Many statements no longer use the term "profit" at all. And while statutory filings must present at least one version of earnings that conforms to GAAP, few rules have been set down by US or Canadian regulators to govern non-GAAP declarations. Accounting bodies in Canada and around the world are charged with policing their members and assuring statutory filings include income and revenue according to GAAP, using supportable interpretations. But pro forma numbers are typically distributed before a company's statutory filing is made.

    "Not to pass the buck," says Cherry, "but how can we set standards for something that's not part of GAAP?" Still, Cherry admits the use of non-GAAP terminology has become so widespread that accounting authorities are being forced to take notice. "The matter is gaining some prominence," he says, "because some of the numbers are just so different."

    Despite his reservations, Cherry acknowledges "the critical point is when information is released to the marketplace," which nowadays is almost always done via a press release. The duty to regulate such releases, he says, must rest with securities bodies - an opinion shared by Edmund Jenkins, chair of the Financial Accounting Standards Board (FASB) in the United States.

    Many authorities view the issue as a matter of education, believing that a high degree of sophistication must now be expected from the retail investing community. Others say the spread of non-GAAP reporting methodology, left unchecked, could distort markets, undermine investor confidence in regulatory regimes and ultimately impede the flow of investment capital. But pro forma devotees insist that introducing tough new measures to govern reporting would do little to protect consumers and encourage retail investment. Instead, new regulations might work to impede growth and limit available, useful financial information.

    Continued at http://www.cica.ca/cica/camagazine.nsf/e2002-mar/Features 


    From The Wall Street Journal Accounting Educators's Review on October 18, 2002

    TITLE: Motorola's Profit: 'Special' Again? 
    REPORTER: Jesse Drucker 
    DATE: Oct 15, 2002 
    PAGE: C1 
    LINK: http://online.wsj.com/article/0,,SB1034631975931460836.djm,00.html  
    TOPICS: Special Items, Pro Forma Earnings, Accounting, Earning Announcements, Earnings Forecasts, Financial Analysis, Financial Statement Analysis, Net Income

    SUMMARY: Motorola has announced both pro forma earnings and net income as determined by generally accepted accounting principles for 14 consecutive quarters. Ironically, pro forma earnings are always greater than net income calculated using generally accepted accounting principles

    QUESTIONS: 
    1.) Distinguish between a special item and an extraordinary item. How are each reported on the income statement?

    2.) Distinguish between pro forma earnings and GAAP based earnings. What are the advantages and disadvantages of allowing companies to report multiple earnings numbers? What are the advantages and disadvantages of not allowing companies to report multiple earnings numbers?

    3.) What items were reported as special by Motorola? Are these items special? Support your answer.

    4.) Are you surprised that all the special items reduced earnings? What is the likelihood that there were positive nonrecurring items at Motorola? How are positive nonrecurring items reported?

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


    "Pro-Forma Earnings Reporting Persists," by Shaheen Pasha, Washington Post, August 16, 2002 --- http://www.washingtonpost.com/wp-dyn/articles/A25384-2002Aug16.html 

    While many on Wall Street are calling for an end to pro forma financial reporting given widespread jitters over corporate clarity, it's clear from second-quarter reports that the accounting practice is a hard habit to break.

    Publicly traded companies are required to report their results according to generally accepted accounting principles, or GAAP, under which all types of business expenses are deducted to arrive at the bottom line of a company's earnings report.

    But an ever-increasing number of companies in recent years has taken to also reporting earnings on a pro forma – or "as if" – basis under which they exclude various costs. Companies defend the practice, saying the inclusion of one-time events don't accurately reflect true performance.

    There is no universal agreement on which expenses should be omitted from pro forma results, but pro forma figures typically boost results.

    Indeed, as the second-quarter reporting season dwindles down with more than 90 percent of the Standard & Poor's 500 companies having reported, only Yahoo Inc., Compuware Corp. and Xilinx Inc. made the switch to reporting earnings under GAAP, according to Thomson First Call.

    While a number of S&P 500 companies, including Computer Associates International Inc. and Corning Inc., made the switch to GAAP in the first quarter, that still brings the number to 11 companies in total that have given up on pro forma over the last two quarters.

    "It's disappointing that at this stage we haven't seen more companies make the switch to GAAP earnings from pro forma," said Chuck Hill, director of research at Thomson First Call.

    Continued at http://www.washingtonpost.com/wp-dyn/articles/A25384-2002Aug16.html  


    A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings are cited as the best benchmarks for a few industries, but not many. The preferred benchmarks are generally pro forma earnings or pro forma earnings per share. http://www.accountingweb.com/item/91934 

    AccountingWEB US - Oct-1-2002 -  A new research report from Bear Stearns identifies the best earnings benchmarks by industry. GAAP earnings (earnings prepared according to generally accepted accounting principles) are cited as the best benchmarks for a few industries, but not many. Most use pro forma earnings or pro forma earnings per share (EPS).

    Examples of the most useful earnings benchmarks for just a few of the 50+ industries included in the report:

    EBITDA=Earnings before interest, taxes, depreciation and amortization.
    FFO=funds from operations.

    The report also lists the most common adjustments made to arrive at pro forma earnings and tells whether securities analysts consider the adjustments valid. Patricia McConnell, senior managing director at Bear Stearns, explains, "Analysts rarely accept managements' suggested 'pro forma' adjustments without due consideration, and sometimes we reject them... We would not recommend using management's version of pro forma earnings without analysis and adjustment, but neither would we blindly advise using GAAP earnings without analysis and adjustment."


    From The Wall Street Journal Accounting Educators' Review on July 27, 2002

    TITLE: Merrill Changes Methods Analysts Use for Estimates 
    REPORTER: Karen Talley DATE: Jul 24, 2002 
    PAGE: C5 
    LINK: http://online.wsj.com/article/0,,BT_CO_20020724_009399.djm,00.html  
    TOPICS: Accounting, Earnings Forecasts, Financial Accounting, Financial Analysis, Financial Statement Analysis

    SUMMARY: Merrill Lynch & Co. has reported that it will begin forecasting both GAAP based earnings estimates in addition to pro forma earnings measures. To accommodate Merrill Lynch & Co., Thomson First Call will collect and report GAAP estimates from other analysts.

    QUESTIONS: 
    1.) Compare and contrast GAAP earnings and pro forma earnings?

    2.) Why do analyst forecast pro forma earnings? Will GAAP earnings forecasts provide more useful information than pro forma earnings forecasts? Support your answer.

    3.) Discuss the advantages and disadvantages of analysts forecasting both pro forma and GAAP earnings. Should analysts continue to provide pro forma earnings forecasts? Should analysts also provide GAAP earnings forecasts? Support your answers.

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


    Denny Beresford's Terry Breakfast Lecture
    Subtitle:  Does Accounting Still Matter in the "New Economy" 

    Every accounting educator and practitioner should read Professor Beresford's Lecture at http://faculty.trinity.edu/rjensen/beresford01.htm


    Readers might also want to go to http://www.npr.org/news/specials/enron/ 
    (Includes an interview with Lynn Turner talking about pro forma reporting.)


    Deferred Taxes Related to FAS123 Expense – Accounting and Administrative Issues on New Trends in Stock Compensation Accounting
    PWC Insight on FAS 123  --- http://www.fei.org/download/HRInsight02_21.pdf 
    A recent PWC HR Insight discusses the applicable rules and answers questions raised on accounting for income taxes related to FAS 123 expense (for both the pro forma disclosure and the recognized FAS 123 expense). Per PWC, the rules are complex and require that the tax benefits arising from stock options and other types of stock-based compensation be tracked on a grant-by-grant and country-by-country basis


    Corporate America's New Math:  Investors Now Face Two Sets of Numbers In Figuring a Company's Bottom Line
    By Justin Gillis
    The Washington Post
    Sunday, July 22, 2001; Page H01 
    http://www.washingtonpost.com/wp-adv/archives/front.htm   

    Cisco Systems Inc., a bellwether of the "new economy," prepared its books for the first three months of this year by slicing and dicing its financial results in the old ways mandated by the rules of Washington regulators and the accounting profession.

    Result: a quarterly loss of $2.7 billion.

    Cisco did more, though. It sliced and diced the same underlying numbers in ways preferred by Cisco, offering an alternative interpretation of its results to the investing public.

    Result: a quarterly profit of $230 million.

    That's an unusually large swing in a company's bottom line, but there's nothing unusual these days about the strategy Cisco employed. Across corporate America, companies are emphasizing something called "pro forma" earnings statements. Because there are no rules for how to prepare such statements, businesses have wide latitude to ignore various expenses in their pro forma results that have to be included under traditional accounting rules.

    Most of the time, the new numbers make companies look better than they would under standard accounting, and some evidence suggests investors are using the massaged numbers more and more to decide what value to attach to stocks. The pro forma results are often strongly emphasized in news releases announcing a corporation's earnings; sometimes the results computed under traditional accounting techniques are not disclosed until weeks later, when the companies file the official results with the Securities and Exchange Commission, as required by law.

    Cisco includes its results under both the pro forma and the traditional accounting methods in its news releases. People skeptical of the practice of using pro forma results worry that investors are being deceived. Karen Nelson, assistant professor of accounting at Stanford University, said some companies were "verging on fraudulent behavior" in their presentation of financial results.

    Companies that use these techniques say they are trying to help investors by giving them numbers that more accurately reflect the core operations of their businesses, in part because they exclude unusual expenses. Cisco's technique "gives readers of financial statements a clearer picture of the results of Cisco's normal business activities," the company said in a statement issued in response to questions about its accounting.

    Until recently, pro forma results had a well-understood and limited use. Most companies used pro forma accounting only to adjust previously reported financial statements so they could be directly compared with current results. This most frequently happened after a merger, when a company would adjust past results to reflect what they would have been had the merger been in effect earlier. Pro forma, Latin for "matter of form," refers to statements "where certain amounts are hypothetical," according to Barron's Dictionary of Finance and Investment Terms.

    What's changed in recent years is that many companies now using the technique also apply it to the current quarter. They include some of the leading names of the Internet age, including Amazon.com Inc., Yahoo Inc. and JDS Uniphase Corp. These companies have received enthusiastic support from many Wall Street analysts for their use of pro forma results. The companies' arguments have also been bolstered by a broader attack on standard accounting launched by some academic researchers and accountants. They believe the nation's financial reporting system, rooted in the securities law reforms of the New Deal, is inadequate to modern needs. In testimony before Congress last year, Michael R. Young, a securities lawyer, called it a "creaky, sputtering, 1930s-vintage financial reporting system."

    The dispute over earnings statements has grown in intensity during the recent economic slide. To skeptics, more and more companies appear to be coping with bad news on their financial statements by redefining the concept of earnings. SEC staffers are worried about the trend and are weighing a crackdown.

    "People are using the pro forma earnings to present a tilted, biased picture to investors that I don't believe necessarily reflects the reality of what's going on with the business," said Lynn Turner, the SEC's chief accountant.

    For the rest of the article (and it is a long article), go to 
    http://www.washingtonpost.com/wp-adv/archives/front.htm 
    The full article is salted with quotes from accounting professors and Bob Elliott (KMPG and Chairman of the AICPA)


    The Future of Amazon.com:  Unlike Enron, Amazon.com seems to thrive without profits.  How long can it last?

    "Economy, the Web and E-Commerce: Amazon.com." An Interview With Jeff Bezos CEO, Amazon.com, The Washington Post,  December 6, 2001 --- http://discuss.washingtonpost.com/zforum/01/washtech_bezos120601.htm 


    Amazon.com is pinning its hopes on pro forma reporting to report the company's first profit in history.  But wait! Plans by U.S. regulators to crack down on "pro forma" abuses in accounting may take a toll on Internet firms, which like the financial reporting technique because it can make losses seem smaller than they really are.  

    "When Pro Forma Is Bad Form," by Joanna Glasner, Wired News, December 6, 2001 --- http://www.wired.com/news/business/0,1367,48877,00.html 

    As part of efforts to improve the clarity of information given to investors, the Securities and Exchange Commission warned this week that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

    In particular, the commission said it will focus on abuse of a popular form of financial reporting known as "pro forma" accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

    Experts say the practice is especially common among Internet firms, which began issuing earnings press releases with pro forma numbers en masse during the stock market boom of the late 1990s. The list of new-economy companies using pro forma figures includes such prominent firms as Yahoo (YHOO), AOL Time Warner (AOL), CNET (CNET) and JDS Uniphase (JDSU).

    Unprofitable firms are particularly avid users of pro forma numbers, said Brett Trueman, professor of accounting at the University of California at Berkeley's Haas School of Business.

    "I can't say for sure why, but I can take a guess: They're losing big time, and they want to give investors the impression that the losses are not as great as they appear," he said.

    Trueman said savvy investors tend to know that companies may have self-serving interests in mind when they release pro forma numbers. Experienced traders often put greater credence in numbers compiled according to generally accepted accounting principles (GAAP), which firms are required to release alongside any pro forma numbers.

    A mounting concern, however, is the fact that many companies rely almost solely on pro forma numbers in projections for future performance.

    Perhaps the best-known proponent of pro forma is the perennially unprofitable Amazon.com, which has a history of guiding investor expectations using an accounting system that excludes charges for stock compensation, restructuring or the declining value of past acquisitions.

    Invariably, the pro forma numbers are better than the GAAP ones. In its most recent quarter, for example, Amazon (AMZN) reported a pro forma loss of $58 million. When measured according to GAAP, Amazon's net loss nearly tripled to $170 million.

    Things are apt to get even stranger in the last quarter of the year, when Amazon said it plans to deliver its first-ever pro forma operating profit. By regular accounting standards, the company will still be losing money.

    Those results might not sit too well with the folks at the SEC, however.

    In its statements this week, the SEC noted that although there's nothing inherently illegal about providing pro forma numbers, figures should not be presented in a deliberately misleading manner. Regulators may have been talking directly to Amazon in one paragraph of their warning, which said:

    "Investors are likely to be deceived if a company uses a pro forma presentation to recast a loss as if it were a profit."

    Neither Amazon nor AOL Time Warner returned phone calls inquiring if they planned to make changes to their pro forma accounting methods in light of the SEC's recent statements.

    According to Trueman, few members of the financial community would advocate getting rid of pro forma numbers altogether.

    Even the SEC said that pro forma numbers, when used appropriately, can provide investors with a great deal of useful information that might not be included with GAAP results. When presented correctly, pro forma numbers can offer insights into the performance of the core business, by excluding one-time events that can skew quarterly results.

    Rather than ditching pro forma, industry groups like Financial Executives International and the National Investor Relations Institute say a better plan is to set uniform guidelines for how to present the numbers. They have issued a set of recommendations, such as making sure companies don't arbitrarily change what's included in pro forma results from quarter to quarter.

    Certainly some consistency would make it easier for folks who try to track this stuff, said Joe Cooper, research analyst at First Call, which compiles analyst projections of earnings.

    The boom in pro forma reporting has created quite a bit of extra work for First Call, Cooper said, because it has to figure out which companies and analysts are using pro forma numbers and how they're using them.

    But the extra work of compiling pro forma numbers doesn't necessarily result in greater financial transparency for investors, Cooper said.

    "In days past, before it was abused, it was a way to give an honest apples-to-apples comparison," he said. "Now, it is being used as a way to continually put their company in a good light."

    See also:
    SEC Fires Warning Shot Over Tech Statements
    Earnings Downplay Stock Losses

    Change at the Top for AOL
    Where's the Money?, Huh?
    There's no biz like E-Biz


    The bellwether Internet firm says it will stop reporting earnings in pro forma, a controversial accounting method popular in the technology sector --- http://www.wired.com/news/business/0,1367,51721,00.html 

    "Yahoo Gives Pro Forma the Boot." By Joanna Glasner, Wired News, April 11, 2002 --- 

    Following the release of its first-quarter results on Wednesday, Yahoo (YHOO) said it will stop reporting earnings using pro forma, a controversial accounting method popular among Internet and technology firms.

    Instead, the company said it plans to release all results according to generally accepted accounting principles, or GAAP. Executives said the shift would provide a clearer picture of the Yahoo's financial performance.

    "We do not believe the pro forma presentation continues to provide a useful purpose," said Sue Decker, Yahoo's chief financial officer. In the past, the company has used pro forma accounting as a way to separate one-time expenses -- such as the costs of closing a unit or acquiring another firm -- from costs stemming from its core business.

    Decker attributed the decision in part to new rules adopted by the U.S. Financial Accounting Standards Board that take effect this year. The new rules require companies to report the amount they overpaid for acquisitions as an upfront charge.

    Accounting experts, however, said the rule change was probably not the only reason for Yahoo to drop pro forma. The accounting practice, popularized by technology firms in the late 1990s, has come under fire from regulators in recent months who say some firms have used nonstandard metrics to mask poor financial performance.

    The U.S. Securities and Exchange Commission warned in December that it will crack down on companies that use creative accounting methods to pump up poor earnings results.

    In particular, the commission said it will focus on abuses of pro forma accounting, which allows companies to exclude certain expenses and gains from their earnings results. The SEC said the method "may not convey a true and accurate picture of a company's financial well-being."

    Experts say use of pro forma is especially common among Internet firms. In addition to Yahoo, the list of prominent Internet and technology firms employing pro forma includes AOL Time Warner (AOL), Cnet (CNET) and JDS Uniphase (JDSU).

    Although pro forma accounting can be useful in helping to predict a company's future performance, investors have grown increasingly suspicious of the metric following the bursting of the technology stock bubble, said Sam Norwood, a partner at Tatum CFO Partners.

    "Once the concept of pro forma became accepted, there were in some cases abuses," Norwood said. "There was a tendency for management to exclude the negative events and to not necessarily exclude the positive events.'

    Brett Trueman, an accounting professor at the University of California at Berkeley's Haas School of Business, said he wouldn't be surprised if other firms follow Yahoo's lead in dropping pro forma.

    Continued at  http://www.wired.com/news/business/0,1367,51721,00.html 


    Bob Jensen's threads on pro forma reporting can be found at the following site:

    http://faculty.trinity.edu/rjensen/roi.htm 


    Triple-Bottom (Sustainability, Social, Environmental, Human Resource) Reporting)

    "The Inside Story of Diageo's Stunning Carbon Achievement ," by Andrew Winston, Harvard Business Review Blog, February 20, 2013 --- Click Here
    http://blogs.hbr.org/winston/2013/02/the-inside-story-of-diageos-st.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date


    "Accountants Will Save the World," by Peter Bakker, Harvard Business Review Blog, March 5, 2013 --- Click Here 
    http://blogs.hbr.org/cs/2013/03/accountants_will_save_the_worl.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    You might also want to read the comments that follow this article.


    Sustainability Accounting --- https://en.wikipedia.org/wiki/Sustainability_accounting

    From the CFO Journal's Morning Ledger on December 1, 2016

    That isn’t what investors want
    A majority of U.S. listed companies are disclosing sustainability risks to investors, but not in any meaningful detail, according to a study by the Sustainability Accounting Standards Board. The SASB analyzed annual reports of more than 700 top companies across 79 industries. It found that 81% addressed social and environmental risks. However, 52% of the companies used vague, boilerplate language to flag the risks without articulating management response strategies, Tatyana Shumsky writes.

    Bob Jensen's threads on sustainability accounting ---
    http://faculty.trinity.edu/rjensen/theory02.htm#TripleBottom


    Externality --- https://en.wikipedia.org/wiki/Externality

    Sustainability --- https://en.wikipedia.org/wiki/Externality

    Farmers are drawing groundwater from the giant Ogallala Aquifer faster than nature replaces it ---
    https://theconversation.com/farmers-are-drawing-groundwater-from-the-giant-ogallala-aquifer-faster-than-nature-replaces-it-100735

    Commons --- https://en.wikipedia.org/wiki/Commons

    The commons is the cultural and natural resources accessible to all members of a society, including natural materials such as air, water, and a habitable earth. These resources are held in common, not owned privately. Commons can also be understood as natural resources that groups of people (communities, user groups) manage for individual and collective benefit. Characteristically, this involves a variety of informal norms and values (social practice) employed for a governance mechanism

    The Digital Library of the Commons defines "commons" as "a general term for shared resources in which each stakeholder has an equal interest".[2]

    The term "commons" derives from the traditional English legal term for common land, which are also known as "commons", and was popularised in the modern sense as a shared resource term by the ecologist Garrett Hardin in an influential 1968 article called The Tragedy of the Commons. As Frank van Laerhoven and Elinor Ostrom have stated; "Prior to the publication of Hardin's article on the tragedy of the commons (1968), titles containing the words 'the commons', 'common pool resources', or 'common property' were very rare in the academic literature."[3]

    Some texts make a distinction in usage between common ownership of the commons and collective ownership among a group of colleagues, such as in a producers' cooperative. The precision of this distinction is not always maintained.

    The use of "commons" for natural resources has its roots in European intellectual history, where it referred to shared agricultural fields, grazing lands and forests that were, over a period of several hundred years, enclosed, claimed as private property for private use. In European political texts, the common wealth was the totality of the material riches of the world, such as the air, the water, the soil and the seed, all nature's bounty regarded as the inheritance of humanity as a whole, to be shared together. In this context, one may go back further, to the Roman legal category res communis, applied to things common to all to be used and enjoyed by everyone, as opposed to res publica, applied to public property managed by the government

    Continued in article

    Jensen Comment
    The Ogallala Aquifer pending crisis is a good example of how sustainability accountancy must take into account externalities and commons issues in financial reporting. This also illustrates how it may not be feasible for a firm to invest more for its own sustainability in the presence of so many other firms and organizations that feed on the commons. For a Kansas wheat farmer there just are no great investment alternatives for water when the Ogallala Aquifer is no longer a cost-effective source of water. There is no ocean near Kansas such that desalinization is not a practical alternative. What is going to prevent Kansas from becoming a desert?


    Enhancing the Quality of Reporting in Corporate Social Responsibility Guidance Documents: The Roles of ISO 26000, Global Reporting Initiative and CSR‐Sustainability Monitor
    SSRN, June 3, 2017
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2979660

    Authors

    S. Prakash Sethi --- CUNY Baruch College

    Janet Rovenpor---  Manhattan College

    Mert Demir CUNY Baruch College

    Abstract

    The intent of this article is to review the phenomenal growth of Corporate Social Responsibility reports published by large corporations around the world. The reports provide companies with an opportunity to inform large segments of society about the impacts of their business operations on the environmental, socio‐political, and governmental (regulatory) aspects of a society. The mostly voluntary nature of these reports, however, places the burden on the corporations creating them to (a) provide an adequate amount of information, (b) cover all the major issues that are relevant to the company and industry, and (c) provide measures of assurance as to the accuracy of information. In this article, we compare and examine three institutional approaches that have played an important role toward improving the quality and consistency of these reports. The institutions involved are ISO 26000, Global Reporting Initiative (GRI), and Corporate Social Responsibility (CSR)‐Sustainability Monitor. We intend to show their different approaches to guiding CSR reporting, and assess their relative strengths and limitations.


    From the CFO Journal's Morning Ledger on July 21, 2015

    Investors: sustainability disclosures are mostly fluff ---
    http://blogs.wsj.com/cfo/2015/07/21/investors-sustainability-disclosures-are-mostly-fluff/?mod=djemCFO_h
    About 75% of companies in the S&P 500 index published sustainability reports last year, CFO Journal’s Emily Chasan reports. But U.S. investors say they are mostly disappointed in the information companies are releasing on greenhouse gas emissions or waste reduction.

    PwC
    In the loop: Sustainability disclosures - Is your company meeting investor expectations? ---- Click Here
    http://www.pwc.com/us/en/cfodirect/publications/in-the-loop/sustainability-disclosure-guidance-sasb.jhtml?display=/us/en/cfodirect/issues/governance

    Sustainability Accounting --- http://en.wikipedia.org/wiki/Sustainability_accounting  

     "Update on Social Accounting - Sustainability Reporting," by Jim Martin, MAAW's Blog, May 1, 2015 ---
    http://maaw.blogspot.com/2015/05/update-on-social-accounting.html

    Bob Jensen's threads on sustainability accounting ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#ResearchVersusProfession



    A New Assignment for Bob Herz
    From the CFO Journal's Morning Ledger on October 15, 2014

    Sustainability accounting group taps former FASB chairman ---
    http://blogs.wsj.com/cfo/2014/10/21/sustainability-accounting-group-taps-former-fasb-chairman/?mod=djemCFO_h
    Robert Herz, the former chairman of the U.S. Financial Accounting Standards Board, will join the board of the nonprofit Sustainability Accounting Standards Board, which is working to write industry standards for corporate sustainability and environmental reporting, reports CFO Journal’s Emily Chasan. SASB sets voluntary standards for firms to disclose information on material social, governance, energy and environmental issues to investors.

    July 20, 2015 reply from Zabihollah Rezaee

    I coauthored with Ann Brockett of EY a book on “Corporate Sustainability: Integrating Performance and Reporting”, which was published by Wiley in 2012 and received the Axiom Gold Award in 2013 (see attached cover page). I am now working on a new book on “Business Sustainability: Performance, Compliance, Accountability and Integrated Reporting”, scheduled for publication by the Greenleaf in October 2015. Attached is cover page of the new book. I will send you a review copy if you are interested in submitting a review report by August 15th, 2015.

    Best regards,

    Zabi

    Jensen Comment

    From the Inside Flap

    Global businesses are under close scrutiny and profound pressure from lawmakers, regulators, the investment community, and their diverse stakeholders to focus on sustainability and accept accountability and responsibility for their multiple bottom lines of economic, governance, social, ethical, and environmental (EGSEE) performance. Would you like to leave more resources for the next generation? Watch your business grow continuously? Have an ethical and competent organizational culture?

    Presenting recent developments in sustainability performance and sustainability reporting and assurance, Corporate Sustainability sheds light on the importance, relevance, and benefits of business sustainability and accountability reporting in all areas of EGSEE performance.

    Filled with features and practical examples relevant to professionals of all levels, corporate leaders, directors and executives, as well as auditors, practitioners, and educators, this timely and essential book discusses:

    Organizations worldwide recognize the importance of sustainability performance and accountability reporting. However, how to actually implement sustainability reporting remains a major challenge. Read Corporate Sustainability and discover how to fully—and successfully—integrate sustainability into your business's reporting and performance management systems.

     

    From the Back Cover

    Make sustainability happen, Corporate sustainability is the responsibility of every organization, not just a select few.

    Corporate Sustainability explores business sustainability and accountability reporting and their integration into strategy, governance, risk assessment, performance management, and the reporting process. Written by renowned experts in the field of managing for sustainable performance, this important book also highlights how people, business, and resources collaborate in a business sustainability and accountability model.

    Take a look inside for essential guidance on:

    A significant contribution on how to put sustainability principles to work, Corporate Sustainability offers real-life tools and practices for creating an authentic corporate framework for sustainability.

    "Companies seeking to embrace sustainability must navigate a thicket of policies and standards, from ethical performance to environmental protection to executive compensation—and do so transparently, comprehensively, and globally. Ann Brockett and Zabihollah Rezaee have created a valuable field guide to this brave new world of multiple bottom lines, providing guidance on how companies can engender public trust and investor confidence while pursuing their economic goals."
    —Joel Makower, Executive Editor, GreenBiz.com, author, Strategies for the Green Economy


    If environmental expenses must be measured and deducted on financial statements, why not make them deductable for taxes?

    "Robert Rubin Off in Accounting Wilderness," by Jonathan Weil, Bloomberg News, January 21, 2014 ---
    http://www.bloomberg.com/news/2014-01-21/robert-rubin-off-in-accounting-wilderness.html

  • Robert Rubin, the former Treasury secretary and one-time chairman of Citigroup Inc.'s executive committee, has put forth an odd idea for new accounting standards. Speaking last week at a conference on climate change, he said that companies should be required to include environmental costs that they impose on the rest of society as expenses in their own earnings reports.

  • Here's the relevant excerpt from Rubin's comments last week, as reported by Bloomberg News:

  • The key to this is really the political system. If you had accounting rules that result in the externalities [i.e., the costs of greenhouse-gas emissions] being captured in financial statements, then obviously people would react.

    It’s not a carbon price issue, it’s an accounting issue: ‘I run a business. I emit. I don't pay the price for the emissions. I produce the good. I sell it. I don't care about the emissions because it's not my cost. It's society’s cost.’ That's an externality.

    [Once] you have accounting standards that require you to reflect that cost in your reported earnings, then it becomes something that every analyst is going to look at and evaluate in your stock
    .

  • The problem with this proposal is it makes no sense. A company that emits greenhouse gasses may very well harm the world at large. However, if the emissions aren't creating a cost for the company itself, there is no incremental expense for it to report on its financial statements.

  • You can't just make up numbers (at least you're not supposed to) and put them on a company's income statement and call it an expense if the company isn't incurring any costs or otherwise making any economic sacrifice. Accounting isn't supposed to be about moral judgment or electoral politics. The purpose is to provide information about a business's financial performance.

  • Changing the accounting standards the way Rubin suggested would require an overhaul of the Financial Accounting Standards Board's definition of the term "expenses." Here's how the FASB defines it now: "Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations."

  • Back in 2008, when Rubin was at Citigroup, the U.S. Comptroller of the Currency sent Citigroup a letter pointing out all sorts of shortcomings with the valuation model that the bank was using for the subprime mortgage bonds on its books. Now Rubin would have companies come up with expense figures for greenhouse-gas emissions out of thin air to include in their earnings. If Citigroup had so much difficulty figuring out the value of its collateralized debt obligations, you have to wonder how it would determine the total cost of pollution that Citigroup causes around the world every year.

  • One final note: Rubin was talking about changing the accounting standards, not the tax code. My guess is that most companies would love to be able to make up whatever numbers they want for emissions expenses and use those figures as deductions for tax purposes on their Internal Revenue Service filings.

  • Continued in article

  • Jensen Comment
    I've never had any respect for Robert Rubin as an economist. Now I have even less respect for him as an accountant.

    Environmental accounting should require meaningful disclosures and some physical measurements such as tons of carbon expelled from smoke stacks or gallons of some pollutants discharged (treated or untreated) into waterways.

    But assigning costs to environmental discharges and booking them into the ledger as expenses essentially pollutes financial statements as much as it pollutes the environment. I called such accounting Phantasmagoric Accounting in 1976. Nothing has transpired to date to make me change my mind about booking environmental costs into the ledgers.

    Volume No. 14. Phantasmagoric Accounting

    By Robert E. Jensen. Published 1976, 209 pages.
    Studies in Accounting Research
    American Accounting Assoiciation
    http://aaahq.org/market/display.cfm?catID=5

    If you want to destroy financial statements fill them with numbers plucked out of the clouds. I would argue that we do too much of that already.

    However, if you want to improve financial reporting make qualitative disclosures more informative, especially now that masses of information can be archived online and searched efficiently with search engines.


    "Triple Bottom Line Accounting and Energy-Efficiency Retrofits in the Social-Housing Sector: A Case Study," by Kathryn Bewley and Thomas Schneider, Accounting and the Public Interest, December 2013, Vol. 13, No. 1, pp. 105-131 ---
    http://aaajournals.org/doi/abs/10.2308/apin-10359
    This is not a free download

    Abstract
    This paper reports the findings of a case study conducted to learn about the information, actors, actions, and processes involved in energy-efficiency investment decisions in the social-housing sector. These decisions draw on environmental, social, and economic factors, which are studied from a “triple bottom line” (TBL) accounting perspective. The quantitative methods we use rely on Levels I, II, and III fair-value measures similar to those used in financial accounting. The qualitative methods rely primarily on interviews conducted and transcribed by the researchers. Our main findings show that a pure financial bottom-line approach would not fully indicate the overall desirability of the type of energy-efficiency investment undertaken in this case. By factoring in other quantitative and qualitative outcomes drawn from the research methods applied, a different conclusion may be reached.


    More than 3,000 companies worldwide produce sustainability reports. A new initiative by the International Integrated Reporting Council zeros in on the creation of value.
    "The greening of accounting," by Yan Barcelo, CA Magazine (Canada), November 2013 ---
    http://www.camagazine.com/archives/print-edition/2013/nov/features/camagazine76387.aspx

    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on January 31, 2014

    How IKEA Protects the Environment and Sofa Margins
    by: Emily Chasan
    Jan 29, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Cost Management

    SUMMARY: IKEA reported good fiscal 2103 results (for the year ended August 31, 2013) focusing on the company's cost savings obtained through environmentally friendly practices. Increased sales in units and increased profits came from sales price reductions based on the cost savings. "IKEA cut transportation costs, retooled warehouses and changed its purchasing...." The company also is investing in environmentally friendly heating and light with photovoltaic and geothermal systems. Ninety percent of the company's U.S. units have solar installations and the company will install a geothermal system in a Kansas City store opening in FY 2014. "While construction is more costly, the return on investment for geothermal energy can come in as few as 8 years, [U.S. CFO Rob] Olson said."

    CLASSROOM APPLICATION: The article may be used in a managerial accounting class to cover corporate social responsibility for environmental matters, product and period cost savings leading to price reductions but increased sales and profits, and the definition of payback period versus return on investment.

    QUESTIONS: 
    1. (Introductory) What price reduction was reported by IKEA? How are these price reductions related to environmental concerns?

    2. (Advanced) Name three components of product cost. Which of these component costs did IKEA reduce in order be able to reduce its product price?

    3. (Advanced) What period costs did IKEA reduce which led to its ability to reduce its product price?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "How IKEA Protects the Environment and Sofa Margins," by Emily Chasan, The Wall Street Journal, January 29, 2014 ---
    http://blogs.wsj.com/cfo/2014/01/28/how-ikea-protects-the-environment-and-sofa-margins/?mod=djem_jiewr_AC_domainid

    IKEA’s U.S. financial chief is no couch potato when it comes to cutting sofa prices.

    The Swedish furniture company reported fiscal year figures Tuesday, noting a 40% price cut on the EKTORP line of sofas with Svanby covers and significant reductions on other lines. Most of the sofa savings came from using more environmentally conscious production methods. IKEA cut transportation costs, retooled warehouses and changed its purchasing, for example.

    “Lower prices are better for the consumer and if we can find efficiencies in the supply chain then it’s a win-win,” Rob Olson told CFO Journal.

    The CFO explained the key was designing a more efficient way to fit the sofa into shipping containers. The price cut also stemmed from more efficient warehousing and energy savings. In addition, IKEA sought new sources for wood and cotton.

    “It’s really about how do we fit more in a cube,” Mr. Olson said.

    It adopted a similar strategy with its tea light candles, for example, switching from loose-packaging to vacuum-packed stacks that increased the number of candles in each container by 50%, he said.

    “Even if it’s fraction of an inch it might mean that we can fit one more item per cube, or we might be able to combine supply with something else on that transport – there are opportunities there,” Mr. Olson said.

    The firm has also modified what it is doing in the U.S. on the ground. Last year, IKEA ended the use of wooden pallets to move retail products around stores by switching to thin cardboard mats. Working with suppliers, sofas now go directly to stores rather than stopping at distribution centers.

    It is “less distance for transport, less resources spent uploading and reloading, and less potential for damage,” Mr. Olson said.

    After spikes in the price of cotton over the past few years, IKEA also shifted to the sustainable cotton production standard and mitigate shortages, Mr. Olson said.

    For another sofa, the company found it could trim costs by 18% by eliminating glue, swapping some materials and improving packaging and delivery. About 10% of the savings came from logistics and 5% from materials.

    Continued in article

     


    More than 3,000 companies worldwide produce sustainability reports. A new initiative by the International Integrated Reporting Council zeros in on the creation of value.

    "The greening of accounting," by Yan Barcelo, CA Magazine (Canada), November 2013 ---
    http://www.camagazine.com/archives/print-edition/2013/nov/features/camagazine76387.aspx

    First there was expense and profit accounting. Then green accounting came along. Now, get ready for value accounting as its notions slowly seep into the heart of the corporate world.

    The requirements of sustainable development have become the key drivers of a potentially long-term transformation of accounting principles and practice.

    To date, sustainable development (SD) has brought about changes in certain areas of financial reporting, but they remain somewhat marginal. However, one major development is what some companies refer to as a corporate social responsibility report; others, a sustainable development report.

    SD has not yet penetrated to the very heart of accounting and financial reporting, and often accountants are not involved in the production of such reports. But that could change. Transformations originating from so-called integrated reporting, and which are supported by the Big Four ac-counting firms, are starting to percolate in the corporate world.

    And judging by how quickly SD and social responsibility (SR) notions have penetrated company reports, the concept’s underlying integrated reporting could land in accountants’ laps before they know it.

    A recent past Although environmental accounting concepts had been around since the 1970s, by the early 1990s, SD and SR reports were still few and far apart.

    And they were often sketchy and superficial. However, mo-mentum picked up rapidly and today more than 3,000 companies worldwide, including more than two-thirds of the Fortune Global 500, produce some type of sustainability report, says Sam Whittaker, national climate change and sustainability services leader at EY in Toronto.

    And over the years the reports have become more detailed and substantial. Metrics have become more precise and the number of items discussed has mushroomed. “When I started in environmental accounting in 1972,” says Jacques Fortin, FCPA, FCA, professor of accounting at HEC Montréal, “we couldn’t even measure carbon emissions spewing out of a coal-generated plant. Today, we can make an exact particle count, determine the impacts on human, animal and plant life, and evaluate the costs of decontamination.”

    As an example, the Telus Social Responsibility 2012 Report delves into details Fortin could never have dreamed of in the ’70s. The report quantifies greenhouse gas emissions in buildings Telus owns and leases and also measures emissions produced by employees when they travel by air.

    “Over the years, performance has improved; reports are getting more comprehensive and meaningful and, in general, Canadian companies are producing some very good quality reports,” says Valerie Chort, partner and national leader, sustainability and climate change at Deloitte in Toronto, which has sponsored the CICA annual report awards in the SD category for the past 10 years.

    Externalities and liabilities A prevalent reference for SD reports is to be found in the guidelines produced by the Global Reporting Initiative, a nonprofit organization that promotes economic, environmental and social sustainability. Its guidelines, used by organizations around the world, outline approximately 150 key indicators SR reports can focus on, ranging from economic criteria such as indirect impacts and procurement practices; to environmental criteria dealing with issues such as energy, water and carbon emissions; to such social issues as occupational health and safety, training and education, labour relations, child labour and grievance mechanisms for negative impacts on society.

    For each category, the guidelines suggest key elements to report on. For example, under the heading “Significant indirect economic impacts,” they propose to include, where applicable, “economic development in areas of high poverty, economic impact of improving or deteriorating social or environmental conditions, availability of products and services for those on low incomes, enhancing skills and knowledge amongst a professional community or in a geographical region, jobs supported in the supply chain or distribution chain, stimulating, enabling, or limiting foreign direct investment,” among others.

    Considering that an accountant or an SR officer could feel overwhelmed by the profusion of details, this set of guidelines (now in its fourth version), “stresses the importance of a materiality assessment,” says Chort, meaning a company should select to report on only those elements that make a difference for the company. For example, some companies operate in areas where child labour is an issue. However, determining whether these companies should report on greenhouse gas emissions could require some reflection.

    A crucial concept in SD accounting is “externalities.” Soil contamination or ground water pollution has little bearing on the bottom line, and that’s why most SD or SR accounting items are considered as externalities. Why? “Because there is no monetary transaction, and the current accounting model is based on transactions,” says Marie-Andrée Caron, professor of accounting at the Université du Québec à Montréal’s school of management.

    That is, until the company has to settle a legal suit for environmental damages directly impacting profit. In the recent Lac Mégantic train catastrophe that razed a complete town centre in Quebec, “if people had realized the real cost of petroleum transport, maybe they would have planned differently,” Caron says. “And the owner of the train, Montreal, Maine & Atlantic Railway, would probably have found a massive ‘externality’ in its financial report.”

    Which brings up the concept of “contingent liabilities” that prompts stimulating questions for the accounting profession, says Fortin, who faced just that when he worked as an accounting adviser for an engineering group hired to evaluate the environmental liabilities caused by the contaminated soil at bases for the Canadian Ministry of Defence in the late 1980s.

    “Contamination measures had been made by engineers, so we knew how much remediation would cost,” Fortin says. “But at what moment do you recognize the liability when a contaminated site is 500 kilometres from any population centre and you know that nature will have done its decontamination after 25 years? Do we have a liability? And if the site is near Montreal or Toronto, do we have one?”

    Such situations, he says, also raise audit and verification theory issues and system procedures to deal with this information. “How do you make it trustworthy in the cases where people who collect it also have an interest in it?”

    Corporations self-propel At their outset, SD and SR reporting were driven by government regulations because many environmental and social issues were considered externalities in corporate financial accounting. The basic equation was very simple, says Caron: “Everything that was not regulated was simply not taken into account.”

    Today government regulation still plays a large part in the propulsion forward of SD and SR reporting, but increasingly the impetus is coming from the corporate world, “which is driven by the expectations of institutional investors, by rating agencies, for example the Dow Jones sustainability index, by peer pressure, consumers and environmental agencies,” says Chort. There is also the increasing realization by companies and organizations that SD reporting “is good for business,” says Daniel Desjardins, senior vice-president, general counsel and corporate secretary, who directs the social responsibility and SD efforts at Bombardier.

    All those factors combined are leading up to the potential next phase — integrated reporting (IR). Why integrated? Because to date, financial reporting and sustainability reporting remain two distinct solitudes with little overlap.

    Of course, there are a few points of intersection. For example, when Bombardier’s evaluation of its carbon footprint leads it to reduce its energy consumption, that saving directly impacts the company’s profit and loss statement. But such intersecting points are the exception. The financial, social and environmental reports “remain parallel and accountants don’t invest themselves very much in them,” says Caron. “If change is going to happen, it will be through the integrated report.”

    This new initiative is lead by the International Integrated Reporting Council, whose objective is to develop an internationally accepted IR framework by 2014. Formed in 2009, the council is still young and the framework it put forward in 2011 is in its pilot phase. Nevertheless, more than 100 companies, including 50 institutional investors, the Big Four accounting firms and corporations such as Coca-Cola, Microsoft, Unilever and Volvo, have joined and are experimenting with features of the framework.

    An old-fashioned future The key concept underlying IR is quite old-fashioned: the creation of value. But value creation goes beyond financial elements into dimensions currently reflected only in SD and SR reports. “Integrated Reporting provides an interesting change in perspective on companies,” according to IIRC’s Pilot Programme 2012 Yearbook. “Many people see sustainability as separate to company behaviour and success. However, it is about how companies are run and their longer term viability, resilience and ability to deliver value. Behind IR is a desire to combine sustainability with more mainstream financial aspects. In the long run, companies that behave well, do well.”

    The new report model IIRC is putting forth would eventually replace the traditional financial report and is centred around six key “capitals” that would be well identified and quantified: manufactured capital, human capital, intellectual capital, natural capital, social capital and, of course, financial capital.

    Though all these capitals are essential to the value creation of any company, many fly under the radar of the traditional financial report. One obvious area is human capital. In the IIRC’s yearbook Microsoft gives an eloquent example. “Microsoft’s balance sheet currently accounts for less than half of the company’s market value. Its financial statements show virtually none of its intangible assets. Bob Laux [director of accounting and reporting] suggested that the focus of companies that largely depend on human and intellectual capital is actually more on financial and manufactured capital in reporting. This reflects a legacy of resistance to change in US businesses that have implemented reporting infrastructure designed for a manufacturing economy. Laux explained: ‘Financial reporting hasn’t kept up with the shift to an IT-based economy. When scandals emerge, such as the dot-com bubble in 1995-2000 and the financial crisis in 2007-2012, Band-Aids are put on problems.’ ”

    In traditional financial reporting, human capital, which is crucial to value creation, is not treated as capital. It is an expense. It is little wonder that a company such as Home Depot missed a key driver of its value creation when a new president decided to change the generation mix of its employees.

    Continued in article


    Recognition, Measurement and Accounting Treatment of Human Resource Accounting
    SSRN, November 17, 2015
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2691896

    Authors

    Md. Shamim Hossain University of Dhaka - Department of Accounting & Information Systems ; Independent

    Md. Rofiqul Islam University of Dhaka

    Md. Majedul Palas Bhuiyan BCS General Education Association ; Government Safar Ali College - Department of Management

    Abstract

    Human Resource Accounting (HRA) involves accounting for costs related to human resources as assets as opposed to traditional accounting. Since the beginning of globalization of business and services, human elements are becoming more important input for the success of every organization. The strong growth of international financial reporting standards (IFRS) encourages the consideration of alternative measurement and reporting standards and lends support to the possibility that future financial reports will include non-traditional measurements such as the value of human resources using HRA methods. It helps the management to frame policies for human resources of their organizations. HRA is a process of identifying and measuring data about human resources. It will help to charge human resource investment over a period of time. It is not a new concept in the arena of business world. Economists consider human capital as a production factor, and they explore different ways of measuring its investment. Now accountants are recognizing human resource investment as an asset. This study is build upon Recognition, Measurement and Accounting Treatment of Human Resource Accounting in different organizations.

    History Question
    What company was the first business firm to value human resources on its balance sheet?

    Jensen Answer
    Although I'm not certain how professional sports teams accounted for player contracts before 1977, my research for an American Accounting Association monograph suggested that the RG Barry Corporation was the first company to value all of its human resources on the balance sheet. However, I could not find any value in this "phantasmagoric" valuation.

    PHANTASMAGORIC ACCOUNTING: Research and Analysis of Economic, Social and Environmental Impact of Corporate Business
    (Sarasota, FL: The American Accounting Association, 1977).

    December 1, 2015 reply from Elliot Kamlet

    The idea of valuing Human Resources of a company has been intriguing to me since I was a student.of  Bikki Jaggi (http://www.business.rutgers.edu/faculty-research/directory/jaggi-bikki) who got together with a statistician at Binghamton (Lau) and came up with a model to value human resources.  At the time, there was resistance to the math involved.  See http://www.jstor.org/stable/245105?seq=1#page_scan_tab_contents

     

    December 2, 2015 reply from Bob Jensen

    Hi Elliot,

    Not everything that can be counted, counts. And not everything that counts can be counted.
    Albert Einstein

    The problems are numerous and complicated in terms of things other than the complicated math in human resource accounting. The biggest problem arises when there is no math whatsoever to make sense out of human resource accounting.

    Firstly, there's the problem of ownership and control. Most employment contracts do not prevent an employee from quitting immediately or in a very short period of time. Hence, you cannot own or lease an employee in the same way that we conceptualize owned or leased assets. Human resource accounting requires an entirely new conceptualization of the left side of the balance sheet.

    Secondly there's a problem of additivity where the value of individual employees varies interactively with other employees. The higher-order joint components of value are almost impossible to measure and may even become negative if it were possible to put measures of value on a work force.

    As an illustration, consider Ivy League tenured faculty. It's not at all uncommon for some departments not to anticipate a tenure track opening for 10-20 years. This is problematic in terms of stagnation when there will be zero now new blood transfusing a department's stale faculty for 10-20 years. Every tenured faculty member is an asset. However, taken as a whole the tenured faculty in a department may become a liability.

    Consider the special problem now faced by Brown University. At one time over 90% of the assistant professors hired by Brown received tenure, thereby leading to many departments that expect no tenure track openings for many years. In 2015 Brown announced a very generous $100 million initiative to hire African American, Hispanic, and Native American faculty. But at Brown what this means is that a goodly portion of that $100 million will be used to buy out the tenure of white faculty to create tenure track positions for Brown's affirmative action hiring.

    In other words in terms of human resource accounting positive value of individuals becomes a negative value when their values are combined.

    Also "value" of a human resource has many contexts vis-à-vis value of a milling machine. With a human resource there's value in terms of routine assigned jobs plus positive and negative values of team contributions plus values of potential leadership promotions plus negative values of lawsuit risks. Milling machines do not sue for falls and slander and microaggressions, but employees sue for millions upon millions.  Human resources also present unique fraud risks relative to physical assets.

    Not everything that can be counted, counts. And not everything that counts can be counted.
    Albert Einstein

    Thanks,
    Bob Jensen


    Teaching Case on Wal-Mart's Audits of Safety Conditions of Foreign Suppliers
    From The Wall Street Journal Accounting Weekly Review on November 21, 2013

    Wal-Mart Audits Reveal Bangladesh Safety Woes
    by: Shelly Banjo
    Nov 18, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Auditing, Supply Chains

    SUMMARY: In the wake of the Bangladesh building collapse that killed more than 1,100 people, Wal-Mart has begun auditing its suppliers to verify their compliance with the retailer's supply-chain safety requirements. "Nearly half the factories in...the initial round of safety inspections...failed their audits and had to make improvements to keep doing business with the giant retailer."

    CLASSROOM APPLICATION: The article may be used in an auditing class to discuss operational audits and the impact of safety violations on Wal-Mart's own operating risks. It may also be used to introduce Corporate Social Responsibility Reporting or supply chains.

    QUESTIONS: 
    1. (Introductory) What devastating events have happened in Bangladesh at companies manufacturing clothing for Wal-Mart and many other retailers?

    2. (Advanced) What type of audits is Wal-Mart conducting? Why is the company performing these audits?

    3. (Introductory) What is the result if a manufacturing location fails an audit? If it fails to make required improvements?

    4. (Advanced) What is Corporate Social Responsibility (CSR)?

    5. (Advanced) Access Wal-Mart's reporting on these audits via its web site location devoted to Corporate Social Responsibility: http://corporate.walmart.com/global-responsibility/ethical-sourcing/ Briefly summarize the types of information you see on the web site.

    6. (Introductory) According to the article, what are the concerns with Wal-Mart's reporting about these audits? What steps could Wal-Mart take to help alleviate these concerns?

    7. (Advanced) Does this audit process over Bangladesh factories have anything at all to do with Wal-Mart's financial reporting? Explain your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Wal-Mart Audits Reveal Bangladesh Safety Woes," by Shelly Banjo, The Wall Street Journal, November 18, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702303985504579204482930379914?mod=djem_jiewr_AC_domainid

    More than 15% of the factories in Wal-Mart Stores Inc. WMT -0.05% 's initial round of safety inspections in Bangladesh failed their audits and had to make improvements to keep doing business with the giant retailer.

    Wal-Mart said most of the three dozen factories were able to correct the problems or are in the process of doing so. One seven-story factory, for example, had to knock down an illegally built eighth floor, the retailer said.

    The company stopped doing business with two factories that failed the safety audits and couldn't sufficiently fix the problems discovered. One factory had to be closed completely.

    Wal-Mart will release the results of 75 inspections on its website and add others as they are completed, a step no other major Western retailer has taken. The company currently does business with more than 200 factories in Bangladesh, and has pledged to inspect all of them. It previously said it would begin posting results of the inspections by last June.

    Wal-Mart is making the moves to get a handle on its supply chain in the wake of deadly disasters at factories that did work for the company and other retailers. The company, based in Bentonville, Ark., is among the largest buyers of apparel made in Bangladesh, and its relentless focus on cost has made it a target for critics of working conditions in the impoverished nation.

    In the past the retailer hadn't regularly named the factories from which it buys clothing. But an April building collapse that killed more than 1,100 Bangladesh garment workers and deadly fires at other facilities focused international attention on the way Western retailers obtain cheap clothing.

    "We've spent $4 million on these audits, and we're not done yet," Jay Jorgensen, Wal-Mart's global chief compliance officer, said in an interview. "There's a lot of progress left to be made."

    During an October safety audit at Epic Garments Manufacturing Co., a factory near Dhaka, engineers hired by Wal-Mart checked on new red fire doors and outside staircases that had been installed to make evacuation easier in case of a fire and to prevent flames from spreading from stock rooms to factory floors.

    "Fireproof doors and materials weren't even available in Bangladesh," Epic Group Chief Executive Ranjan Mahtani said in an October interview at his plant "We had to fly them in from abroad and teach local manufacturers how to make them." He said he had already spent $300,000 on safety improvements to meet standards set by Wal-Mart and other Western retailers.

    The published audits won't offer specific findings about conditions at the factories, such as whether there are too few exits or if a building's columns are capable of bearing the weight of the structure. Rather, they will give a general risk assessment based on a letter grade that ranges from A through D.

    Wal-Mart said it would stop production at factories that receive a D rating, though the factories have a chance to correct the problems and go through another assessment.

    Critics say the disclosures don't provide enough information to workers and others who want to keep tabs on factory improvements.

    "I am struck by how little real information they are providing," said Scott Nova, executive director of the Worker Rights Consortium, a Washington labor-monitoring group. "They offer no specifics whatsoever as to the dangers workers face in these factories, all we get is a scoring system that is largely opaque."

    Wal-Mart said the letter-grade system aims to help give people an easily understandable overview of the safety situation in a given factory.

    Jan Saumweber, Wal-Mart's head of ethical sourcing, said she plans to increase her staff by 40% this year and add a team of 10 engineers to the company's Bangladesh sourcing office to regularly inspect factories. Ms. Saumweber took over the ethical sourcing job in September when Rajan Kamalanathan stepped down after a decade-long tenure at Wal-Mart.

    Wal-Mart said it will also start to incorporate safety standards into merchants' incentive-based compensation and train buyers to take safety into account when placing orders with factories.

    "These are big changes, and the company takes this very seriously," Ms. Saumweber said.

    Continued in article


    Sustainability Accounting Standards Board
    The SASB apparently will have some forthcoming accounting standards by the end of 2013. Does anybody know something useful about this accounting standards board which got a short publicity module on Page 52 of the September 30, 2013 issue of Time Magazine?

    A woman named Jean Rogers is apparently the Founder and Executive Director of the SASB which has a home page at
    http://www.sasb.org/ 

    The current Board of Directors is somewhat impressive although lacking in directors who have contributed to the literature of accounting or its social media ---
    http://www.sasb.org/sasb/board-directors/ 

    The curmudgeon in me makes me skeptical about the accounting expertise needed to generate "accounting standards."

    September 24, 2013

    Hi Bob

    Have a look at this http://csr-reporting.blogspot.co.uk/2013/09/will-sasb-make-g4-redundant.html 

    Until recently, I taught a class in sustainability accounting, and I can tell you that it is just as fraught with big issues as is ‘real’ accounting. Indeed, they are many of the same issues. They really do need standards, but the problem – the same problem faced in the early days of accounting standards – is that the businesses are very different, and the stakeholders’ needs diverge enormously.

    Elaine Cohen, author of the CSR reporting blog, is someone I respect in the field. I have met her, and have used her material. I do enjoy her blog. She would agree that sustainability accounting is very different to the sort of accounting that we do, but it is important and it does need some level of standardisation, whether done by ‘real’ accountants or by others.

    Kind regards

    Ruth

    September 25, 2013 reply from Bob Jensen

    Hi Ruth,

    In the USA, the SASB has no jurisdiction unless one of the government agencies like the SEC takes it on like the SEC took on the FASB.

    The SASB will be somewhat like the IASC in the earliest days before it became the IASB. The IASC adopted only non-controversial milk toast standards when compliance was only voluntary. The major factor that allowed the IASB to take on more controversial issues was its agreement with IOSCO that forced it to take on more controversial issues like IAS 39 ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/pacter.htm 

    But like the IASC in its earliest days, the SASB is a start.

    Respectfully,
    Bob Jensen

    Bob Jensen's threads on triple-bottom reporting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#TripleBottom

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


    Michael Jensen --- http://en.wikipedia.org/wiki/Michael_Jensen

    Maximizing Shareholder Value --- http://en.wikipedia.org/wiki/Shareholder_value#Maximizing_shareholder_value

    "Why the “Maximizing Shareholder Value” Theory of Corporate Governance is Bogus," Naked Capitalism, October 21, 2013 ---
    http://www.nakedcapitalism.com/2013/10/why-the-maximizing-shareholder-value-theory-of-corporate-governance-is-bogus.html

    . . .

    So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.

    A terrific 2010 paper by Frank Dobbin and Jiwook Jung, “The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Might Do It Again,” explains how this line of thinking went mainstream. I strongly suggest you read it in full, but I’ll give a brief recap for the time-pressed.

    In the 1970s, there was a great deal of hand-wringing in America as Japanese and German manufacturers were eating American’s lunch. That led to renewed examination of how US companies were managed, with lots of theorizing about what went wrong and what the remedies might be. In 1976, Jensen and William Meckling asserted that the problem was that corporate executives served their own interests rather than those of shareholders, in other words, that there was an agency problem. Executives wanted to build empires while shareholders wanted profits to be maximized.

    I strongly suspect that if Jensen and Meckling had not come out with this line of thinking, you would have gotten something similar to justify the actions of the leveraged buyout kings, who were just getting started in the 1970s and were reshaping the corporate landscape by the mid-1980s. They were doing many of the things Jensen and Meckling recommended: breaking up multi-business companies, thinning out corporate centers, and selling corporate assets (some of which were clearly excess, like corporate art and jet collection, while other sales were simply to increase leverage, like selling corporate office buildings and leasing them back). In other words, a likely reason that Jensen and Meckling’s theory gained traction was it appeared to validate a fundamental challenge to incumbent managements. (Dobbin and Jung attribute this trend, as pretty much everyone does, to Jensen because he continued to develop it. What really put it on the map was a 1990 Harvard Business Review article, “It’s Not What You Pay CEOs, but How,” that led to an explosion in the use of option-based pay and resulted in a huge increase in CEO pay relative to that of average workers.)

    To forestall takeovers, many companies implemented the measures an LBO artist might take before his invading army arrived: sell off non-core divisions, borrow more, shed staff.

    The problem was to the extent that the Jensen/Meckling prescription had merit, only the parts that helped company executives were adopted. Jensen didn’t just call on executives to become less ministerial and more entrepreneurial; they also called for more independent and engaged boards to oversee and discipline top managers, and more equity-driven pay, both options and other equity-linked compensation, to make management more sensitive to both upside and downside risks.

    Over the next two decades, companies levered up, became more short-term oriented, and executive pay levels exploded. As Dobbin and Jung put it, “The result of the changes promoted by agency theory was that by the late 1990s, corporate America’s leaders were drag racing without the brakes.”

    The paper proceeds to analyze in considerable detail how three of the major prescriptions of “agency theory” aka “executives and boards should maximize value,” namely, pay for (mythical) performance, dediversification, and greater reliance on debt all increased risk. And the authors also detail how efforts to improve oversight were ineffective.

    But the paper also makes clear that this vision of how companies should be run was simply a new management fashion, as opposed to any sort of legal requirement:

    Organizational institutionalists have long argued that new management practices diffuse through networks of firms like fads spread through high schools….In their models, new paradigms are socially constructed as appropriate solutions to perceived problems or crises….Expert groups that stand to gain from having their preferred strategies adopted by firms then enter the void, competing to have their model adopted….

    And as Dobbin and Jung point out, the parts of the Jensen formula that got adopted were the one that had constituents. The ones that promoted looting and short-termism had obvious followings. The ones for prudent management didn’t.

    And consider the implications of Jensen’s prescriptions, of pushing companies to favor shareholders, when they actually stand at the back of the line from a legal perspective. The result is that various agents (board compensation consultants, management consultants, and cronyistic boards themselves) have put incentives in place for CEOs to favor shareholders over parties that otherwise should get better treatment. So is it any surprise that companies treat employees like toilet paper, squeeze vendors, lobby hard for tax breaks and to weaken regulations, and worse, like fudge their financial reports? Jensen himself, in 2005, repudiated his earlier prescription precisely because it led to fraud. From an interview with the New York Times:

    Q. So the maximum stock price is the holy grail?

    A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin – it feels really great when you start out; you’re feted on television; investment bankers vie to float new issues.

    But it doesn’t take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: “Holy Moley! How are we going to generate the returns?” They look for legal loopholes in the accounting, and when those don’t work, even basically honest people move around the corner to outright fraud.

    If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

    Q. Are you suggesting that executives be rewarded for driving down the price of the stock?

    A. I’m saying they should be rewarded for being honest. A C.E.O. should be able to tell investors, “Listen, this company isn’t worth its $70 billion market cap; it’s really worth $30 billion, and here’s why.”

    But the board would fire that executive immediately. I guess it has to be preventative – if executives would present the market with realistic numbers rather than overoptimistic expectations, the stock price would stay realistic. But I admit, we scholars don’t yet know the real answer to how to make this happen.

    So having led Corporate America in the wrong direction, Jensen ‘fesses up no one knows the way out. But if executives weren’t incentivized to take such a topsy-turvey shareholder-driven view of the world, they’d weigh their obligations to other constituencies, including the community at large, along with earning shareholders a decent return. But it’s now become so institutionalized it’s hard to see how to move to a more sensible regime. For instance, analysts regularly try pressuring Costco to pay its workers less, wanting fatter margins. But the comparatively high wages are an integral part of Costco’s formula: it reduces costly staff turnover and employee pilferage. And Costco’s upscale members report they prefer to patronize a store they know treats workers better than Walmart and other discounters. If managers with an established, successful formulas still encounter pressure from the Street to strip mine their companies, imagine how hard it is for struggling companies or less secure top executives to implement strategies that will take a while to reap rewards. I’ve been getting reports from McKinsey from the better part of a decade that they simply can’t get their clients to implement new initiatives if they’ll dent quarterly returns.

    This governance system is actually in crisis, but the extraordinary profit share that companies have managed to achieve by squeezing workers and the asset-goosing success of post-crisis financial policies have produced an illusion of health. But porcine maquillage only improves appearances; it doesn’t mask the stench of gangrene. Nevertheless, executives have successfully hidden the generally unhealthy state of their companies. As long as they have cheerleading analysts, complacent boards and the Fed protecting their back, they can likely continue to inflict more damage, using “maximizing shareholder value” canard as the cover for continuing rent extraction.


    Read more at http://www.nakedcapitalism.com/2013/10/why-the-maximizing-shareholder-value-theory-of-corporate-governance-is-bogus.html#ehj10weqAL2vdXkh.99
    So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.

    A terrific 2010 paper by Frank Dobbin and Jiwook Jung, “The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Might Do It Again,” explains how this line of thinking went mainstream. I strongly suggest you read it in full, but I’ll give a brief recap for the time-pressed.

    In the 1970s, there was a great deal of hand-wringing in America as Japanese and German manufacturers were eating American’s lunch. That led to renewed examination of how US companies were managed, with lots of theorizing about what went wrong and what the remedies might be. In 1976, Jensen and William Meckling asserted that the problem was that corporate executives served their own interests rather than those of shareholders, in other words, that there was an agency problem. Executives wanted to build empires while shareholders wanted profits to be maximized.

    I strongly suspect that if Jensen and Meckling had not come out with this line of thinking, you would have gotten something similar to justify the actions of the leveraged buyout kings, who were just getting started in the 1970s and were reshaping the corporate landscape by the mid-1980s. They were doing many of the things Jensen and Meckling recommended: breaking up multi-business companies, thinning out corporate centers, and selling corporate assets (some of which were clearly excess, like corporate art and jet collection, while other sales were simply to increase leverage, like selling corporate office buildings and leasing them back). In other words, a likely reason that Jensen and Meckling’s theory gained traction was it appeared to validate a fundamental challenge to incumbent managements. (Dobbin and Jung attribute this trend, as pretty much everyone does, to Jensen because he continued to develop it. What really put it on the map was a 1990 Harvard Business Review article, “It’s Not What You Pay CEOs, but How,” that led to an explosion in the use of option-based pay and resulted in a huge increase in CEO pay relative to that of average workers.)

    To forestall takeovers, many companies implemented the measures an LBO artist might take before his invading army arrived: sell off non-core divisions, borrow more, shed staff.

    The problem was to the extent that the Jensen/Meckling prescription had merit, only the parts that helped company executives were adopted. Jensen didn’t just call on executives to become less ministerial and more entrepreneurial; they also called for more independent and engaged boards to oversee and discipline top managers, and more equity-driven pay, both options and other equity-linked compensation, to make management more sensitive to both upside and downside risks.

    Over the next two decades, companies levered up, became more short-term oriented, and executive pay levels exploded. As Dobbin and Jung put it, “The result of the changes promoted by agency theory was that by the late 1990s, corporate America’s leaders were drag racing without the brakes.”

    The paper proceeds to analyze in considerable detail how three of the major prescriptions of “agency theory” aka “executives and boards should maximize value,” namely, pay for (mythical) performance, dediversification, and greater reliance on debt all increased risk. And the authors also detail how efforts to improve oversight were ineffective.

    But the paper also makes clear that this vision of how companies should be run was simply a new management fashion, as opposed to any sort of legal requirement:

    Organizational institutionalists have long argued that new management practices diffuse through networks of firms like fads spread through high schools….In their models, new paradigms are socially constructed as appropriate solutions to perceived problems or crises….Expert groups that stand to gain from having their preferred strategies adopted by firms then enter the void, competing to have their model adopted….

    And as Dobbin and Jung point out, the parts of the Jensen formula that got adopted were the one that had constituents. The ones that promoted looting and short-termism had obvious followings. The ones for prudent management didn’t.

    And consider the implications of Jensen’s prescriptions, of pushing companies to favor shareholders, when they actually stand at the back of the line from a legal perspective. The result is that various agents (board compensation consultants, management consultants, and cronyistic boards themselves) have put incentives in place for CEOs to favor shareholders over parties that otherwise should get better treatment. So is it any surprise that companies treat employees like toilet paper, squeeze vendors, lobby hard for tax breaks and to weaken regulations, and worse, like fudge their financial reports? Jensen himself, in 2005, repudiated his earlier prescription precisely because it led to fraud. From an interview with the New York Times:

    Q. So the maximum stock price is the holy grail?

    A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin – it feels really great when you start out; you’re feted on television; investment bankers vie to float new issues.

    But it doesn’t take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: “Holy Moley! How are we going to generate the returns?” They look for legal loopholes in the accounting, and when those don’t work, even basically honest people move around the corner to outright fraud.

    If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

    Q. Are you suggesting that executives be rewarded for driving down the price of the stock?

    A. I’m saying they should be rewarded for being honest. A C.E.O. should be able to tell investors, “Listen, this company isn’t worth its $70 billion market cap; it’s really worth $30 billion, and here’s why.”

    But the board would fire that executive immediately. I guess it has to be preventative – if executives would present the market with realistic numbers rather than overoptimistic expectations, the stock price would stay realistic. But I admit, we scholars don’t yet know the real answer to how to make this happen.

    So having led Corporate America in the wrong direction, Jensen ‘fesses up no one knows the way out. But if executives weren’t incentivized to take such a topsy-turvey shareholder-driven view of the world, they’d weigh their obligations to other constituencies, including the community at large, along with earning shareholders a decent return. But it’s now become so institutionalized it’s hard to see how to move to a more sensible regime. For instance, analysts regularly try pressuring Costco to pay its workers less, wanting fatter margins. But the comparatively high wages are an integral part of Costco’s formula: it reduces costly staff turnover and employee pilferage. And Costco’s upscale members report they prefer to patronize a store they know treats workers better than Walmart and other discounters. If managers with an established, successful formulas still encounter pressure from the Street to strip mine their companies, imagine how hard it is for struggling companies or less secure top executives to implement strategies that will take a while to reap rewards. I’ve been getting reports from McKinsey from the better part of a decade that they simply can’t get their clients to implement new initiatives if they’ll dent quarterly returns.

    This governance system is actually in crisis, but the extraordinary profit share that companies have managed to achieve by squeezing workers and the asset-goosing success of post-crisis financial policies have produced an illusion of health. But porcine maquillage only improves appearances; it doesn’t mask the stench of gangrene. Nevertheless, executives have successfully hidden the generally unhealthy state of their companies. As long as they have cheerleading analysts, complacent boards and the Fed protecting their back, they can likely continue to inflict more damage, using “maximizing shareholder value” canard as the cover for continuing rent extraction.


    Read more at http://www.nakedcapitalism.com/2013/10/why-the-maximizing-shareholder-value-theory-of-corporate-governance-is-bogus.html#ehj10weqAL2vdXkh.99
    So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.

    A terrific 2010 paper by Frank Dobbin and Jiwook Jung, “The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Might Do It Again,” explains how this line of thinking went mainstream. I strongly suggest you read it in full, but I’ll give a brief recap for the time-pressed.

    In the 1970s, there was a great deal of hand-wringing in America as Japanese and German manufacturers were eating American’s lunch. That led to renewed examination of how US companies were managed, with lots of theorizing about what went wrong and what the remedies might be. In 1976, Jensen and William Meckling asserted that the problem was that corporate executives served their own interests rather than those of shareholders, in other words, that there was an agency problem. Executives wanted to build empires while shareholders wanted profits to be maximized.

    I strongly suspect that if Jensen and Meckling had not come out with this line of thinking, you would have gotten something similar to justify the actions of the leveraged buyout kings, who were just getting started in the 1970s and were reshaping the corporate landscape by the mid-1980s. They were doing many of the things Jensen and Meckling recommended: breaking up multi-business companies, thinning out corporate centers, and selling corporate assets (some of which were clearly excess, like corporate art and jet collection, while other sales were simply to increase leverage, like selling corporate office buildings and leasing them back). In other words, a likely reason that Jensen and Meckling’s theory gained traction was it appeared to validate a fundamental challenge to incumbent managements. (Dobbin and Jung attribute this trend, as pretty much everyone does, to Jensen because he continued to develop it. What really put it on the map was a 1990 Harvard Business Review article, “It’s Not What You Pay CEOs, but How,” that led to an explosion in the use of option-based pay and resulted in a huge increase in CEO pay relative to that of average workers.)

    To forestall takeovers, many companies implemented the measures an LBO artist might take before his invading army arrived: sell off non-core divisions, borrow more, shed staff.

    The problem was to the extent that the Jensen/Meckling prescription had merit, only the parts that helped company executives were adopted. Jensen didn’t just call on executives to become less ministerial and more entrepreneurial; they also called for more independent and engaged boards to oversee and discipline top managers, and more equity-driven pay, both options and other equity-linked compensation, to make management more sensitive to both upside and downside risks.

    Over the next two decades, companies levered up, became more short-term oriented, and executive pay levels exploded. As Dobbin and Jung put it, “The result of the changes promoted by agency theory was that by the late 1990s, corporate America’s leaders were drag racing without the brakes.”

    The paper proceeds to analyze in considerable detail how three of the major prescriptions of “agency theory” aka “executives and boards should maximize value,” namely, pay for (mythical) performance, dediversification, and greater reliance on debt all increased risk. And the authors also detail how efforts to improve oversight were ineffective.

    But the paper also makes clear that this vision of how companies should be run was simply a new management fashion, as opposed to any sort of legal requirement:

    Organizational institutionalists have long argued that new management practices diffuse through networks of firms like fads spread through high schools….In their models, new paradigms are socially constructed as appropriate solutions to perceived problems or crises….Expert groups that stand to gain from having their preferred strategies adopted by firms then enter the void, competing to have their model adopted….

    And as Dobbin and Jung point out, the parts of the Jensen formula that got adopted were the one that had constituents. The ones that promoted looting and short-termism had obvious followings. The ones for prudent management didn’t.

    And consider the implications of Jensen’s prescriptions, of pushing companies to favor shareholders, when they actually stand at the back of the line from a legal perspective. The result is that various agents (board compensation consultants, management consultants, and cronyistic boards themselves) have put incentives in place for CEOs to favor shareholders over parties that otherwise should get better treatment. So is it any surprise that companies treat employees like toilet paper, squeeze vendors, lobby hard for tax breaks and to weaken regulations, and worse, like fudge their financial reports? Jensen himself, in 2005, repudiated his earlier prescription precisely because it led to fraud. From an interview with the New York Times:

    Q. So the maximum stock price is the holy grail?

    A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin – it feels really great when you start out; you’re feted on television; investment bankers vie to float new issues.

    But it doesn’t take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: “Holy Moley! How are we going to generate the returns?” They look for legal loopholes in the accounting, and when those don’t work, even basically honest people move around the corner to outright fraud.

    If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

    Q. Are you suggesting that executives be rewarded for driving down the price of the stock?

    A. I’m saying they should be rewarded for being honest. A C.E.O. should be able to tell investors, “Listen, this company isn’t worth its $70 billion market cap; it’s really worth $30 billion, and here’s why.”

    But the board would fire that executive immediately. I guess it has to be preventative – if executives would present the market with realistic numbers rather than overoptimistic expectations, the stock price would stay realistic. But I admit, we scholars don’t yet know the real answer to how to make this happen.

    So having led Corporate America in the wrong direction, Jensen ‘fesses up no one knows the way out. But if executives weren’t incentivized to take such a topsy-turvey shareholder-driven view of the world, they’d weigh their obligations to other constituencies, including the community at large, along with earning shareholders a decent return. But it’s now become so institutionalized it’s hard to see how to move to a more sensible regime. For instance, analysts regularly try pressuring Costco to pay its workers less, wanting fatter margins. But the comparatively high wages are an integral part of Costco’s formula: it reduces costly staff turnover and employee pilferage. And Costco’s upscale members report they prefer to patronize a store they know treats workers better than Walmart and other discounters. If managers with an established, successful formulas still encounter pressure from the Street to strip mine their companies, imagine how hard it is for struggling companies or less secure top executives to implement strategies that will take a while to reap rewards. I’ve been getting reports from McKinsey from the better part of a decade that they simply can’t get their clients to implement new initiatives if they’ll dent quarterly returns.

    This governance system is actually in crisis, but the extraordinary profit share that companies have managed to achieve by squeezing workers and the asset-goosing success of post-crisis financial policies have produced an illusion of health. But porcine maquillage only improves appearances; it doesn’t mask the stench of gangrene. Nevertheless, executives have successfully hidden the generally unhealthy state of their companies. As long as they have cheerleading analysts, complacent boards and the Fed protecting their back, they can likely continue to inflict more damage, using “maximizing shareholder value” canard as the cover for continuing rent extraction.


    Read more at http://www.nakedcapitalism.com/2013/10/why-the-maximizing-shareholder-value-theory-of-corporate-governance-is-bogus.html#ehj10weqAL2vdXkh.99

    So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.

    A terrific 2010 paper by Frank Dobbin and Jiwook Jung, The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Might Do It Again,” explains how this line of thinking went mainstream. I strongly suggest you read it in full, but I’ll give a brief recap for the time-pressed.

    In the 1970s, there was a great deal of hand-wringing in America as Japanese and German manufacturers were eating American’s lunch. That led to renewed examination of how US companies were managed, with lots of theorizing about what went wrong and what the remedies might be. In 1976, Jensen and William Meckling asserted that the problem was that corporate executives served their own interests rather than those of shareholders, in other words, that there was an agency problem. Executives wanted to build empires while shareholders wanted profits to be maximized.

    I strongly suspect that if Jensen and Meckling had not come out with this line of thinking, you would have gotten something similar to justify the actions of the leveraged buyout kings, who were just getting started in the 1970s and were reshaping the corporate landscape by the mid-1980s. They were doing many of the things Jensen and Meckling recommended: breaking up multi-business companies, thinning out corporate centers, and selling corporate assets (some of which were clearly excess, like corporate art and jet collection, while other sales were simply to increase leverage, like selling corporate office buildings and leasing them back). In other words, a likely reason that Jensen and Meckling’s theory gained traction was it appeared to validate a fundamental challenge to incumbent managements. (Dobbin and Jung attribute this trend, as pretty much everyone does, to Jensen because he continued to develop it. What really put it on the map was a 1990 Harvard Business Review article, It’s Not What You Pay CEOs, but How,” that led to an explosion in the use of option-based pay and resulted in a huge increase in CEO pay relative to that of average workers.)

    To forestall takeovers, many companies implemented the measures an LBO artist might take before his invading army arrived: sell off non-core divisions, borrow more, shed staff.

    The problem was to the extent that the Jensen/Meckling prescription had merit, only the parts that helped company executives were adopted. Jensen didn’t just call on executives to become less ministerial and more entrepreneurial; they also called for more independent and engaged boards to oversee and discipline top managers, and more equity-driven pay, both options and other equity-linked compensation, to make management more sensitive to both upside and downside risks.

    Over the next two decades, companies levered up, became more short-term oriented, and executive pay levels exploded. As Dobbin and Jung put it, “The result of the changes promoted by agency theory was that by the late 1990s, corporate America’s leaders were drag racing without the brakes.”

    The paper proceeds to analyze in considerable detail how three of the major prescriptions of “agency theory” aka “executives and boards should maximize value,” namely, pay for (mythical) performance, dediversification, and greater reliance on debt all increased risk. And the authors also detail how efforts to improve oversight were ineffective.

    But the paper also makes clear that this vision of how companies should be run was simply a new management fashion, as opposed to any sort of legal requirement:

    Organizational institutionalists have long argued that new management practices diffuse through networks of firms like fads spread through high schools….In their models, new paradigms are socially constructed as appropriate solutions to perceived problems or crises….Expert groups that stand to gain from having their preferred strategies adopted by firms then enter the void, competing to have their model adopted….

    And as Dobbin and Jung point out, the parts of the Jensen formula that got adopted were the one that had constituents. The ones that promoted looting and short-termism had obvious followings. The ones for prudent management didn’t.

    And consider the implications of Jensen’s prescriptions, of pushing companies to favor shareholders, when they actually stand at the back of the line from a legal perspective. The result is that various agents (board compensation consultants, management consultants, and cronyistic boards themselves) have put incentives in place for CEOs to favor shareholders over parties that otherwise should get better treatment. So is it any surprise that companies treat employees like toilet paper, squeeze vendors, lobby hard for tax breaks and to weaken regulations, and worse, like fudge their financial reports? Jensen himself, in 2005, repudiated his earlier prescription precisely because it led to fraud. From an interview with the New York Times:

    Q. So the maximum stock price is the holy grail?

    A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin – it feels really great when you start out; you’re feted on television; investment bankers vie to float new issues.

    But it doesn’t take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: “Holy Moley! How are we going to generate the returns?” They look for legal loopholes in the accounting, and when those don’t work, even basically honest people move around the corner to outright fraud.

    If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

    Q. Are you suggesting that executives be rewarded for driving down the price of the stock?

    A. I’m saying they should be rewarded for being honest. A C.E.O. should be able to tell investors, “Listen, this company isn’t worth its $70 billion market cap; it’s really worth $30 billion, and here’s why.”

    But the board would fire that executive immediately. I guess it has to be preventative – if executives would present the market with realistic numbers rather than overoptimistic expectations, the stock price would stay realistic. But I admit, we scholars don’t yet know the real answer to how to make this happen.

    So having led Corporate America in the wrong direction, Jensen ‘fesses up no one knows the way out. But if executives weren’t incentivized to take such a topsy-turvey shareholder-driven view of the world, they’d weigh their obligations to other constituencies, including the community at large, along with earning shareholders a decent return. But it’s now become so institutionalized it’s hard to see how to move to a more sensible regime. For instance, analysts regularly try pressuring Costco to pay its workers less, wanting fatter margins. But the comparatively high wages are an integral part of Costco’s formula: it reduces costly staff turnover and employee pilferage. And Costco’s upscale members report they prefer to patronize a store they know treats workers better than Walmart and other discounters. If managers with an established, successful formulas still encounter pressure from the Street to strip mine their companies, imagine how hard it is for struggling companies or less secure top executives to implement strategies that will take a while to reap rewards. I’ve been getting reports from McKinsey from the better part of a decade that they simply can’t get their clients to implement new initiatives if they’ll dent quarterly returns.

    This governance system is actually in crisis, but the extraordinary profit share that companies have managed to achieve by squeezing workers and the asset-goosing success of post-crisis financial policies have produced an illusion of health. But porcine maquillage only improves appearances; it doesn’t mask the stench of gangrene. Nevertheless, executives have successfully hidden the generally unhealthy state of their companies. As long as they have cheerleading analysts, complacent boards and the Fed protecting their back, they can likely continue to inflict more damage, using “maximizing shareholder value” canard as the cover for continuing rent extraction.

     

    Read more at
    http://www.nakedcapitalism.com/2013/10/why-the-maximizing-shareholder-value-theory-of-corporate-governance-is-bogus.html#ehj10weqAL2vdXkh.99

    Jensen Comment
    Mike Jensen was the headliner at the 2013 American Accounting Association Annual Meetings. AAA members can watch various videos by him and about him at the AAA Commons Website.

    Actually Al Rappaport at Northwestern may have been more influential in spreading the word about creating shareholder value ---
    Rappaport, Alfred (1998). Creating Shareholder Value: A guide for managers and investors. New York: The Free Press. pp. 13–29.

    It would be interesting if Mike Jensen and/or Al Rappaport wrote rebuttals to this article.

    Bob Jensen's threads on theory are at
    http://faculty.trinity.edu/rjensen/Theory01.htm

     


    While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative may help make the vision more feasible. The GRI's guidelines for "triple-bottom- line reporting" would broaden financial reporting into a three- dimensional model for economic, social and environmental reporting. http://www.accountingweb.com/item/78245 

    While some in the profession may question the long-term viability of audit-only accounting firms, proposed guidelines issued recently by the Global Reporting Initiative (GRI) may help make the vision more feasible. The GRI's guidelines for "triple-bottom-line reporting" would broaden financial reporting into a three-dimensional model for economic, social and environmental reporting. Each dimension of the model would contain information that is valuable to stakeholders and could be independently verified.

    Numbers, Ratios and Explanations

    Despite the convenient shorthand reference to bottom lines, many of the GRI indicators are multi-faceted, consisting of tables, ratios and qualitative descriptions of policies, procedures, and systems. Below are examples of indicators within each of the three dimensions:

    Economic performance indicators. Geographic breakdown of key markets, percent of contracts paid in accordance with agreed terms, and description of the organization's indirect economic impacts.

    Environmental performance indicators. Breakdown of energy sources used, (e.g., for electricity and heat), total water usage, breakdown of waste by type and destination, list of penalties paid for non-compliance with environmental laws and regulations, and description of policies and procedures to minimize adverse environmental impacts.

    Social performance indicators. Total workforce including temporary workers, percentage of employees represented by trade unions, schedule of average hours of training per year per employee for all major categories of employee, male/female ratios in upper management positions, and descriptions of policies and procedures to address such issues as human rights, product information and labeling, customer privacy, and political lobbying and contributions. The GRI was formed in 1997 by a partnership of the United Nations Environment Program (UNEP) and the Coalition for Environmentally Responsible Economies (CERES). Several hundred organizations have participated in working groups to help form the guidelines for triple-bottom-line reporting. These organizations include corporations, accounting firms, investors, labor organizations and other stakeholders.

    "What Is Environmental Accounting?" AccountingWeb, January 6, 2006 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=101639

    Environmental Management Accounting (EMA) is a cover title used to describe different aspects of this burgeoning field of accounting. The focus of EMA is as a management accounting tool used to make internal business decisions, especially for proactive environmental management activities. EMA was developed to recognize some limitations of conventional management accounting approaches to environmental costs, consequences, and impacts. For example, overhead accounts were the destination of many environmental costs in the past. Cost allocations were inaccurate and could not be traced back to processes, products, or process lines. Wasted raw materials were also inaccurately accounted for during production.

    Each aspect of EMA has a general accounting type that serves as its foundation, according to the EMA international website. The following examples indicate the general accounting type followed by the environmental accounting parallel:

    Management Accounting (MA) entails the identification, collection, estimation, analysis, and use of cost, or other information used for organizational decision-making. Environmental Management Accounting (EMA) is Management Accounting with a focus on materials and energy flow information, with environmental cost information.

    Financial Accounting (FA) comprises the development and organizational reporting of financial information to external parties, such as stockholders and bankers. Environmental Financial Accounting (EFA) builds on Financial Accounting, focusing on the reporting of environmental liability costs with other significant environmental costs.

    National Accounting (NA) is the development of economic and other information used to describe national income and economic health. Environmental National Accounting (ENA) is National Accounting focusing on the stocks of natural resources, their physical flows, environmental costs, and externality costs.

    EMA is a broad set of approaches and principles that provide views into the physical flows and costs critical to the successful completion of environmental management activities and increasingly, routine management activities, such as product and process design, capital budgeting, cost control and allocation, and product pricing, according to the EMA international website.

    Continued in article


    "Cheap Solar Panels Aren't Enough to Make Solar Installers Profitable:  SolarCity's IPO filings show it needs to grow and lower costs," by Kevin Bullis, MIT's Technology Review, October 8, 2012 --- Click Here
    http://www.technologyreview.com/view/429533/cheap-solar-panels-arent-enough-to-make-solar/?utm_campaign=newsletters&utm_source=newsletter-daily-all&utm_medium=email&utm_content=20121009

    Jensen Comment
    This article might be useful in cost, managerial, and environmental accounting courses as well as courses in financial analysis of the IPO filings


    "Real Estate with a Cause: Identifying Investments that Serve a Triple Bottom Line," Knowledge@Wharton, December 19, 2012 ---
    http://knowledge.wharton.upenn.edu/article.cfm?articleid=3141

    A derelict medical center for veterans in Salem, Va., that was transformed into an energy efficient place to live and work -- thanks to a mélange of private and public funds -- proves that investors can make money and support social change at the same time.

    That was the message of a panel discussion at the recent Wharton Social Impact Conference focused on innovative approaches to financing socially responsible projects in the real estate sector. How much money is potentially available for building while also serving social and environmental benefits is anybody's guess. One expert, who manages a large, San Francisco-based investment fund dedicated to creating quality jobs in low-income areas of California, estimated $20 trillion. Figures from JPMorgan, however, came in substantially lower -- $400 billion to $1 trillion within the next eight years.

    Douglas P. Lawrence, managing principal for 5 Stone Green Capital, a small investment fund that is focused on green technologies, called the veterans' medical complex in Virginia, a "win-win" because "investors get an 8% return, and homeless veterans get a modern, light-filled place to live, stellar medical care and a chance to make some money in a year-round greenhouse. For the environment, we reduced energy consumption by 30%. For the military, this project has impact because it cares deeply about veterans," said Lawrence, a former co-portfolio manager for JPMorgan's urban green property fund.

    In addition, the Virginia veterans' project was a rock-solid investment because construction loans and rents were government guaranteed, Lawrence noted, adding that he "wouldn't even look at a building project today that does not incorporate green technologies."

    Socially responsible or sustainable real estate development does more than turn a profit. While investors expect gains, there is a growing number who also want to do something for the greater good, whether it is in urban housing, green technology, job creation, preserving historic treasures, providing access to health care, education, clean water, healthy food or numerous other areas around the world in need of capital for change.

    "Building green does not cost more. It costs different because the savings are over the long haul," said Lawrence. "With the population expected to grow to seven billion by 2050 and the depletion of our fossil fuels, it only makes sense that we employ the best technologies to keep operating costs as low as possible."

    Forget Bamboo Floors and Bike Racks

    Lawrence's fund is targeted to three types of real estate: multi-family housing in cities, old industrial buildings suitable for rehabilitation because they are likely to spawn new companies and jobs, and construction of grocery stores and pharmacies because they will "always be essential." He derided what he called "merchant builders who build as cheaply as possible, then move out and leave the problems for the next guy."

    On the contrary, he noted, "building green is not about bamboo floors and bicycle racks. It is about improving the bottom line by driving down expenses. It's also about learning how to be a better steward of the resources we have on the planet and how to build better in the first place. This is nothing more than old-fashioned asset management, instead of financial engineering, as a way to increase profits."

    While impact investing is gaining momentum in these post-recessionary times, it is far from mainstream, said panel moderator Benjamin Blakney, an investment consultant and former treasurer of the city of Philadelphia. He credited a subtle shift in language for an uptick in interest.

    "There is movement away from the term 'socially responsible' investing because it sounds a bit inferior, like maybe the investor should expect a compromise in returns," he noted. "The term 'impact investing' shifts the emphasis to the target. It acknowledges that cash is king and that investment conversations are mercenary. Show me the money. Don't forget money managers have a fiduciary responsibility to seek out market-rate or above market-rate returns."

    Other buzz words for the practice that are growing in popularity are "venture philanthropy" or "responsible capitalism." Bill Gates' name surfaced repeatedly during the conference to illustrate the need to make money first before having enough to give away.

    Better Analytics Align Money with Passion

    Real estate development is inherently complex. Sometimes the desire to add impact investing can make a tentative deal collapse, warned Blakney. A major obstacle, according to The Gallin Group, a market research firm that surveyed 51 leading impact investors last year, is the dearth of high-quality investments along with too few investment managers, consultants and entrepreneurs who can construct and promote measurable investments.

    "Asset owners say they would put more capital to work if they were able to find high-quality investments," the study said. "They recognize that their investments serve as demonstration projects, and success may be able to catalyze the flow of additional capital. Therefore, the management teams of the investments must be solid."

    Industry pioneers, such as the $3 billion Rockefeller Foundation in New York, view impact investing as a way to reduce poverty and other social problems, but more importantly as a carrot to attract wealth from the largest private capital markets.

    More investors are beginning to poke around for social benefit investments because "traditional investments in the last few years have left them dry," noted panelist Joseph J. Haslip, managing director of Blue Harbour Group, a hedge fund. Previously, he was the city of New York's representative to four pension funds with assets in excess of $100 billion. "The atmosphere is definitely getting better. Increased availability of analytics is also helping investors align their money with their passions, he said. "For example, data has shown that corporations with minorities and women on their boards actually outperform those that have none."

    While some observers consider green construction to be the "new normal," panelist Stuart Brodsky, a professor at New York University's Schack Institute of Real Estate, predicted that U.S. commercial markets are still 15 years away from "building totally green." The market has made progress, "but there is still a lot of wasted money in construction. The industry would benefit from greater standardization of requirements and government leadership," said Brodsky, who served as the national manager for ENERGY STAR, a program that resulted in a 24 million metric ton reduction in greenhouse gas emissions and a savings of $7.5 billion in energy operating costs.

    Tax credits and other government-sponsored redevelopment strategies incentivize private investors to put their money into public projects. Approximately 20 states already mandate or encourage public pension funds to invest in initiatives with a social benefit and, in particular, to support local economies.

    A 'Second Downtown' for D.C.

    Panelist Elinor R. Bacon, president of a real estate development company in Washington, D.C., and a former deputy assistant secretary for the U.S. Department of Housing and Urban Development's office of public housing investments, noted that the amount of private capital invested in public housing in the last decade has increased four-fold. Her latest project is a 23-acre waterfront site in southwest Washington that is a private-public partnership between the District of Columbia and a team of six development companies, including Bacon's.

    Construction on The Wharf is expected to begin early next year and be completed in 2020. It is a poster child for socially responsible real estate development, Bacon added, because it will transform a swath of blighted and isolated waterfront land, owned by the District, into a vibrant place to live, work, shop, study and play. By creating what some are calling a "second downtown" for D.C., as opposed to pushing into the suburbs where building costs are lower, the project exemplifies smart growth, she noted.

    Continued in article


    "The Yale Environment Review wants to brief you on the latest in environmental research," by David Wogan, Scientific American, May 4, 2012 ---
    http://blogs.scientificamerican.com/plugged-in/2012/05/04/the-yale-environment-review-wants-to-brief-you-on-the-latest-in-environmental-research/

    I’m excited to share with y’all the Yale Environment Review, fresh out of the Yale School of School of Forestry and Environmental Studies. The Review is a super refined weekly web publication curated by subject matter experts from Yale who summarize important research articles from leading natural and social science journals with the hope that people can make more informed decisions using latest research results.

    The Review launched this week and covers a wide range of topics, like this brief about climate change and biodiversity (“Biodiversity Left Behind in Climate Change Scenarios”):

    They find that simply using the traditional classification of a species in climate change simulations can underestimate the true scale of biodiversity loss. This happens because the subtle genetic variations among similar-looking species – typically hidden from view – are overlooked. Such a misstep in the models could undermine future conservation efforts.

    And another about the effect of air pollution standards on economic growth (“Economic Growth by Stricter Regulation”):

    Environmental regulation is often cast as a growth-inhibiting tax on producers and consumers. But a recent working paper from the National Bureau of Economic Research (NBER) provides a strong foundation for the economic benefits of regulation. The authors flip the conventional view on its head and present tighter regulation as an investment in human capital, and thus a tool for promoting economic growth.

    A quick glance at the topics page hints at future articles: business, climate change, ecosystem conservation, energy, environmental policy, industrial ecology, land management, urban planning, and water resources. It’s practically a greatest hits album of pressing environmental policy issues.

    Continued in article


    "Non-Financial Data is Material: the Sustainability Paradox," by Eric Rostin, Bloomberg News, April 13, 2012 ---
    http://www.bloomberg.com/news/2012-04-13/non-financial-data-is-material-the-sustainability-paradox.html

    You might think any corporate data that helps investors weigh the value of a company would be called "financial information," right? Not so. Welcome to the world of "non-financial information."

    Five U.S. companies in 2011 expanded their financial disclosures -- information required of publicly traded companies -- to include data about environmental performance, employee and community relations, and corporate governance. Investors, nongovernmental organizations and even some governments are increasingly seeking this information as it relates to business risks and opportunities. Non-financial information, it turns out, can have a pretty big impact on financial performance.

    So here's the paradox: If non-financial data, such as greenhouse gas emissions per dollar of revenue, is included in a financial report for investors, how can it still be called non-financial? Institutional investors and companies aren't yet making the leap to calling greenhouse gas emissions, percentage of female executives or other ESG metrics "financial." But they are increasingly considering them to be material.

    Combining this so-called non-financial information with legally mandated disclosures is called integrated reporting, a practice that emerged from the widespread publication of corporate sustainability reports. It requires a deep knowledge of what's strategically important to a company.

    A company might disclose data on any of dozens of metrics beyond conventional balance-sheet accounting, whether they are "integrated" or released in a separate format. Practitioners collectively refer sustainability reporting as ESG, for the three major categories of data -- environmental, social and corporate governance.

    The amount of non-financial information flying around the marketplace is overwhelming and growing. The main delivery mechanism is the corporate sustainability report, or the corporate responsibility report, or the citizenship report, environment report, corporate social responsibility report "or some title that fits," as Hank Boerner put it. Boerner is chairman of Governance & Accountability Institute, Inc. The group collects and analyzes companies' disclosures, and is the U.S. data partner for the Global Reporting Initiative (GRI), a widely used framework for producing sustainability reports.

    Boerner's organization has completed its tally of U.S. sustainability reports for 2011 -- the conventional, feel-good variety, not necessarily integrated with balance sheets. The numbers themselves aren’t as significant as the jumbled snapshot they offer to investors -- who expect standardized disclosures that are generally comparable from company to company and industry to industry.

    Companies and nonprofits in the U.S. issued 242 reports last year, 228 of which came from corporations or their U.S. subsidiaries. Thirty-one company reports were assured by an independent auditor.

    GRI guidelines were followed by 186 companies, about 44 percent more than in 2010.

    The five U.S. companies who combined traditional and sustainability data into one "integrated" report were Clorox, Northrup Grumman, SAS, Genentech and Polymer Group Inc.

    Companies considering integrated reporting are determining what information is "material" to their business, according to a recent Deloitte report. The U.S. Securities and Exchange Commission said in 1999 that "a matter is 'material' if there is a substantial likelihood that a reasonable person would consider it important." This definition hasn't changed with the advent of sustainability disclosure and integrated reporting. The rest of the world has.

    The Securities and Exchange Commission issued guidance to public companies in early 2010, clarifying the circumstances in which public companies should disclose information related to climate change. Apple is the most recent company to discover that global supply chains and intense public interest make worker conditions, even at far-flung factories, material.

    Continued in article

     

     


    "Reimagining Capitalism." by Polly LaBarre, Harvard Business Review Blog, February 27, 2012 --- Click Here
    http://blogs.hbr.org/cs/2012/02/reimagining_capitalism.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    The comments following this article range across the entire spectrum of reactions we've seen for years about social responsibility accounting for business. Milton Friedman, of course, argued that the only responsibility of business is to obey the letter and spirit of the law without losing sight of the main goal of profit maximization.  Friedman argued that it's not the responsibility of business firms to make externality resource allocation decisions best left to government. This is reflected in the comment of Kozarms.

    The concepts herein are very disturbing. This strikes me as socialism, and a socialist mentality. "How do we build the consideration of social return into every conversation and every decision at every level in the organization?" That's easy - see any communist country, and ask yourself if those are great societies full of innovation despite their professions of acting for the common good. Who decides what is a good social return - everyone all at once? The government? And: "inspire sacrifice, stimulate innovation" - why would an innovator also being willing to contribute his/her work as a sacrifice to the masses? The problems attributed in this article to capitalism are problems are not related to capitalism at all, but are problems of the mixed up ideaology of this mixed economy. We need to return to the correct ideas about what capitalism really means, not an ideaology where the true innovators/leaders first ask permission from the masses.

    Ian Ford-Terry replies:

    Have you talked to Howard Bloom at all? His "Genius of the Beast: A Radical Revision of Capitalism" laid out some very similar concepts in 2009...

    Jensen Added Comment
    The supposed refutation of Friedman rests mainly on the idea of long-term versus short-term profitability. This refutation proceeds along the lines that short-term profit maximization may become self-defeating if constrains or destroys the long-term profitability. For example, a company that strips the tops off mountains in West Virginia to get at cheap coal (which is now technically feasible and a controversial proposal) might maximize short-term profits but destroy long-term profitability as such monumental degradation of the earth triggers massive lawsuits for the destruction of human health (e.g. leaching of heavy metals into water supplies), destruction of tourism, and the putting off of research for alternative energy alternatives.

    However, the long-term versus short-term "refutation" of Friedman is not legitimate since, in my viewpoint, Friedman was more interested in the long-term profitability and is falsely accused of being too short-term minded. I don't really think Milton Friedman would've advocated mountain top removal mining for the sake of short-term profits and then declaring bankruptcy before the environmental lawsuits commence.

    Mountain Top Removal Mining --- http://en.wikipedia.org/wiki/Mountaintop_removal_mining

    Critics contend that MTR is a destructive and unsustainable practice that benefits a small number of corporations at the expense of local communities and the environment. Though the main issue has been over the physical alteration of the landscape, opponents to the practice have also criticized MTR for the damage done to the environment by massive transport trucks, and the environmental damage done by the burning of coal for power. Blasting at MTR sites also expels dust and fly-rock into the air, which can disturb or settle onto private property nearby. This dust may contain sulfur compounds, which corrodes structures and is a health hazard.

    A January 2010 report in the journal Science reviews current peer-reviewed studies and water quality data and explores the consequences of mountaintop mining. It concludes that mountaintop mining has serious environmental impacts that mitigation practices cannot successfully address.[7] For example, the extensive tracts of deciduous forests destroyed by mountaintop mining support several endangered species and some of the highest biodiversity in North America. There is a particular problem with burial of headwater streams by valley fills which causes permanent loss of ecosystems that play critical roles in ecological processes. In addition, increases in metal ions, pH, electrical conductivity, total dissolved solids due to elevated concentrations of sulfate are closely linked to the extent of mining in West Virginia watersheds.[7] Declines in stream biodiversity have been linked to the level of mining disturbance in West Virginia watersheds.

    Published studies also show a high potential for human health impacts. These may result from contact with streams or exposure to airborne toxins and dust. Adult hospitalization for chronic pulmonary disorders and hypertension are elevated as a result of county-level coal production. Rates of mortality, lung cancer, as well as chronic heart, lung and kidney disease are also increased.[7] A 2011 study found that counties in and near mountaintop mining areas had higher rates of birth defects for five out of six types of birth defects, including circulatory/respiratory, musculoskeletal, central nervous system, gastrointestinal, and urogenital defects. These defect rates were more pronounced in the most recent period studied, suggesting the health effects of mountaintop mining-related air and water contamination may be cumulative.[37] Another 2011 study found "the odds for reporting cancer were twice as high in the mountaintop mining environment compared to the non mining environment in ways not explained by age, sex, smoking, occupational exposure, or family cancer history.”

    A United States Environmental Protection Agency (EPA) environmental impact statement finds that streams near some valley fills from mountaintop removal contain higher levels of minerals in the water and decreased aquatic biodiversity. The statement also estimates that 724 miles (1,165 km) of Appalachian streams were buried by valley fills between 1985 to 2001.[5] On September 28, 2010, the U.S. Environmental Protection Agency’s (EPA) independent Science Advisory Board (SAB) released their first draft review of EPA’s research into the water quality impacts of valley fills associated with mountaintop mining, agreeing with EPA’s conclusion that valley fills are associated with increased levels of conductivity threatening aquatic life in surface waters.

    Although U.S. mountaintop removal sites by law must be reclaimed after mining is complete, reclamation has traditionally focused on stabilizing rock formations and controlling for erosion, and not on the reforestation of the affected area. Fast-growing, non-native flora such as Lespedeza cuneata, planted to quickly provide vegetation on a site, compete with tree seedlings, and trees have difficulty establishing root systems in compacted backfill. Consequently, biodiversity suffers in a region of the United States with numerous endemic species.[41] In addition, reintroduced elk (Cervus canadensis) on mountaintop removal sites in Kentucky are eating tree seedlings.

    Advocates of MTR claim that once the areas are reclaimed as mandated by law, the area can provide flat land suitable for many uses in a region where flat land is at a premium. They also maintain that the new growth on reclaimed mountaintop mined areas is better suited to support populations of game animals.

    Continued in article

    Jim Martin's MAAW threads on social responsibility accounting ---
    http://maaw.info/SocialAccountingMain.htm

    Bob Jensen's threads Triple-Bottom (Social, Environmental, Human Resource) Reporting --- "
    http://faculty.trinity.edu/rjensen/Theory02.htm#TripleBottom

     


    Reconsidering California Transport Policies: Reducing Greenhouse Gas Emissions in an Uncertain Future --- 
    http://www.rand.org/pubs/rgs_dissertations/RGSD292.htm

    Jensen Comment
    An explosive externality (nonconvexity in mathematical economics) is centers on greenhouse gas emissions and the setting of laws and regulations on such emissions. If we get beyond the outlier sensationalism of the "emissions are destroying the planet" versus "humans need jobs" extremes, there is a laboratory of sorts to study the emissions problems in our troubled state of California that has some of the worst air pollution problems in the United States and some of the worst economic problems (job losses, traffic congestion, refinery shortages, budget deficits, high taxes, labor strife, etc.) in the United States.

    This is also one of the most troubling research problems in accountancy where the problems of measuring the costs of externalities are known but the research answers range from "we can't measure these costs" to "superficial research" recommendations that should be published as sick humor rather than academic research. Some of the less-than-stellar accounting research in this area, including my own not-so-great research publications, are cited at
    http://maaw.info/SocialAccountingMain.htm

    Accounting issues brought up in the above Rand Corporation study could be pursued to great depths by researchers who have both accounting and engineering backgrounds. Several examples are shown below:

    Page 14
    The second reason for the large discrepancy in estimated impact is an accounting problem. To the extent that liquid fuel providers are able to comply with the LCFS, they must do so by purchasing credits from non-liquid fuel providers (like utilities that provide electricity) and blending low carbon ethanol. Any electricity consumed for transportation in the CALD-GEM model is automatically credited to the fuels industry (and treated as a transfer between the purchasers of liquid motor fuels and electricity, bearing no net cost). So the only compliance strategy available within the model (and arguably, in reality as well), is to blend lower carbon ethanol. The accounting problem arises from the fact that the state’s GHG inventory and emissions targets are based on x combustion, rather than the life-cycle perspective used in the LCFS. Practically, this means that a substitute fuel must produce fewer greenhouse gas emissions during the combustion stage than the one it displaces in order to affect GHG reductions for the inventory targets. While the LCFS does indeed force fuel providers to blend lower carbon ethanol (either from Brazilian sugarcane or cellulosic ethanol made from one of many different feedstocks and conversion processes), this ethanol is chemically no different from the corn ethanol that is prominent now. Ethanol produces fewer greenhouse gas emissions through combustion than California’s blended gasoline, but the low-carbon intensity ethanol is no better than corn in this respect. Emissions reductions do occur over the life-cycle of the fuel, reducing the total GHG emissions for which California can be said to be responsible, but these “upstream” reductions accrue in other states — during the cultivation of ethanol feedstocks and across the transportation and distribution phases of the fuel, rather than during combustion. These emissions reductions do not contribute to the targets. Only by increasing the overall quantity of ethanol consumed — for example, by subsidizing the consumption of E85 — and displacing gasoline, can the LCFS affect reductions in GHG emissions. Unfortunately, the ARB’s estimated emissions savings from the program simply represents a 10% reduction in the CO2 emissions from the combustion of motor fuels based on the goal of the standards to reduce emissions by 10% (California Air Resources Board, 2009e). However, one cannot expect fuel providers to reduce the emissions from motor fuel combustion when the standard allows them to achieve credits by reducing the CO2 emissions in other stages of the fuels’ life-cycle, even though they occur beyond California’s boarders. The accounting discrepancy is not a large problem for electricity, which incurs most of its life-cycle carbon emissions when it is generated, but represents a considerable challenge for compliance strategies that rely heavily on ethanol blending.

    Page 15
    This is a shortcoming of California’s current strategy, and represents an important disconnect between the accounting methodology used to calculate the state’s Greenhouse Gas Inventory and the methodology used to estimate savings from the LCFS. Updating the LCFS standards for carbon intensity so that they are based on the baseline GHG emissions from combustion, rather than the full life-cycle, could induce the desired GHG savings from combustion, but would change the nature of the standards. Alternatively, since emissions reductions would occur in other states as a result ...

    Page 90
    The ARB estimates the carbon intensity of Midwestern corn ethanol to be 98gCO2/MJ, compared to the most current EPA estimate of 75gCO2/MJ. If the ARB revises its estimates downward, making conventional corn ethanol significantly less carbon intensive, the program costs associated with the LCFS could drop dramatically. However, the carbon intensity of Brazilian sugarcane is even more adversely impacted by the current land-use impact estimate than Midwestern corn ethanol and would benefit even more if the EPA’s carbon intensity values are used. If the carbon intensity estimates are revised for all fuels in the program (including California reformulated gasoline (E10), the baseline fuel on which the carbon intensity targets are based) based on EPA’s methodology, Brazilian sugarcane would be an even more attractive alternative to corn ethanol. However, such accounting changes will also, predictably, lead to lower consumption of lignocellulosic ethanol until it is fully cost-competitive with existing corn-based products. Program changes that make readily-available Brazilian ethanol more attractive could reduce program costs and provide reassurance to fuel providers worries about the rate of progress in the advanced ethanol market.

    Page 98
    One important distinction to note in a carbon specific policy, whether tax or permit based, is that carbon can be assessed either at the point where fuel is burned or through the entire life-cycle of the fuel. Using a life-cycle perspective requires additional accounting on the part of regulators, and increases the burden of monitoring transportation fuel providers to ensure that the fuels brought to market use approved pathways (for production, distribution, etc). These estimates of carbon intensity for fuel pathways are likely to be contentious, as providers petition for lower regulatory estimates of carbon intensity for their fuel products.

    Page 142
    The remaining facets of the policy are modeled faithfully. The LCFS regulations allow for some flexibility in credit accounting from one year to the next. In particular, fuel providers (industry, in this case) may carry credits over from one year to the next.

    Page 184
    Transportation fuels are likely to enter the state’s cap-and-trade program in some capacity by 2016, but the precise accounting methodology by which the passenger transportation sector complies with a carbon cap has yet to be defined. As a simplification, all of the potential VMT levers are modeled as fuel tax increases — above the current California fuel excise tax of $0.355/gallon and federal fuel excise tax of $0.184/gallon. These policies are implemented in 2016 and are fixed at the same level until the end of the simulation in 2020.

    Page 198
    The methodology used to estimate statewide carbon emissions is still evolving and being integrated into the regulatory definitions of the state’s cap-and-trade program, which will also be administered by the Air Resources Board. This creates ambiguity about the carbon accounting methodology for transportation fuels, which are scheduled to enter the cap-and-trade program in 2015.

    Page 216
    The second reason for the large discrepancy in estimated impact is an accounting problem. To the extent that liquid fuel providers are able to comply with the LCFS, they must do so by purchasing credits from non-liquid fuel providers (like utilities that provide electricity) and blending low carbon ethanol. Any electricity consumed for transportation in the CALD-GEM model is automatically credited to the fuels industry (and treated as a transfer between the purchasers of liquid motor fuels and electricity, bearing no net cost).

    Page 281
    Definitions and accounting practices are important considerations

     

     


    Human Resource Accounting for Financial Statements

    The value of human resource employees in a business is currently not booked and usually not even disclosed as an estimated amount in footnotes. In general a "value" is booked into the ledger only when cash or explicit contractual liabilities are transacted such as a bonus paid for a professional athlete or other employee. James Martin provides an excellent bibliography on the academic literature concerning human resource accounting ---
    http://maaw.info/HumanResourceAccMain.htm

    Bob Jensen's threads on human resource accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#TripleBottom

    What turned into a sick joke was the KPMG Twist applied to valuing the executives of Worldcom who later went to prison:

    KPMG’s “Unusual Twist”
    While KPMG's strategy isn't uncommon among corporations with lots of units in different states, the accounting firm offered an unusual twist: Under KPMG's direction, WorldCom treated "foresight of top management" as an intangible asset akin to patents or trademarks.
     
    See  http://faculty.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

    Punch Line
    This "foresight of top management" led to a 25-year prison sentence for Worldcom's CEO, five years for the CFO (which in his case was much to lenient) and one year plus a day for the controller (who ended up having to be in prison for only ten months.) Yes all that reported goodwill in the balance sheet of Worldcom was an unusual twist.

     

    Early experiments to book human resource values into the ledger usually were abandoned after a brief experiment. Investors and analysts placed little, if any faith, in human resource value estimates such as the R.G. Barry experiments years ago.

    There are many problems with assigning an estimated value to human resources. Aside from being able to unattribute future cash flow streams to particular employees, there's the enormous problem that employees are no longer slaves that can be bought, sold, and traded without their permission. And employees may simply resign at will outside the control of their employers, although in some cases they do so by paying contractual penalties that they agreed to when signing employment contracts.

    Another problem is bifurcation of the value of a valuable employee from the subset of other employees and circumstances such as group esprit de corps ---
    http://en.wikipedia.org/wiki/Esprit_de_corps_%28disambiguation%29
    A great pitcher needs a great catcher and seven other players on the field that can make great defensive plays. The President of the United States may be less important than the staff surrounding that President. A bad staff can do a lot to bring down a President. This had a lot to do with the downfall of President Carter.

    Another problems is that greatness of an employee may vary dramatically with circumstances. Winston Churchill was a great leader and inspiration in the darkest days of World War II. But his value should've been subject to very rapid accelerated depreciation. He was a lousy leader after the end of the war, including making some awful choices such as chemical weapons use on some tribes in Iraq.

    "Power From the People:  Can human Capital Financial Statements Allow Companies to Measure the Value of Their Employees?," by David McCann, CFO Magazine, November 2011, pp. 52-59 ---
    http://www.cfo.com/article.cfm/14604427?f=search

    If a company's most important assets are indeed its people, as corporate executives parrot endlessly, that's news to investors, analysts, and even, as it turns out, many companies.

    It is hardly a secret that the industrial economy that prevailed for two centuries has evolved into a talent-driven, knowledge-based economy. Still, extant accounting standards define "assets" mostly in terms of cash, receivables, and hard goods like property, equipment, and inventory, even though the value of many companies lies chiefly in the experience and efforts of their employees.

    Public companies are required to disclose virtually nothing about their human capital other than the compensation packages of top executives, and most are happy to report only that. The furthest most companies will go in reporting on human capital within their public filings is to mention "key-man" risks and executive succession plans.

    More than two decades ago, Jac Fitz-enz and Wayne Cascio separately pioneered the idea that metrics could shine a light on human-capital value. From their work grew the notion that formal reporting of such metrics could add value to financial statements. That discussion simmered quietly for many years, but recently it has grown more bubbly, as some of the best minds in human-capital management and workforce analytics work hard to influence the acceptance of such reporting.

    Some are crafting detailed structures for what they generally refer to as human-capital financial statements or reports, which would complement (but not replace) traditional financial reporting. Their goal is to quantify a company's financial results as a return on people-related expenditures, and express a company's value as a measure of employee productivity.

    To be sure, finance and human-resources executives alike have long considered many important aspects of human-capital value to be unquantifiable. That's why an effort by the Society for Human Resource Management, less-granular than some similar efforts but very well organized, shows promise to have a sizable impact. SHRM's Investor Metrics Workgroup, in conjunction with American National Standards Institute (ANSI), is developing recommendations for broad standards on human-capital reporting. The group plans to release its recommendations for public comment early in 2012. Should ANSI certify the standards, the next phase would be a marketing campaign aimed at investor groups and analysts, encouraging them to demand that companies provide the information.

    If demand for that data were to reach a critical mass, then presumably accounting-standards setters would eventually look at adopting some type of human-capital reporting, and the Securities and Exchange Commission and other regulators would subsequently get involved. Of course, that's a grand vision, and even its most optimistic proponents admit that it will take at least a decade, and probably twice that long, to fully materialize.

    But the SHRM group's chair, Laurie Bassi, is confident that the effort will succeed, however long it may take. "It's going to serve as a catalyst for change," says Bassi, a labor economist and human-capital-management consultant. "When investors start to demand this information, it's going to be a wake-up call for many, many companies. For some well-managed, well-run firms it won't be a stretch, but others will be hard-pressed to produce the information in a meaningful way."

    Bassi says that the driving forces behind the effort boil down to two things: "supply and demand, or, you might say, opportunity and necessity."

    On the supply/opportunity side, advancing technology and lower computing costs have greatly eased the collection and crunching of people-related data, enabling companies to get their arms around what's going on with their human capital in a much more analytic, metrics-driven way than was possible a few years ago. The demand/necessity side is that, driven by macroeconomic forces, human-capital management is emerging as a core competency for employers, particularly those in high-wage, developed nations.

    Something for (Almost) Everyone Investors and analysts aren't demanding human-capital reporting yet, but they might not need much prodding. Upon hearing for the first time about SHRM's project, Matt Orsagh, director of capital-markets policy for the CFA Institute, says that "it sounds fabulous. I want all the transparency and inputs I can have. Quantifying the worth of human capital would be fantastic, because right now you have to take it on faith, and I don't know if I can trust it."

    Predictably, some CFOs are less enthusiastic. "It's a fair point that the balance sheet doesn't recognize the value of human capital, and certainly not the full value of your intellectual property," says John Leahy, finance chief at iRobot, a publicly traded, $400 million firm. "For a high-growth technology company like ours, there is significant intrinsic value in the know-how and innovation of our people, which is why we've traded over the last couple of years at a fairly attractive multiple.

    Continued in article

     "The 50 Most Influential Management Gurus," by Clayton Christensen, Harvard Business Review Blog, November 2011 ---
    http://hbr.org/web/slideshows/the-50-most-influential-management-gurus/1-christensen
    Of course there's no Harvard bias whispering into this selection --- no it's shouting!
    Watch the video --- http://www.thinkers50.com/

     


    "The Berkshire Hathaway Corporate Governance Performance," by Francine McKenna, re:TheAuditors, September 2, 2011 ---
    http://retheauditors.com/2011/09/02/the-berkshire-hathaway-corporate-governance-performance/

    . . .

    Buffett’s reluctance to sell loser portfolio operating companies or fire under performing managers means he has to make repetitive $5 billion Bank of America and Goldman Sachs preferred stock plays to compensate for tragic flaws like misplaced loyalty and day-to-day conflict avoidance.

    And then there’s the numbers.

    Berkshire Hathaway is a publicly traded company, listed on the New York Stock Exchange and regulated by the Securities and Exchange Commission. The integrity of Berkshire Hathaway’s external financial reporting should be ensured by the strictures of the Sarbanes-Oxley Act of 2002. Berkshire Hathaway and Warren Buffett, however, pay no more than lip service to the requirements and reject many other recommended corporate governance practices.

    What’s left – of the financial reporting process, the internal audit organization, and the external audit relationship – is not enough, in my opinion, to prevent someone from spinning straw into gold.

    Questionable corporate political campaign finance practices and foreign corrupt practices in the mid -1970s prompted the U.S. Securities and Exchange Commission and the U.S. Congress to enact campaign finance law reforms and the 1977 Foreign Corrupt Practices Act (FCPA) which criminalized transnational bribery and required companies to implement internal control programs. The Treadway Commission, a private-sector initiative, was formed in 1985 to inspect, analyze, and make recommendations on fraudulent corporate financial reporting. The original chairman of the Treadway Commission was James C. Treadway, Jr., Executive Vice President and General Counsel, Paine Webber and a former Commissioner of the U.S. Securities and Exchange Commission.

    The accounting industry regulator, the PCAOB, tells us that existing auditing standards are neutral regarding the internal control framework that auditors use for obtaining an understanding of internal controls over financial reporting (ICFR), testing and evaluating controls, and, in integrated audits, reporting on ICFR. For integrated audits, PCAOB standards state that auditors should use the same internal control framework that management uses.

    Since the Committee Of Sponsoring Organizations of the Treadway Commission’s (COSO) Internal Control-Integrated Framework (IC-IF) was published in 1992, many companies and auditors have used IC-IF as their framework in considering internal control over financial reporting. Also, since companies and auditors began reporting on the effectiveness of ICFR pursuant to §404 of Sarbanes-Oxley Act of 2002, many of those companies and auditors have used IC-IF as the framework for evaluating and reporting on ICFR.

    Before leading the Treadway Commission, before the savings and loan scandals of the 1980’s, before Enron and the rest of the scandals of the 90’s such as WorldCom, Tyco, Adelphia, HealthSouth, and many others, James Treadway, SEC Commissioner, made a speech about financial fraud.  His remarks specifically mentioned corporate structure, in particular a decentralized organizational structure, as a common characteristic of companies involved in financial fraud.

    An excerpt of remarks by James Treadway to the Third Annual Southern Securities Institute, Miami Beach, Florida, April 8,1983

    I refer to a decentralized corporate structure, with autonomous divisional management. Such a structure is intended to encourage responsibility, productivity, and therefore profits—all entirely laudable objectives. But the unfortunate corollary has been a lack of accountability.

    The situation has been exacerbated when central headquarters has unilaterally set profit goals for a division or, without expressly stating goals, applied steady pressure for increased profits. Either way, the pressure has created an atmosphere in which falsification of books and records at middle and lower levels became possible, even predictable. This atmosphere has caused middle and lower level management and entire divisions to adopt the attitude that the outright falsification of book and records on a regular, on going, pervasive basis is an entirely appropriate way to achieve unrealistic profit objectives, as long as the falsifications get by the independent auditors, who are viewed as fair game to be deceived.

    Treadway goes on to describe a company that’s almost an exact replica of Berkshire Hathaway.  What’s most troubling is that nearly thirty years later there’s no excuse – lack of technology, real time communications, or specific regulatory requirements -  for these conditions to still exist in a company of the size and systemic importance of Berkshire Hathaway. The weaknesses remain by design, not by default, which begs the question of whether they could serve an illegal or unethical purpose at any time.

    Continued in article

    "Bringing banks to book Financial institutions are not going to voluntarily embrace honesty and social responsibility - there is little evidence they do so now," by Prem Sikka, The Guardian, February 27, 2008 --- http://commentisfree.guardian.co.uk/prem_sikka_/2008/02/bringing_banks_to_book.html

    Bob Jensen's threads on corporate social responsibility accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#TripleBottom

    Bob Jensen's threads on corporate governance ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm#Governance

     


    Sustainability Accounting --- Click Here


    Triple Bottom Reporting

    "PwC & Puma produce first global environmental P&L account,"  by Rachael Singh, Accountancy Age, May 27, 2011 --- Click Here
    http://www.accountancyage.com/aa/news/2074230/pwc-puma-produce-global-environmental-account?WT.rss_f=&WT.rss_a=PwC+%26+Puma+produce+first+global+environmental+P%26L+account.

    PUMA HAS UNVEILED the first global environmental profit and loss account, with the help of PwC and analysts Trucost. It is the first time water usage and carbon emissions have been monetised.
    The sportswear retailer values both commodities for 2010 to be in the region of €94.4m (£81.9m).

    Trucost worked on collating the data with PwC organising and reporting the findings as well as valuing the commodities. The Puma board was hoping to complete the environmental P&L alongside its annual report however, it missed the deadline and has released the information as a standalone statement. In future the annual report will contain the environmental information as part of its financial statements.

     

    Continued in article

     


    "Sustainability reporting: Seven questions CEOs and boards should ask," Ernst & Young, May 2011 --- Click Here
    http://www.ey.com/Publication/vwLUAssets/Seven_things_CEOs_boards_should_ask_about_climate_reporting/$FILE/Seven_things_CEOs_boards_should_ask_about_climate_reporting.pdf

    1. Who issues sustainability reports?

    More than 3,000 companies worldwide, including more than two-thirds of the Fortune Global 500.

    2. Why report on sustainability if you don't have to?

    Increasingly, external stakeholders such as institutional investors expect it. Reporting can also bring operational improvements, strengthen compliance, and enhance your corporate reputation.

    3. What information should a sustainability report contain?

    Reports should contain key performance indicators relevant to the reporter’s industry. Four principles for deciding what to include are materiality, stakeholder inclusiveness, sustainability context, and completeness.

    4. What governance, systems and processes are needed to report on sustainability?

    Governance requires a high-level mandate and clear reporting lines. Also needed: robust systems and processes that help companies collect, store and analyze sustainability information.

     5. Do sustainability reports have to be audited?

    Not yet. But they are being more closely monitored than ever before. As this trend continues, users of sustainability information will come to expect that the information has been validated by a reliable third party.

    6. What are the challenges and risks of reporting?

    Sustainability reporting presents many challenges, including data consistency, striking a balance between positive and negative information, continually improving performance and keeping reports readable and concise.

    7. How can companies get the most value out of sustainability reporting?

    Sustainability reports should be mandatory reading for all employees, and can be a valuable tool for communicating with external audiences as well. Setting targets in the form of KPIs also forces the organization to meet publicly stated goals, which makes reporting an accountability tool.

    Download the full report: Seven questions CEOs and boards should ask about triple bottom line reporting

    Continued in article

    Bob Jensen's threads on triple bottom reporting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#TripleBottom


    Banks Illustrate the Hypocrisy of Social Responsibility Accounting

    We hang the petty thieves and appoint the great ones to public office.
    Aesop

    That some bankers have ended up in prison is not a matter of scandal, but what is outrageous is the fact that all the others are free.
    Honoré de Balzac

    "Holding back the banks:  Predatory banking practices are likely to continue while political parties are too close to corporations and regulators lack teeth," by Prem Sikka, The Guardian (in the U.K.), February 15, 2008 ---
    http://commentisfree.guardian.co.uk/prem_sikka_/2008/02/holding_back_the_banks.html

    Politicians and regulators have been slow to wake up to the destructive impact of banks on the rest of society. Their lust for profits and financial engineering has brought us the sub-prime crisis and possibly a recession. Billions of pounds have been wiped off the value of people's savings, pensions and investments.

    Despite this, banks are set to make record profits (in the U.K.) and their executives will be collecting bumper salaries and bonuses. These profits are boosted by preying on customers in debt, making exorbitant charges and failing to pass on the benefit of cuts in interest rates. Banks indulge in insider trading, exploit charity laws and have sold suspect payment protection insurance policies. As usual, the annual financial reports published by banks will be opaque and will provide no clues to their antisocial practices.

    Some governments are now also waking up to the involvement of banks in organised tax avoidance and evasion. Banks have long been at the heart of the tax avoidance industry. In 2003, the US Senate Permanent Subcommittee on Investigations concluded (pdf) that the development and sale of potentially abusive and illegal tax shelters have become a lucrative business for accounting firms, banks, investment advisory firms and law firms. Banks use clever avoidance schemes, transfer pricing schemes and offshore (pdf) entities, not only to avoid their own taxes but also to help their rich clients do the same.

    The role of banks in enabling Enron, the disgraced US energy giant, to avoid taxes worldwide, is well documented (pdf) by the US Senate joint committee on taxation. Enron used complex corporate structures and transactions to avoid taxes in the US and many other countries. The Senate Committee noted (see pages 10 and 107) that some of the complex schemes were devised by Bankers Trust, Chase Manhattan and Deutsche Bank, among others. Another Senate report (pdf) found that resources were also provided by the Salomon Smith Barney unit of Citigroup and JP Morgan Chase & Co.

    The involvement of banks is essential as they can front corporate structures and have the resources - actually our savings and pension contributions - to provide finance for the complex layering of transactions. After examining the scale of tax evasion schemes by KPMG, the US Senate committee concluded (pdf) that complex tax avoidance schemes could not have been executed without the active and willing participation of banks. It noted (page 9) that "major banks, such as Deutsche Bank, HVB, UBS, and NatWest, provided purported loans for tens of millions of dollars essential to the orchestrated transactions," and a subsequent report (pdf) (page111) added "which the banks knew were tax motivated, involved little or no credit risk, and facilitated potentially abusive or illegal tax shelters".

    The Senate report (pdf) noted (page 112) that Deutsche Bank provided some $10.8bn of credit lines, HVB Bank $2.5bn and UBS provided several billion Swiss francs, to operationalise complex avoidance schemes. NatWest was also a key player and provided about $1bn (see page 72 [pdf]) of credit lines.

    Deutsche Bank has been the subject of a US criminal investigation and in 2007 it reached an out-of-court settlement with several wealthy investors, who had been sold aggressive US tax shelters.

    Some predatory practices have also been identified in other countries. In 2004, after a six-year investigation, the National Irish Bank was fined £42m for tax evasion. The bank's personnel promoted offshore investment policies as a secure destination for funds that had not been declared to the revenue commissioners. A government report found that almost the entire former senior management at the bank played some role in tax evasion scams. The external auditors, KPMG, and the bank's own audit committee were also found to have played a role in allowing tax evasion.

    In the UK, successive governments have shown little interest in mounting an investigation into the role of banks in tax avoidance though some banks have been persuaded to inform authorities of the offshore accounts held by private individuals. No questions have been asked about how banks avoid their taxes and how they lubricate the giant and destructive tax avoidance industry. When asked "if he will commission research on the levels of use of offshore tax havens by UK banks and the economic effects of that use," the chancellor of the exchequer replied: "There are no plans to commission research on the levels of use of offshore tax havens by UK banks and the economic effects of that use."

    Continued in article

    "Bringing banks to book Financial institutions are not going to voluntarily embrace honesty and social responsibility - there is little evidence they do so now," by Prem Sikka, The Guardian, February 27, 2008 --- http://commentisfree.guardian.co.uk/prem_sikka_/2008/02/bringing_banks_to_book.html

    Anyone visiting the websites of banks or browsing through their annual reports will find no shortage of claims of "corporate social responsibility". Yet their practices rarely come anywhere near their claims.

    In pursuit of higher profits and bumper executive rewards, banks have inflicted both the credit crunch and sub-prime crisis on us. Their sub-prime activities may also be steeped in fraud and mis-selling of mortgage securities. They have developed onshore and offshore structures and practices to engage in insider trading, corruption, sham tax-avoidance transactions and tax evasion. Money laundering is another money-spinner.

    Worldwide over $2tn are estimated to be laundered each year. The laundered amounts fund private armies, terrorism, narcotics, smuggling, corruption, tax evasion and criminal activity and generally threaten quality of life. Large amounts of money cannot be laundered without the involvement of accountants, lawyers, financial advisers and banks.

    The US is the world's biggest laundry and European countries are not far behind. Banks are required to have internal controls and systems to monitor suspicious transactions and report them to regulators. As with any form of regulation, corporations enjoy considerable discretion about what they record and report. Profits come above everything else.

    A US government report (see page 31) noted that "the New York branch of ABN AMRO, a banking institution, did not have anti-money laundering program and had failed to monitor approximately $3.2 billion - involving accounts of US shell companies and institutions in Russian and other former republics of the Soviet Union".

    A US Senate report on the Riggs Bank noted that it had developed novel strategies for concealing its trade with General Augusto Pinochet, former Chilean dictator. It noted (page 2) that the bank "disregarded its anti-money laundering (AML) obligations ... despite frequent warnings from ... regulators, and allowed or, at times, actively facilitated suspicious financial activity". The committee chairman Senator Carl Levin stated that "the 'Don't ask, Don't tell policy' at Riggs allowed the bank to pursue profits at the expense of proper controls ... Million-dollar cash deposits, offshore shell corporations, suspicious wire transfers, alteration of account names - all the classic signs of money laundering and foreign corruption made their appearance at Riggs Bank".

    The Senate committee report (see page 7) stated that:

    "Over the past 25 years, multiple financial institutions operating in the United States, including Riggs Bank, Citigroup, Banco de Chile-United States, Espirito Santo Bank in Miami, and others, enabled [former Chilean dictator] Augusto Pinochet to construct a web of at least 125 US bank and securities accounts, involving millions of dollars, which he used to move funds and transact business. In many cases, these accounts were disguised by using a variant of the Pinochet name, an alias, the name of an offshore entity, or the name of a third party willing to serve as a conduit for Pinochet funds."

    The Senate report stated (page 28) that "In addition to opening multiple accounts for Mr Pinochet in the United States and London, Riggs took several actions consistent with helping Mr Pinochet evade a court order attempting to freeze his bank accounts and escape notice by law enforcement". Riggs bank's files and papers (see page 27) contained "no reference to or acknowledgment of the ongoing controversies and litigation associating Mr Pinochet with human rights abuses, corruption, arms sales, and drug trafficking. It makes no reference to attachment proceedings that took place the prior year, in which the Bermuda government froze certain assets belonging to Mr Pinochet pursuant to a Spanish court order - even though ... senior Riggs officials obtained a memorandum summarizing those proceedings from outside legal Counsel."

    The bank's profile did not identify Pinochet by name and at times he is referred to (see page 25) as "a retired professional, who achieved much success in his career and accumulated wealth during his lifetime for retirement in an orderly way" (p 25) ... with a "High paying position in Public Sector for many years" (p 25) ... whose source of his initial wealth was "profits & dividends from several business[es] family owned" (p 27) ... the source of his current income is "investment income, rental income, and pension fund payments from previous posts " (p 27).

    Finger is also pointed at other banks. Barclays France, Société Marseillaise de Credit, owned by HSBC, and the National Bank of Pakistan are facing allegations of money laundering. In 2002, HSBC was facing a fine by the Spanish authorities for operating a series of opaque bank accounts for wealthy businessmen and professional football players. Regulators in India are investigating an alleged $8bn (£4bn) money laundering operation involving UBS.

    Nigeria's corrupt rulers are estimated to have stolen around £220bn over four decades and channelled them through banks in London, New York, Jersey, Switzerland, Austria, Liechtenstein, Luxembourg and Germany. The Swiss authorities repatriated some of the monies stolen by former dictator General Sani Abacha. A report by the Swiss federal banking commission noted (page 7) that there were instances of serious individual failure or misconduct at some banks. The banks were named as "three banks in the Credit Suisse Group (Credit Suisse, Bank Hofmann AG and Bank Leu AG), Crédit Agricole Indosuez (Suisse) SA, UBP Union Bancaire Privée and MM Warburg Bank (Schweiz) AG".

    Continued in article

    Jensen Comment
    Prem Sikka has written a rather brief but comprehensive summary of many of the bad things banks have been caught doing and in many cases still getting away with. Accounting standards have be complicit in many of these frauds, especially FAS 140 (R) which allowed banks to sell bundles of "securitized" mortgage notes from SPE's (now called VIEs) using borrowed funds that are kept off balance sheet in these entities called SPEs/VIEs. The FASB had in mind that responsible companies (read that banks) would not issue debt in excess of the value of the collateral (e.g., mortgage properties). But FAS 140 (R) fails to allow for the fact that collateral values such as real estate values may be expanding in a huge bubble about to burst and leave the bank customers and possibly the banks themselves owing more than the values of the securities bundles of notes. Add to this the frauds that typically take place in valuing collateral in the first place, and you have FAS 140 (R) allowing companies, notably banks, incurring huge losses on debt that was never booked due to FAS 140 (R).

    FAS 140 (R) needs to be rewritten --- http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
    However, the banks now control their regulators! We're not about to see the SEC, FED, and other regulators allow FAS 140 (R) to be drastically revised.

    Also banks are complicit in the "dirty secrets" of credit cards and credit reporting --- http://faculty.trinity.edu/rjensen/FraudReporting.htm#FICO

    Then there are the many illegal temptations which lure in banks such as profitable money laundering and the various departures from ethics discussed above by Prem Sikka.

    Bob Jensen's "Rotten to the Core" threads are at http://faculty.trinity.edu/rjensen/FraudRotten.htm

     

    Lessons Not Learned from Enron
    Bad SPE Accounting Rules are Still Dogging Us

    From The Wall Street Journal Accounting Weekly Review on October 19, 2007

    Call to Brave for $100 Billion Rescue
    by David Reilly
    The Wall Street Journal

    Oct 16, 2007
    Page: C1
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Securitization

    SUMMARY: This article addresses a proposed bailout plan for $100 billion of commercial paper to maintain liquidity in credit markets that have faced turmoil since July 2007, and the fact that this bailout "...raises two crucial questions: Why didn't investors see the problems coming? And how could they have happened in the first place?" The author emphasizes that post-Enron accounting rules "...were supposed to prevent companies from burying risks in off-balance sheet vehicles." He argues that the new rules still allow for some off-balance sheet entities and that "...the new rules in some ways made it even harder for investors to figure out what was going on."

    CLASSROOM APPLICATION: The bailout plan is a response to risks and losses associated with special purpose entities (SPEs) that qualified for non-consolidation under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing of financial Assets and Extinguishments of Liabilities, and Financial Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities.

    QUESTIONS: 
    1.) Summarize the plan to guarantee liquidity in commercial paper markets as described in the related article. In your answer, define the term structured investment vehicles (SIVs).

    2.) The author writes that SIVs "...don't get recorded on banks books...." What does this mean? Present your answer in terms of treatment of qualifying special purpose entities (SPEs) under Statement of Financial Accounting Standards 140, Accounting for Transfers and Servicing Financial Assets and Extinguishments of Liabilities.

    3.) The author argues that current accounting standards make it difficult for investors to figure out what was going on in markets that now need bailing out. Explain this argument. In your answer, comment on the quotations from Citigroup's financial statements as provided in the article.

    4.) How might reliance on "principles-based" versus "rules-based" accounting standards contribute to solving the reporting dilemmas described in this article?

    5.) How might the use of more "principles-based standards" potentially add more "fuel to the fire" of problems associated with these special purpose entities?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Call to Brave to $100 Billion Rescue: Banks Seek Investors for Fund to Shore Up Commercial Paper
    by Carrick Mollenkamp, Deborah Solomon and Craig Karmin
    The Wall Street Journal
    Oct 16, 2007
    Page: C1

    Plan to Save Banks Depends on Cooperation of Investors
    by David Reilly
    The Wall Street Journal
    Oct 15, 2007
    Page: C1
     

     

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory01.htm


    Low chances of preventing another global banking crisis

    I have an article today on The Guardian website with the title "After Northern Rock". The lead line reads "The government's proposals for preventing another banking crisis are inadequate and will not work without major surgery". It is available at http://commentisfree.guardian.co.uk/prem_sikka_/2008/02/after_northern_rock.html 

    As many of you will know Northern Rock, a UK bank, is a casualty of the subprime crisis and has been bailed out by the UK government, which could possibly cost the UK taxpayer £100 billion. My article looks at the reform proposals floated by the government to prevent a repetition. These have been formulated without any investigation of the problems. Within the space permitted, the article refers to a number of major flaws, including regulatory, auditing and governance failures, as well offshore, remuneration and moral hazard issues.

    The above may interest you and you may wish to contribute to the debate by adding comments.

    As always there is more on the AABA website ( http://www.aabaglobal.org  <http://www.aabaglobal.org/>  ).

    Regards

    Prem Sikka
    Professor of Accounting
    University of Essex
    Colchester, Essex CO4 3SQ UK


    Accounting for Carbon Trading

    Teaching Case from The Wall Street Journal Accounting Weekly Review on September 20, 2012

    Carbon Trading Heating Up
    by: Katy Burne and Cassandra Sweet
    Sep 15, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Derivatives, emissions trading schemes, Intangible Assets

    SUMMARY: Carbon-emission credit markets in California are becoming active after failure of a lawsuit and a referendum vote designed to block the cap-and-trade system that is becoming effective on January 1, 2013. Energy companies operating in California such as Constellation, a unit of Exelon, and NRG Energy, Inc., are trading in the market.

    CLASSROOM APPLICATION: The article may be used in any financial or managerial accounting class to introduce the topic of carbon credits and their trading. Question 4 asks students to consider accounting practices; they might conclude that the expenditure for an emission allowances purchases an asset that is either an intangible or a derivative. There are no financial reporting standards on this topic in U.S. GAAP and the FASB has idled a project it once began on the subject. Issues faced in Europe on this subject are well summarized in the following article Jan Bebbington & Carlos Larrinaga-González (2008): Carbon Trading: Accounting and Reporting Issues, European Accounting Review, 17:4, 697-717 (available online at http://dx.doi.org/10.1080/09638180802489162)

    QUESTIONS: 
    1. (Advanced) How do carbon emissions allowances work? In your answer, explain the statement in the article that "California's cap on statewide emissions drops every year, likely raising demand for allowances."

    2. (Advanced) What is a carbon emissions allowances trading market?

    3. (Introductory) Why have carbon markets in California seen renewed interest in 2012?

    4. (Advanced) Suppose you are an accountant for a California based power plant, which has recently purchased carbon credits to meet its required limit on total carbon emissions. How would you account for the purchase of these credits? When would the benefit of these allowances be used up?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Carbon Trading Heating Up," by Katy Burne and Cassandra Sweet, The Wall Street Journal, September 15, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443779404577643592149738280.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    After a series of false starts, the market for trading carbon-emission credits is showing new signs of life in California.

    Trading volumes for these carbon credits—which allow holders to emit as many greenhouse-gas emissions as they want, provided they acquire enough of them—are at a nine-month high. Prices are up 1% since the start of this year, even as prices on carbon allowances elsewhere in the world are plumbing lows.

    While federal efforts to regulate carbon-dioxide pollution collapsed in 2010—and other carbon markets have run into trouble—California is now on track to implement its own laws capping heat-trapping gases that scientists believe contribute to climate change. As the Jan. 1, 2013, start date for the new rules approaches and as opponents of the rules run out of time to mount new legal challenges, operators of power plants, oil refineries and other facilities are wading in to purchase credits.

    The spurt of activity has been a score for a small group of traders and other investors who had wagered that California officials would prevail in a lawsuit and a referendum that sought to block the cap on carbon-dioxide emissions. They say they see more opportunity to stock up on credits, ahead of an expected spike in demand next year.

    Enlarge Image image image

    "What's changed is we are really at a phase now where [California is] in implementation mode," said Greg Arnold, president at CE2 Carbon Capital, a fund backed by private-equity firm Energy Capital Partners that owns carbon contracts, expecting prices to rise.

    California's cap on statewide emissions drops every year, likely raising demand for allowances.

    It is mostly power producers and other companies that will need credits in the market today. But that could change as volume picks up, traders say, as investors come in to speculate on the direction of prices.

    "Once we get going, the hedge funds will be there," said Randall Lack, founder of Element Markets in Houston, an asset manager that helps clients hedge in carbon markets.

    A state appeals court in June upheld California's cap-and-trade program and dismissed a lawsuit filed by some community groups that had argued the program wouldn't reduce emissions.

    Trading picked up in carbon credits, or allowances, soon after. More than 1,000 contracts traded on the IntercontinentalExchange in August, up from 246 in May, the month before the lawsuit was dismissed. Prices for contracts promising the delivery of 1,000 California carbon allowances in December 2013 hit an 11-month high of $20.10 a metric ton on July 24 on the ICE.

    But the market turned again in August, after regulators said they would reconsider the way they plan to enforce a ban on shuffling out-of-state energy purchases to claim an emissions reduction. Any changes made to the rules might affect the number of credits California power producers need to buy. Credits settled at $15.65 a ton on Friday.

    Some still think the carbon market is too risky. "We are supposed to be getting off the starting blocks soon, but California has made it clear if there are any issues, possible further delays are not off the table," said Francisco Padua, manager of environmental commodities at brokerage firm Amerex Brokers LLC.

    The cap-and-trade program is proceeding on schedule and there are no proposed rule changes pending, said Air Resources Board spokesman Dave Clegern.

    Continued in article

    Accounting for Carbon Credits, by Rob Derivaux and Dave Nichols, AAA Commons, May 2, 2009 ---
    http://commons.aaahq.org/posts/78699eceed?commentId=18146#18146

    The thesis concerns the search for a converged International Financial Reporting Standard (IFRS) and U. S. GAAP standard to account for carbon credit trading schemes. Many nations, including those in the European Union, have adopted carbon credit trading schemes in order to reduce carbon emissions. Carbon emissions trading schemes present many accounting challenges, including the exact nature of the credits and how to measure the obligation to which credits will be applied. However, there is not a standard to address these accounting issues. The short-lived former standard was withdrawn because of extensive shortcomings. Currently, participating companies use a variety of approaches to account for carbon credits, and this creates comparability issues in the financial statements. A survey was conducted of graduate accounting students and accounting professionals to solicit input on the possible ways to account for carbon credits. The survey contained a scenario of a company’s carbon activity for the year. Five distinct approaches were gathered from the surveys and were scrutinized using existing accounting standards and frameworks promulgated by IFRS and US GAAP. The conclusion was reached that carbon credits granted by the government are not actually a government grant; they should be netted out by an allowance for granted credits. It was also concluded that a liability should be measured as the estimated excess of carbon emissions over held credits both at interim and year-end reporting dates. It was also concluded that the research was limited by the lack of a converged IFRS/US GAAP framework, the small size of the survey, and the lack of development of carbon credit trading schemes to date.

    Bob Jensen's accounting theory tutorials are at the following two sites:
    Part 1 --- http://faculty.trinity.edu/rjensen/Theory01.htm
    Part 2 --- http://faculty.trinity.edu/rjensen/Theory02.htm

     


    The Sad State of Government Accounting and Accountability

    Government Accountability Office (GAO) Podcast [iTunes] http://www.gao.gov/podcast/watchdog.xml

    Yellow Book of Generally Accepted Government Auditing Standards (GAGAS) ---
    https://en.wikipedia.org/wiki/Government_Auditing_Standards

    Financial Data for Each of the 50 States in the USA ---
    http://www.statedatalab.org/

    Video: Fora.Tv on Institutional Corruption & The Economy Of Influence ---
    http://www.simoleonsense.com/video-foratv-on-institutional-corruption-the-economy-of-influence/


    Pension Spiking --- https://en.wikipedia.org/wiki/Pension_spiking

    An August 17 California appeals court ruling rejected a public employee union's claim that its members had a right to "pension spiking," which the court described as "various stratagems and ploys to inflate their income and retirement benefits." Public employees often will pad their final salary total with vacation leave, bonuses and "special pay" categories to inflate the pension benefits they receive for the rest of their lives.
    https://reason.com/archives/2016/09/02/is-ruling-too-late-to-fix-californias-pe
    But it's probably too late to do much good.

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    From the CFO Journal's Morning Ledger on August 5, 2015

    New rule to lift veil on tax breaks
    http://www.wsj.com/articles/new-rule-to-lift-veil-on-tax-breaks-1438725046?mod=djemCFO_h
    The Governmental Accounting Standards Board will require government officials to show the value of property, sales and income taxes that have been waived under agreements with companies or other taxpayers. It kicks in next year. Cities and states have plied companies with tax breaks for decades hoping to attract jobs and commerce.


    EY:  FASB finishes deliberations on not-for-profit proposal --- Click Here
    http://www.ey.com/Publication/vwLUAssetsAL/TothePoint_BB2862_NotforProfit_16October2014/$FILE/TothePoint_BB2862_NotforProfit_16October2014.pdf

    EY:  GASB overhauls government retiree health care rules

    What you need to know

    • The GASB issued final guidance that will change how state and local g overnment s calculate and report the costs and obligations associated with defined benefit other postemployment benefit (OPEB) plans .

    • Government employers that do not prefund OPEB obligations will have to record a gross OPEB liability , while those that fund their OPEB plans through a trust that meets the specified criteria will have to record a net OPEB liability in their accrual - basis financial statements based on the plan fiduciary net position rather than plan funding.

    • The new standard will make a government’s obligations more transparent, and m any governments will likely report a much larger OPEB liability than they do today.

    • The guidance is effective for fiscal years beginning after 15 June 201 7 , and early application is encouraged.


    From the CPA Newsletter on September 22, 2014

    Framework for public sector accounting approved ---
    http://r.smartbrief.com/resp/gdtyBYbWhBCJshzyCidKtxCicNezAJ?format=standard
    The International Public Sector Accounting Standards Board has approved its general framework for standard-setting and guidance. The Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities will be issued by the end of October. Accounting Today (9/19)


    FASB
    "Not-for-profit financial reporting headed for a change," by Larry Smith and Ken Euwema, Journal of Accountancy, July 1, 2015 ---
    http://www.journalofaccountancy.com/issues/2015/jul/not-for-profit-financial-reporting.html

    As a part of the response to the call for increased transparency and accountability among not-for-profit entities (NFPs), FASB has taken on a project to improve the existing NFP financial reporting model. The goal is to improve the usefulness of NFP financial statements by providing better information about an NFP's liquidity, financial performance, and cash flows to the primary users of financial statements, governing boards, donors, grantors, creditors, and other stakeholders of NFPs.

    The fundamental reporting model for NFPs has existed for over 20 years. During that time, NFP organizations have developed different methods of reporting their operating results in a way that conveys the connection between financial choices and mission execution because existing GAAP does not prescribe a specific way of reporting operating performance. Additionally, changes in endowment laws together with the existing framework for reporting restricted and unrestricted net assets, and the lack of required information about the liquidity of an organization, have contributed to the confusion in determining whether an NFP is in sound or poor financial condition.

    Continued in article

    Bob Jensen's threads on NFP accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Internal Control --- https://en.wikipedia.org/wiki/Internal_control

    "In the NSF's Priciest Grant-Fraud Settlement, Northeastern U. Will Pay $2.7 Million," by Paul Baskin, Chronicle of Higher Education, August 21, 2015 ---
    http://chronicle.com/article/In-the-NSFs-Priciest/232511/?cid=at&utm_source=at&utm_medium=en

    Northeastern University has agreed to pay $2.7 million to cover nine years of mishandling federal research funds, in the largest-ever civil settlement with the National Science Foundation.

    The case stems from the management of NSF grant money awarded to Northeastern for work at CERN, the European Organization for Nuclear Research, from 2001 to 2010. The work was led by a professor of physics, Stephen ­Reucroft.

    Both the NSF and Northeastern declined to discuss the matter in detail. But the university issued a written statement that put the blame largely on Mr. Reucroft, who retired from Northeastern in 2010.

    "The conduct in question related to accounting and grant oversight," Northeastern said in a written statement. "The university self-reported the discrepancies to the funding agency, the National Science Foundation, as soon as they were discovered and fully cooperated with the agency’s review."

    But the terms of the $2.7-million settlement suggested that Northeastern bore substantial responsibility. According to the agreement, the university failed to provide necessary oversight, failed to pay interest due, paid salaries without required documentation, and paid expense money based on inadequate or fraudulent documentation submitted by Mr. Reucroft.

    Northeastern "continued to engage in these practices when it knew or should have known in 2006, if not before, that Professor Reucroft had violated NSF requirements when he submitted fraudulent claims for personal expenses," said the settlement, which was signed by lawyers for Northeastern and by Anita Johnson, an assistant U.S. attorney in Boston.

    Continued in article

    One of the problems is that the first trait may make the organization complacent about the other two traits. Exhibit A is Brigham Young University that certainly gets an A+ on the "encouraging an ethical culture" trait. But this made BYU complacent about skepticism and engaging employees in internal controls. Who would have guessed that a financial officer at BYU would pilfer hundreds of thousands of dollars (2002)?
    http://www.deseretnews.com/article/948838/Ex-BYU-official-is-charged-with-stealing-fees.html?pg=all

    PROVO — Prosecutors say that a former BYU finance officer and his wife used a defunct corporation as a shell to steal hundreds of thousands of dollars in collection fees from the university over several years.

    In a preliminary hearing Friday in 4th District Court, deputy Utah County Attorney David Wayment charged that John Davis and his wife, Carol, used an expired corporate name as a front to skim thousands in inflated student fees that were supposed to go to collection agencies.

    By the end of the four-hour hearing, Judge James Taylor found probable cause to bind John Davis over on seven counts of theft and one count of racketeering, all second-degree felonies. Taylor, however, found the state lacked enough evidence to prove that Carol Davis knew that potential criminal activity was going on, despite having her name on several bank accounts related to the crime.

    Taylor ordered that four counts of theft and one count of racketeering be dropped against Carol Davis.

    During the hearing, finance officials with Brigham Young University testified finding strange financial activity involving John Davis, who worked as BYU's supervisor of collections.

    Mark Madsen, assistant treasurer over student financial services at BYU, testified of finding several checks requested by John Davis made payable to a company called RCM (Regional Credit Management). Madsen assumed that the company was a collection agency contracted with BYU to collect on outstanding debts from students who had failed to pay their tuition, library fees or parking tickets.

    Continued in article

    Jensen Comment
    Universities are notorious for relying upon trust without adequate internal controls. Much of the problem lies in tight budgets and unwillingness to allocate funds for better internal control systems.

    Bob Jensen's Fraud Updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Teaching Case
    "The City of Providence, RI: A Case Examining the Financial Condition of a U.S. Municipality." by Christine E. Earley, Nancy Chun Feng, and Patrick T. Kelly, Issues in Accounting Education, Volume 30, Issue 2 (May 2015)  ---
    http://aaajournals.org/doi/full/10.2308/iace-51042
    This case is not free

    Continued in artciel

    Bob Jensen's Threads on the Sad State of Governmental Accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    How to Mislead With Statistics
    "Government Accounting Deceptions Are Everywhere," by Jason Richwine, National Review, September 26, 2014 ---
    http://www.nationalreview.com/agenda/388983/government-accounting-deceptions-are-everywhere-jason-richwine

    The new issue of National Affairs features my article with Jason Delisle, “The Case for Fair-Value Accounting.” We go into a lot of detail about what fair-value accounting (FVA) is, why it’s needed, and how both parties have hypocritically flip-flopped on it.

    I’m not someone who is easily shocked by government misconduct, but when we assembled all  the examples of accounting malfeasance for this article, even I was surprised at how widespread and deceptive it all is.

    Some quick background: The “fair value” of an investment is its current market price. Built into the market price of any asset are the expectations of its future value and the risk that those expectations may not be met. Both components of the price are critical. All else equal, investors obviously prefer assets with higher expected returns, but that preference is mediated by the risk involved. Investors may prefer low-returning assets with low risk (such as bonds) over high-return and high-risk assets (such as stocks). FVA cost estimates naturally include both expected returns and the cost of risk.

    But most federal credit programs are scored based on expectations only, disregarding the cost of market risk. When the federal government offers student loans, for example, it estimates how much students will pay back and then assumes that its estimate carries no uncertainty. But no private investor would purchase the right to collect student loan repayments for just the expected value. The investor would demand a lower price for such a risky asset.

    By placing a greater value on its assets than the market does, the government generates a number of bogus “free lunch” scenarios, and politicians try to exploit them:

    For example, in the depths of the recession, Ohio senator Sherrod Brown proposed that the federal government buy up private student loans, convert them to federal loans, and then reduce the interest rates that borrowers pay. Lenders holding the loans would be paid face value for them — that is, the government would pay the lenders the full outstanding balance on the loans. Borrowers would receive new, better terms and repay the remainder of their loans to the Department of Education. The CBO was required under [current law] to show that this transaction would result in an immediate $9.2 billion profit to the government.

    Bear in mind that this was a debt swap in which borrowers would pay less interest to the government than they would pay to private lenders. But, miraculously, $9.2 billion in new cash for the government would appear out of thin air as soon as the transaction was made. This money could then promptly be spent on more government programs.

    Under FVA, Senator Brown’s scheme would not have generated a profit at all, but rather a cost of $700 million.

    Now consider the Federal Housing Administration’s single-family mortgage-insurance program, which provides default guarantees to home-mortgage lenders:

    Home buyers secure subsidized mortgages, which are loans with terms better than any private lender would offer without the government guarantee. Because [government accounting] rules exclude a market-risk premium, the program appears to both subsidize homeowners and generate profits for the government, “earning” a $60 billion free lunch for the government over ten years. But once a market-risk premium is added to these tallies, the loan guarantees show a $3 billion annual cost.

    The same problem of disregarding market risk affects public pensions:

    As discussed earlier, [government] accounting enables the federal government to claim a “profit” simply by purchasing a private-sector loan. In the pension world, the analogous transaction is the “pension-obligation bond,” which allows states to conjure money through an interest-rate arbitrage scheme. In essence, a state sells a government bond that pays, say, a guaranteed 5% interest rate and then places the proceeds from the bond sale into the pension fund. The trick is that the pension fund is assumed to return 8%, so the state nets 3% per year in “free” money. The fallacy, of course, is that the pension fund’s 8% expected return carries risk — which is why investors are willing to buy the (safer) pension-obligation bonds in the first place.

    The examples go on and on, and the only way to end this mischief is to apply FVA to all government credit and investment programs.

     

    How to Mislead With Statistics
    "Government Accounting Deceptions Are Everywhere," by Jason Richwine, National Review, September 26, 2014 ---
    http://www.nationalreview.com/agenda/388983/government-accounting-deceptions-are-everywhere-jason-richwine

    The new issue of National Affairs features my article with Jason Delisle, “The Case for Fair-Value Accounting.” We go into a lot of detail about what fair-value accounting (FVA) is, why it’s needed, and how both parties have hypocritically flip-flopped on it.

    I’m not someone who is easily shocked by government misconduct, but when we assembled all  the examples of accounting malfeasance for this article, even I was surprised at how widespread and deceptive it all is.

    Some quick background: The “fair value” of an investment is its current market price. Built into the market price of any asset are the expectations of its future value and the risk that those expectations may not be met. Both components of the price are critical. All else equal, investors obviously prefer assets with higher expected returns, but that preference is mediated by the risk involved. Investors may prefer low-returning assets with low risk (such as bonds) over high-return and high-risk assets (such as stocks). FVA cost estimates naturally include both expected returns and the cost of risk.

    But most federal credit programs are scored based on expectations only, disregarding the cost of market risk. When the federal government offers student loans, for example, it estimates how much students will pay back and then assumes that its estimate carries no uncertainty. But no private investor would purchase the right to collect student loan repayments for just the expected value. The investor would demand a lower price for such a risky asset.

    By placing a greater value on its assets than the market does, the government generates a number of bogus “free lunch” scenarios, and politicians try to exploit them:

    For example, in the depths of the recession, Ohio senator Sherrod Brown proposed that the federal government buy up private student loans, convert them to federal loans, and then reduce the interest rates that borrowers pay. Lenders holding the loans would be paid face value for them — that is, the government would pay the lenders the full outstanding balance on the loans. Borrowers would receive new, better terms and repay the remainder of their loans to the Department of Education. The CBO was required under [current law] to show that this transaction would result in an immediate $9.2 billion profit to the government.

    Bear in mind that this was a debt swap in which borrowers would pay less interest to the government than they would pay to private lenders. But, miraculously, $9.2 billion in new cash for the government would appear out of thin air as soon as the transaction was made. This money could then promptly be spent on more government programs.

    Under FVA, Senator Brown’s scheme would not have generated a profit at all, but rather a cost of $700 million.

    Now consider the Federal Housing Administration’s single-family mortgage-insurance program, which provides default guarantees to home-mortgage lenders:

    Home buyers secure subsidized mortgages, which are loans with terms better than any private lender would offer without the government guarantee. Because [government accounting] rules exclude a market-risk premium, the program appears to both subsidize homeowners and generate profits for the government, “earning” a $60 billion free lunch for the government over ten years. But once a market-risk premium is added to these tallies, the loan guarantees show a $3 billion annual cost.

    The same problem of disregarding market risk affects public pensions:

    As discussed earlier, [government] accounting enables the federal government to claim a “profit” simply by purchasing a private-sector loan. In the pension world, the analogous transaction is the “pension-obligation bond,” which allows states to conjure money through an interest-rate arbitrage scheme. In essence, a state sells a government bond that pays, say, a guaranteed 5% interest rate and then places the proceeds from the bond sale into the pension fund. The trick is that the pension fund is assumed to return 8%, so the state nets 3% per year in “free” money. The fallacy, of course, is that the pension fund’s 8% expected return carries risk — which is why investors are willing to buy the (safer) pension-obligation bonds in the first place.

    The examples go on and on, and the only way to end this mischief is to apply FVA to all government credit and investment programs.

    Bob Jensen's threads on the sad state of public sector accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    "Measuring Pension Liabilities under GASB Statement No. 68," by John W. Mortimer and Linda R. Henderson, Accounting Horizons, September 2014, Vol. 28, No. 3, pp. 421-454 ---
    http://aaajournals.org/doi/full/10.2308/acch-50710

    While retired government employees clearly depend on public sector defined benefit pension funds, these plans also contribute significantly to U.S. state and national economies. Growing public concern about the funding adequacy of these plans, hard hit by the great recession, raises questions about their future viability. After several years of study, the Governmental Accounting Standards Board (GASB) approved two new standards, GASB 67 and 68, with the goal of substantially improving the accounting for and transparency of financial reporting of state/municipal public employee defined benefit pension plans. GASB 68, the focus of this paper, requires state/municipal governments to calculate and report a net pension liability based on a single discount rate that combines the rate of return on funded plan assets with a low-risk index rate on the unfunded portion of the liability. This paper illustrates the calculation of estimates for GASB 68 reportable net pension liabilities, funded ratios, and single discount rates for 48 fiscal year state employee defined benefit plans by using an innovative valuation model and readily available data. The results show statistically significant increases in reportable net pension liabilities and decreases in the estimated hypothetical GASB 68 funded ratios and single discount rates. Our sensitivity analyses examine the effect of changes in the low-risk rate and time period on these results. We find that reported discount rates of weaker plans approach the low-risk rate, resulting in higher pension liabilities and creating policy incentives to increase risky assets in pension portfolios.

    Bob Jensen's threads on pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    Where are governmental payments (especially tax refund, Medicaid, Medicare, disability, and unemployment fraud) internal controls? What controls?

    From the CPA Newsletter on July 9, 2014

    Improper government payments reached $100B in 2013
    By its own reckoning, the U.S. government made $100 billion in improper payments last year in the form of tax credits and unemployment benefits to people who didn't qualify, and medical payments for unnecessary procedures. Improper payments peaked in 2010, reaching $121 billion. The government has been trying to put controls in place to address this issue. The House Subcommittee on Government Operations is holding a hearing today on the matter. San Francisco Chronicle (free content)/The Associated Press (7/9


    How to Mislead With Governmental Accounting
    "How Much Do We Really Owe?," by John Goodman, Forbes, August 7, 2014 ---
    http://www.forbes.com/sites/johngoodman/2014/08/07/how-much-do-we-really-owe/

    First the good news: the official federal deficit is only 3% of GDP – way below the 10% figure it reached only a few years ago. Now the bad news: The real deficit is more than ten times that amount.

    The U.S. government’s deficit is expected to be $514 billion this year, according to the Congressional Budget Office (CBO). That’s the number you get when you look at cash flow. It means the government will spend $514 billion more than it takes in during the 2014 fiscal year.

    But this kind of accounting ignores federal government liabilities that will become due in future years. For example, over the course of a year millions of people earn Social Security and Medicare benefits as well as other government entitlement benefits that will have to be paid in future years. When you total all that up (and subtract expected future revenues to pay those benefits), we added $5 trillion in debt last year according to Boston University economist Larry Kotlikoff.

    Another way to look at the problem is to consider not just one year’s deficit, but the total amount of debt that government has accumulated. US debt held by the public is currently $12.6 trillion, or about 75% of the size of our economy the way the CBO measures things. But in arriving at that number, the CBO doesn’t recognize promises to pay Social Security checks and medical bills as real obligations.

    Take a senior citizen who is expecting an interest payment on a government bond next month and who is also expecting a Social Security check. The way the CBO looks at the world, the interest payment on the bond is a real obligation of the government. But the Social Security check isn’t.

    That’s a strange way of accounting and Kotlikoff and his colleagues reject it. Instead they project the value of all the promises we have made under Social Security and other entitlement programs – benefits that ordinary citizens believe they have earned – and subtract expected future revenues, given the current tax law. The difference is an unfunded liability that is every bit as real as promises to make future interest payments on bonds and Treasury bills.

    Calculating obligations in this way, Kotlikoff estimates that the total unfunded liability of the federal government is $210 trillion, or about 12 times the size of our economy. Writing in The New York Times, Kotlikoff says:

    “The fiscal gap — the difference between our government’s projected financial obligations and the present value of all projected future tax and other receipts — is, effectively, our nation’s credit card bill. Eliminating it, would require an immediate, permanent 59 percent increase in federal tax revenue. An immediate, permanent 38 percent cut in federal spending would also suffice. The longer we wait, the worse the pain. If, for example, we do nothing for 20 years, the requisite federal tax increase would be 70 percent, or the requisite spending cut, 43 percent.”

    And the tax increase, by the way, doesn’t work unless the money is sequestered and invested. It can’t just be deposited in the Treasury’s bank account and spent on other things.

    Bob Jensen's threads on the USA's entitlements disaster ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm

     


    The New GASB Standard Will Bring Light to the Dark Corners of Underfunded Government Pension Funds

    From EY on August 15, 2014
    GASB proposes changes in accounting for other postemployment benefits
    http://www.ey.com/Publication/vwLUAssetsAL/TechnicalLine_BB2797_OPEBPlans_14August2014/$FILE/TechnicalLine_BB2797_OPEBPlans_14August2014.pdf

    What you need to know

    • The GASB has proposed chang ing how state and local governments calculate and report the costs and obligations associated with defined benefit other postemployment benefit (OPEB) plans .

    • Government employers that fund their OPEB plans through a trust that meets the specified criteria would have to record a net OPEB liability in their accrual - basis financial statements for defined benefit plans that would be based on the plan fiduciary net position rath er than plan funding.

    • The proposal would make a government’s obligations more transparent, and m any governments would likely report a much larger OPEB liability than they do today.

    • The guidance would be effective for fiscal years beginning after 15 December 2016 , and early application would be encouraged.

    • Comments are due by 29 August 2014 . Public hearings are s et for September 2014.

    Overview
    The Governmental Accounting Standards Boa rd (GASB) has proposed changing how state and local governments calculate and report the cost of other postemployment benefits , which consist of retiree health insurance and defined benefits other than pensions and termination benefits that are provided to retirees .

    Accounting Change Will Expose ...
    http://www.statedatalab.org/news/detail/accounting-change-will-expose

    JUNE 25, 2014 | FORT WAYNE NEWS-SENTINEL (INDIANA)

    By Michael Hicks, includes “This week marked the full implementation of two new Government Accounting Standards Board rules affecting the reporting of pension liabilities. These rules -- known in the bland vernacular of accountancy as Statements 67 and 68 -- require state and municipal governments to report their pensions in ways more like that of private-sector pensions. … One result of this is that governments with very high levels of unfunded liabilities will see their bond ratings drop to levels that will make borrowing impossible. In some places, like Indianapolis or Columbus, Ohio, may have to increase their pension contributions and perhaps make modest changes to retirement plans, such as adding a year or two of work for younger workers. Places like Chicago or Charleston, West Virginia, will be effectively unable to borrow in traditional bond markets.  Pension funds in Chicago alone are underfunded by almost $15 billion. Under the new GASB rules Chicago's liability could swell to almost $60 billion or roughly $21,750 per resident. Retiree health care liabilities add another $3.6 billion or $1,324 per resident, so that each Chicago household will need to cough up $61,000 to fully fund their promises to city employees. The promise will be broken. …

    Bob Jensen's threads on pensions and post-retirement benefits ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions


    "Fraudulent Government Accounting:  How Congress disguises the real cost of federal loan guarantees," The Wall Street Journal, June 2, 2014 ---
    http://online.wsj.com/articles/fraudulent-government-accounting-1401662602?tesla=y&mod=djemMER_h&mg=reno64-wsj

    This headline will strike many readers as redundant. But we're hoping that through repetition Members of Congress may be motivated to stop misleading their constituents about the cost of federal credit programs.

    Many politicians still claim that taxpayers make money on things like student loans, single-family home mortgages backed by the Federal Housing Administration, and long-term guarantees from the Export-Import Bank. Yet under honest accounting, taxpayers lose on all three.

    The Congressional Budget Office, Washington's official financial scorekeeper, says in a new report that the Department of Education's four largest student loan programs will yield an official savings of about $135 billion in fiscal years 2015-2024. That's $135 billion that Congress will claim it has available to spend.

    But CBO also notes that under fair-value accounting that is practiced in the real world, the four student loan programs will likely cost $88 billion. An official $14 billion projected taxpayer gain at the Export-Import Bank is actually a $2 billion loss. And the official $63 billion windfall expected from the FHA's single-family mortgage guarantee program is in reality a $30 billion taxpayer fleecing.

    CBO is obligated to practice bogus accounting under the amusingly titled Federal Credit Reform Act of 1990. But CBO periodically does a public service by calling attention to this legal fraud and explaining why its official estimates don't accurately measure what these programs really cost. CBO's new report is especially informative. You see, federal law does not allow official bookkeeping to account for a phenomenon that must seem alien to the Beltway culture: "market risk."

    As CBO helpfully explains: "The government is exposed to market risk when the economy is weak because borrowers default on their debt obligations more frequently and recoveries from borrowers are lower." Yet even after the financial crisis and a historically weak recovery, Washington officially will not admit that such a scenario is possible.

    Just as loans look less expensive for taxpayers than they really are, government guarantees can appear to be nearly a free lunch under federal accounting rules. But the government bears the risk of losses. "Because of that government commitment a lender places more value on a loan with a guarantee than on the same loan without a guarantee. The difference in value between them is the 'fair value' of the guarantee," says CBO.

    As bad as the math appears once honest accounting is applied, it still doesn't fully describe the problem for taxpayers. That's because none of these figures includes the administrative costs of federal credit programs, which are counted separately in the federal budget.

    CBO is expecting robust growth in loan volumes at both the FHA and the Department of Education. If taxpayers are forced to come along for this ride, the least the Congress should do is enact Rep. Scott Garrett's (R., N.J.) plan to require fair-value accounting in government loan programs.

    And as for the Export-Import Bank—a corporate welfare program that disproportionately benefits a handful of giant multinationals—bogus accounting is one more reason to allow its charter to expire on schedule at the end of September.


    "The Government Doesn’t Know How Much Its Student Loans Cost," by Karen Weise, Bloomberg Businessweek, January 31, 2013 ---
    http://www.businessweek.com/articles/2014-01-31/the-government-doesnt-know-how-much-its-student-loans-cost

    Depending on whom you ask, the government either makes tens of billions of dollars on the backs of student borrowers, or more or less breaks even. The debate, which boils down to the arcana of accounting techniques, was hotly contested last year, with Democrats such as Massachusetts Senator Elizabeth Warren decrying how the government “profits” off student loans. The controversy caused Congress to ask the Government Accountability Office to weigh in, which led to a report released today. The GAO came back with a non-answer, finding that there’s no good way to know how much the government spends or makes on funding student loans.

    The GAO said it could take as long as 40 years to figure the true costs of the program because there are so many variables, from the overall interest rate environment to the number of students who take advantage of different repayment options. In the meantime, the government is stuck using estimates that can vary greatly based on several factors, most important the amount students pay in interest and what it costs the government itself to borrow. The government readjusts its models each year based on more recent data, which can lead to highly volatile results. One year the budget assumed loans taken out in 2008 made the government $9.09 per hundred dollars borrowed. The next year it estimated the very same loans cost the government 24¢ per hundred dollars.

    One figure is pretty clear: how much the Department of Education spends administering the loans. That’s jumped from $314 million in 2007 to $864 million in 2012, reflecting changes in the federal program that removed banks as intermediaries and caused the number of loans directly issued by the government to increase threefold. Overall, the administration costs per borrower has stayed the same or even fallen slightly.

    The overall difficulty in nailing down these estimates is an increasingly relevant problem as student debt tops $1 trillionmost of it financed by the government.

    Jensen Comment
    It might be a good project for governmental accounting or managerial accounting students to be assigned to advise the government on how to compute the cost of student loans.

     


    Over 75% Off-Balance-Sheet Financing by Federal and State Governments (not counting over a trillion dollars in unbooked entitlements obligations)
    "Hiding the Financial State of the Union -- and the States," State Data Lab, January 24, 2014 ---
    http://www.statedatalab.org/

    Next Tuesday, President Barack Obama will give the annual “State of the Union” address. One of the most important issues is the Financial State of the Union. But what about the Financial State of the States?

    Truth in Accounting has found that the lack of truth and transparency in governmental budgeting and financial reporting enables our federal and state governments to not tell us what they really owe. Obscure accounting rules allow governments to hide trillions of dollars of debt from citizens and legislators.

    The President and many governmental officials tell us the national debt is $17 trillion, but that does not include more than $58 trillion of retirement benefits that have been promised to our veterans and seniors. In addition, state officials do not report more than $948 billion of retirement liabilities.

    The charts above show 77% of the federal government's true debt is hidden and 75% of state government debt is hidden. Total hidden federal and state debt amounts to more than $59 trillion, or roughly $625,000 per U.S. taxpayer.

    The five states with the greatest hidden debt include Texas ($66 billion), Michigan ($67 billion), New York ($75 billion), Illinois ($106 billion), and California ($112 billion).

    Truth in Accounting promotes truthful, transparent and timely financial information from our governments, because citizens deserve to know the amount of debt they and their children will be responsible for paying in the future.


    "The Future of Public Sector Accounting Standards," by Ken Warren, Deloitte, September 13, 2012 ---
    http://www.iasplus.com/en/news/2012/september/the-future-for-ipsas

    Ken Warren, a board member of the International Public Sector Accounting Standards Board (IPSASB) and the New Zealand External Reporting Board (XRB), has written an article providing some insights into the future direction of International Public Sector Accounting Standards (IPSAS). The article, entitled 'IPSASs through the looking glass' and recently published on the website of the New Zealand Institute of Chartered Accountants (NZICA), discusses conceptual differences between IFRS and IPSAS and likely developments in public sector accounting.

    Video from the AICPA
    What's at Stake? A CPA's Insights into the Federal Government's Finances ---
    http://www.aicpa.org/Advocacy/Pages/CPAsInsight.aspx

     

    Why single out capitalism for immorality and ethics misbehavior?
    Making capitalism ethical is a tough task – and possibly a hopeless one.
    Prem Sikka (see below)

    The global code of conduct of Ernst & Young, another global accountancy firm, claims that "no client or external relationship is more important than the ethics, integrity and reputation of Ernst & Young". Partners and former partners of the firm have also been found guilty of promoting tax evasion.
    Prem Sikka (see below)

    Jensen Comment
    Yeah right Prem, as if making the public sector and socialism ethical is an easier task. The least ethical nations where bribery, crime, and immorality are the worst are likely to be the more government (dictator) controlled and lower on the capitalism scale. And in the so-called capitalist nations, the lowest ethics are more apt to be found in the public sector that works hand in hand with bribes from large and small businesses.

    Rotten Fraud in General --- http://faculty.trinity.edu/rjensen/FraudRotten.htm
    Rotten Fraud in the Public Sector (The Most Criminal Class Writes the Laws) --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

    We hang the petty thieves and appoint the great ones to public office.
    Aesop

    Congress is our only native criminal class.
    Mark Twain --- http://en.wikipedia.org/wiki/Mark_Twain

    Why should members of Congress be allowed to profit from insider trading?
    Amid broad congressional concern about ethics scandals, some lawmakers are poised to expand the battle for reform: They want to enact legislation that would prohibit members of Congress and their aides from trading stocks based on nonpublic information gathered on Capitol Hill. Two Democrat lawmakers plan to introduce today a bill that would block trading on such inside information. Current securities law and congressional ethics rules don't prohibit lawmakers or their staff members from buying and selling securities based on information learned in the halls of Congress.
    Brody Mullins, "Bill Seeks to Ban Insider Trading By Lawmakers and Their Aides," The Wall Street Journal, March 28, 2006; Page A1 --- http://online.wsj.com/article/SB114351554851509761.html?mod=todays_us_page_one

    The Culture of Corruption Runs Deep and Wide in Both U.S. Political Parties:  Few if any are uncorrupted
    Committee members have shown no appetite for taking up all those cases and are considering an amnesty for reporting violations, although not for serious matters such as accepting a trip from a lobbyist, which House rules forbid. The data firm PoliticalMoneyLine calculates that members of Congress have received more than $18 million in travel from private organizations in the past five years, with Democrats taking 3,458 trips and Republicans taking 2,666. . . But of course, there are those who deem the American People dumb as stones and will approach this bi-partisan scandal accordingly. Enter Democrat Leader Nancy Pelosi, complete with talking points for her minion, that are sure to come back and bite her .... “House Minority Leader Nancy Pelosi (D-Calif.) filed delinquent reports Friday for three trips she accepted from outside sponsors that were worth $8,580 and occurred as long as seven years ago, according to copies of the documents.
    Bob Parks, "Will Nancy Pelosi's Words Come Back to Bite Her?" The National Ledger, January 6, 2006 --- http://www.nationalledger.com/artman/publish/article_27262498.shtml 

    And when they aren't stealing directly, lawmakers are caving in to lobbying crooks
    Drivers can send their thank-you notes to Capitol Hill, which created the conditions for this mess last summer with its latest energy bill. That legislation contained a sop to Midwest corn farmers in the form of a huge new ethanol mandate that began this year and requires drivers to consume 7.5 billion gallons a year by 2012. At the same time, Congress refused to include liability protection for producers of MTBE, a rival oxygen fuel-additive that has become a tort lawyer target. So MTBE makers are pulling out, ethanol makers can't make up the difference quickly enough, and gas supplies are getting squeezed.
    "The Gasoline Follies," The Wall Street Journal, March 28, 2006; Page A20  --- Click Here

    Once again, the power of pork to sustain incumbents gets its best demonstration in the person of John Murtha (D-PA). The acknowledged king of earmarks in the House gains the attention of the New York Times editorial board today, which notes the cozy and lucrative relationship between more than two dozen contractors in Murtha's district and the hundreds of millions of dollars in pork he provided them. It also highlights what roughly amounts to a commission on the sale of Murtha's power as an appropriator: Mr. Murtha led all House members this year, securing $162 million in district favors, according to the watchdog group Taxpayers for Common Sense. ... In 1991, Mr. Murtha used a $5 million earmark to create the National Defense Center for Environmental Excellence in Johnstown to develop anti-pollution technology for the military. Since then, it has garnered more than $670 million in contracts and earmarks. Meanwhile it is managed by another contractor Mr. Murtha helped create, Concurrent Technologies, a research operation that somehow was allowed to be set up as a tax-exempt charity, according to The Washington Post. Thanks to Mr. Murtha, Concurrent has boomed; the annual salary for its top three executives averages $462,000.
    Edward Morrissey, Captain's Quarters, January 14, 2008 --- http://www.captainsquartersblog.com/mt/archives/016617.php

    The booked National Debt in August 2012 went over $16 trillion --- 
    U.S. National Debt Clock --- http://www.usdebtclock.org/
    Also see http://www.brillig.com/debt_clock/


    Seeking more transparency in tax free bond markets
    |"SEC Plans To Act on Many Muni Report Recommendations," by Kyle Glazier, The Bond Buyer, February 3, 2014 ---
    http://www.bondbuyer.com/issues/123_23/sec-plans-to-act-on-many-muni-report-recommendations-1059543-1.html

    The Securities and Exchange Commission plans to take action on many of the recommendations in its 2012 municipal market report as well as strengthen its oversight of municipal advisors, according to its draft strategic plan released Monday.

    The 42-page document lays out the SEC's "mission, vision, values, and strategic goals" for fiscal years 2014 through 2018. Among the topics covered is the nearly two year-old comprehensive muni market report, which was written after a lengthy examination of the market spearheaded by then-commissioner Elisse Walter. That 165-page report recommended a number of both legislative and regulatory changes that Congress and the SEC could make to strengthen transparency in the market.

    Among the recommendations for the SEC and the Municipal Securities Rulemaking Board were to require muni dealers to disclose to customers markups and markdowns of riskless principal transactions, and to encourage the use of alternative trading systems.

    "The SEC plans to pursue many of the recommendations highlighted in the July 2012 Report on the Municipal Securities Market through a combination of SEC, MSRB, and [Financial Industry Regulatory Authority] initiatives, in an effort to enhance the market structure for all fixed income securities, including taxable and tax-exempt securities," the draft plan states. "This effort will include initiatives aimed at promoting transparency and the development of new mechanisms to facilitate the provision of liquidity, as well as initiatives to improve the execution quality of investor orders."

    SEC commissioner Michael Piwowar said last week that he is working with the commission's Office of Municipal Securities on the need to disclose markups and markdowns in riskless principal transactions. The MSRB is working on some other aspects of the report, such as the expansion of MSRB's EMMA website to become a comprehensive central transparency platform and the development of a best execution rule requiring dealers to seek the best price for their customers. The SEC has oversight of the MSRB and must approve its rule proposals.

    The plan notes the SEC's mandate, under the Dodd-Frank Act, to regulate municipal advisors, and states that the commission will focus on getting MA's properly registered. The plan is open for public comment until March 10.


    "Buffalo Grove may not be so great, after all," State Data Lab, January 14, 2014 ---
    http://www.statedatalab.org/news/detail/buffalo-grove-may-not-be-so-great-after-all

    CNN Money included Buffalo Grove as one of the top 50 places to live. CNN placed the village at 46 and highlighted that the village "enjoys economic stability."

    Truth in Accounting reviewed the village's audited financial report and found a different story.  While the balance sheet indicates the village has $21 million available to be used to meet a current and future bills, this amount does not take into account more than $60 million of off-balance sheet liabilities.

    These liabilities represent unfunded pension and retirees' health care commitments of $62.7 million. If this amount was included in its bills, the village needs $41.9 million to pay the bills it has accumulated to date. 

    This amount is almost three times the property taxes collected.  Each taxpayer's (household's) share is $2,585.

    Buffalo Grove, like most Cook County municipalities, has large amounts of unfunded retirement benefits. Buffalo Grove's police and firefighters’ pensions are unfunded by more than four times their payroll. In other words, the village would have to stop paying their police and firefighters for four years and divert all of those funds to their pension plans just to catch up.

    The lack of truth and transparency in local government finances has resulted in the accumulation of significant debt without public knowledge. Fortunately, people are now focusing on the debt of Illinois and the federal government. Unfortunately, people aren't aware that debt is most likely a problem in their local government as well.

    Continued in article

    Truth in Accounting has also examined the comparisons between Chicago and the bankrupt city of Detroit ---
    http://www.rebootillinois.com/chicago-detroit-comparison-not-far-fetched-says-truth-in-accounting  


    "Undisclosed Pension Extras Cost Detroit Billions," by Mary Williams Walsch, The New York Times, September 25, 2013 ---
    http://dealbook.nytimes.com/2013/09/25/undisclosed-payments-cost-detroit-pension-plan-billions/?_r=0

    Detroit’s municipal pension fund made undisclosed payments for decades to retirees, active workers and others above and beyond normal benefits, costing the struggling city billions of dollars, according to an outside actuary hired to examine the payments.

    The payments included bonuses to retirees, supplements to workers not yet retired and cash to the families of workers who died too young to get a pension, according to a report by the outside actuary and other sources.

    How much each person received is not known because payments were not disclosed in the annual reports of the fund.

    Detroit has nearly 12,000 retired general workers, who last year received pensions of $19,213 a year on average — hardly enough to drive a great American city into bankruptcy. But the total excess payments in some years ran to more than $100 million, a crushing expense for a city in steep decline. In some years, the outside actuary found, Detroit poured more than twice the amount into the pension fund that it would have had to contribute had it only paid the specified pension benefits.

    And even then, the city’s contributions were not enough. So much money had been drained from the pension fund that by 2005, Detroit could no longer replenish it from its dwindling tax revenues. Instead, the city turned to the public bond markets, borrowed $1.44 billion and used that to fill the hole.

    Even that didn’t work. Last June, Detroit failed to make a $39.7 million interest payment on that borrowing — the first default of what was soon to become the biggest municipal bankruptcy case in American history.

    Detroit said that making the interest payment would have consumed more than 90 percent of its available cash. And besides, the hole in its pension fund was growing again, and it needed yet another $200 million for that.

    When Detroit turned to the bond market in 2005, it acknowledged that it needed cash for its pension fund but did not explain its long history of paying out more than the plan’s legitimate benefits, including the bonuses, known as “13th checks,” which were reported earlier this month by The Detroit Free Press. Nor did the city describe the pension fund’s distributions to active workers, or that a 1998 shift to a 401(k)-style plan had been blocked and turned instead into a death benefit. In its most recent annual valuation of the fund, the plan’s actuary said it was still trying to determine the “effect of future retroactive transfers to the 1998 defined contribution plan,” without mentioning that it had not been carried out.

    All of these things eroded the financial health of the pension system, but neither the magnitude of the harm, nor its effect on the city’s own finances, were disclosed to investors. German banks were big buyers of Detroit’s pension debt; now, they are complaining that they were told it was sovereign debt.

    Finally, in 2011, the city hired the outside actuary to get a handle on where all the money was going. The pension system’s regular actuaries, with the firm of Gabriel Roeder Smith, would not provide the information because they worked for the plan trustees, not the city.

    The outside actuary, Joseph Esuchanko, concluded that the various nonpension payments had cost the struggling city nearly $2 billion from 1985 to 2008 because the city had to constantly replenish the money, with interest. The trustees began making the payments even before 1985, but it appears that Mr. Esuchanko could not get data for earlier years.

    His calculations included only the extra payments by Detroit’s pension fund for general workers. Detroit has a second pension fund, for police officers and firefighters, which also made excess payments in the past. But Mr. Esuchanko could not get the data he needed to calculate those, either.

    When Mr. Esuchanko reported his findings, Detroit’s city council voted to halt all payments except legitimate pensions, as described in plan documents. The police and firefighters’ plan trustees appear to have discontinued the practice earlier.

    Detroit’s pension trustees, and their lawyers, were unavailable on Wednesday to comment on the extra payments.

    Joseph Harris, who served as Detroit’s independent auditor general from 1995 to 2005, said the payments were approved by the pension board of trustees, and it would have been useless for the city to have tried to stop them during his term.

    “It was like dandelions,” he said. “You just accept them. They were there, something you’ve seen all your life.”

    Continued in article

    Bob Jensen's threads on the sad state of pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    GAO Report
    "Social Security Overpays $1.3 Billion in Benefits," by Joel Seidman, CNBC, September 13, 2013 ---
     http://www.cnbc.com/id/101032599

    An upcoming GAO report obtained by NBC News says the federal government may have paid $1.29 billion in Social Security disability benefits to 36,000 people who had too much income from work to qualify.

    At least one recipient collected a potential overpayment of $90,000 without being caught by the Social Security Administration, according to the report, which will be released Sunday, while others collected $57,000 and $74,000.

    The GAO also said its estimate of "potentially improper" payments, which was based on comparing federal wage data to Disability Insurance rolls between 2010 and 2013, "likely understated" the scope of the problem, but that an exact number could not be determined without case by case investigations.

    More from NBC News:
    Protecting social security for the next generation
    Is now the worst time to retire? Not even close
    Obama's fix would trim Social Security checks

    To qualify for disability, recipients must show that they have a physical or mental impairment that prevents gainful employment and is either terminal or expected to last more than a year. Once approved, the average monthly payment to a recipient is just under $1,000.

    (Read more: Social Security Benefits—10 Things You Must Know)

    There is a five-month waiting period during which monthly income cannot exceed $1,000 before an applicant can qualify for disability, as well as a nine-month trial period during which someone who is already receiving benefits can return to work without terminating his or her disability payments.

     

    The GAO said that its analysis showed that about 36,000 individuals either earned too much during the waiting period or kept collecting too long after their nine-month trial period had expired. The report recommended that "to the extent that it is cost-effective and feasible," the Social Security Administration's enforcement operation should step up efforts to detect earnings during the waiting period.
     

    (Read more: How to maximize your social security benefit)
     

    In fiscal 2011, more than 10 million Americans received disability benefits totaling more than $128 billion. The GAO's report estimates that less than half of one percent of recipients might be receiving improper payments.

    A spokesperson for the Social Security Administration said the agency had a "more than 99 percent accuracy rate" for paying disability benefits. "While our paymen taccuracy rates are very high, we recognize that even small payment errors cost taxpayers. We are planning to do an investigation and we will recoup any improper payments from beneficiaries."

    (Read more: Medicare will be exhausted in 2026)

    "It is too soon to tell what caused these overpayments," said the spokesperson, "but if we determine that fraud is involved, we will refer these cases to our Office of the Inspector General for investigation."


    Question
    What is worse than austerity on economic recovery and boom times?

    Answer
    Government honesty in economic reporting

    "The Numbers Are Still Being Cooked In Buenos Aires," by Joe Weisenthal, Business Insider, July 22, 2013 ---
    http://www.businessinsider.com/the-numbers-are-still-being-cooked-in-buenos-aires-2013-7


    "How Detroit went broke: The answers may surprise you - and don't blame Coleman Young," by Nathan Bomey and John Gallagher/Detroit Free Press Business Writers, Detroit Free Press, September 15, 2013 ---
    http://www.freep.com/interactive/article/20130915/NEWS01/130801004/Detroit-Bankruptcy-history-1950-debt-pension-revenue

    . . .

    For this report, the Free Press examined about 10,000 pages of documents gathering dust in the public library’s archives. Since most of those documents have never been digitized, the Free Press created its own database of 50 years of Detroit’s financial history. Reporters also conducted dozens of interviews with participants from the last six mayoral administrations as well as city bureaucrats and outside experts. Among the highlights from the review:

     

    Taxing higher and higher: City leaders tried repeatedly to reverse sliding revenue through new taxes. Despite a new income tax in 1962, a new utility tax in 1971 and a new casino revenue tax in 1999 — not to mention several tax increases along the way — revenue in today’s dollars fell 40% from 1962 to 2012. Higher taxes helped drive residents to the suburbs and drove away business. Today, Detroit still doesn’t take in as much tax revenue as it did just from property taxes in 1963.

     

     

    Reconsidering Coleman Young: Serving from 1974-1994, Young was the most austere Detroit mayor since World War II, reducing the workforce, department budgets and debt during a particularly nasty national recession in the early 1980s. Young was the only Detroit mayor since 1950 to preside over a city with more income than debt, although he relied heavily on tax increases to pay for services.

     

    Downsizing — too little, too late: The total assessed value of Detroit property — a good gauge of the city’s tax base and its ability to pay bills — fell a staggering 77% over the past 50 years in today’s dollars. But through 2004, the city cut only 28% of its workers, even though the money to pay them was drying up. Not until the last decade did Detroit, in desperation, cut half its workforce. The city also failed to take advantage of efficiencies, such as new technology, that enabled enormous productivity gains in the broader economy.

    Skyrocketing employee benefits: City leaders allowed legacy costs — the tab for retiree pensions and health care — to spiral out of control even as the State of Michigan and private industry were pushing workers into less costly plans. That placed major stress on the budget and diverted money from services such as streetlights and public safety. Detroit’s spending on retiree health care soared 46% from 2000 to 2012, even as its general fund revenue fell 20%.

     

    Gifting a billion in bonuses: Pension officials handed out about $1 billion in bonuses from the city’s two pension funds to retirees and active city workers from 1985 to 2008. That money — mostly in the form of so-called 13th checks — could have shored up the funds and possibly prevented the city from filing for bankruptcy. If that money had been saved, it would have been worth more than $1.9 billion today to the city and pension funds, by one expert’s estimate.

     

    Missing chance after chance: Contrary to myth, the city has not been in free fall since the 1960s. There have been periods of economic growth and hope, such as in the 1990s when the population decline slowed, income-tax revenue increased and city leaders balanced the budget. But leaders failed to take advantage of those moments of calm to reform city government, reduce expenses and protect the city and its residents from another downturn.

     

    Borrowing more and more: Detroit went on a binge starting around 2000 to close budget holes and to build infrastructure, more than doubling debt to $8 billion by 2012. Under Archer, Detroit sold water and sewer bonds. Kilpatrick, who took office in 2002, used borrowing as his stock answer to budget issues, and Bing borrowed more than $250 million.

     

    Adding the last straw — Kilpatrick’s gamble: He’s best known around the globe for a sex and perjury scandal that sent him to jail and massive corruption that threatens to send him to prison next month for more than 20 years. The corruption cases further eroded Detroit’s image and distracted the city from its fiscal storm. But perhaps the greatest damage Kilpatrick did to the city’s long-term stability was with Wall Street’s help when he borrowed $1.44 billion in a flashy high-finance deal to restructure pension fund debt. That deal, which could cost $2.8 billion over the next 22 years, now represents nearly one-fifth of the city’s debt.

    With all the lost opportunities over decades, with Detroit’s debt mounting, with the housing crash and Great Recession just over the horizon, 2005 turned out to be the watershed year.

    Although no one could see it at the time, Detroit’s insolvency was guaranteed.

     

    Continued in article

    Jensen Comment
    There's a difference between spending your way out of debt in the Federal Government versus spending your way out of debt Detroit. The enormous difference is that the Federal government controls the money supply, which put another way, the Federal government can print trillions of dollars under the guise of "Quantitative Easing." Detroit can't print its own dollars to spend.


    Book Cooking at the Highest Levels of USA Government

    Why all this controversy over new lease accounting standard revisions to show more debt on the books.
    The best way to not show more debt is to simply stop booking more debt when you borrow more money to pay your bills.

    "Jack Lew’s “Extraordinary Measures” on Debt Just 'Cooking the Books”'," by Morgan Brittany, Townhall, August 19, 2013 --- Click Here
    http://finance.townhall.com/columnists/morganbrittany/2013/08/19/jack-lews-extraordinary-measures-on-debt-just-cooking-the-books-n1667607?utm_source=thdaily&utm_medium=email&utm_campaign=nl

    . . .

    When you delve deeper into what the Treasury Department did, you see that there is a magic number of $16,699,421,000,000 to reach the debt limit set in a law passed by Congress and signed by the King himself.  Isn’t it odd that the number reached when the clock stopped ticking was about $25 million below the limit?

    If the clock had continued to click, by the end of July it would have gone over the legal debt limit and would have been in violation of the law.  However, according to the Monthly Treasury Statement for July, even though money was spent, their reports didn’t show a change in the debt by even one penny.  Isn’t that the definition of “cooking the books”?

    When it became apparent that the debt was going to exceed the limit, Jack Lew sent a “cover my behind” letter to Speaker John Boehner explaining that he was going to take “extraordinary measures” to prevent the Treasury from exceeding the legal limit on the Federal debt. This massaging of the numbers has been going on for months now.

    Jensen Comment
    The GAO declared the Pentagon and the IRS are impossible to audit. Why should it come as a surprise that the Treasury Department of the U.S. Government is incapable of being audited? Why all this debate about whether QE is tantamount to printing money. Our Treasury Secretary has a better idea. Borrow all you want and just don't book it into the accounts. Why didn't I think of that?

    The Bureau of Economic Analysis numbers can no longer be believed. Honesty in reporting is no longer a policy of our Government leaders ---
    http://finance.townhall.com/columnists/peterschiff/2013/08/11/the-half-full-economy-n1661450?utm_source=thdaily&utm_medium=email&utm_campaign=nl

    Welcome to Zimbabwe of North America.

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    "The Pentagon Is Wasting Billions Of Dollars Because It Can't Audit Its Own Contracts," by David Francis (The Fiscal Times), Business Insider, May 22, 2013 ---
    http://www.businessinsider.com/pentagon-wastes-billions-it-cant-audit-2013-5

    Jensen Comment
    The GAO declared that it's impossible to audit the Pentagon and the IRS. Both departments rely a lot on the Fifth Amendment.


    Fraud Beat:
    Canadians Massively Screwed by Their City, Province, and Local Governments ---
    http://www.businessinsider.com/the-three-reasons-canada-is-in-big-trouble-2013-6

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Nonprofit Groups Tackle Newfangled Metrics

    From the CFO Journal's Morning Ledger on June 4, 2013

    Standardizing the way newfangled metrics are calculated is a big job. As companies churn out their own performance benchmarks to satisfy investors’ demands, nonprofit groups are cropping up to help them develop and report new metrics in a uniform way and decide whether they should be included on balance sheets, writes Emily Chasan in Today’s Marketplace section. In some cases they’ve even leapfrogged the FASB.

    The Sustainability Accounting Standards Board expects  next quarter to release its first draft of standards for the health-care industry, including guidelines for reporting product recalls and fatalities in drug clinical trials. Meanwhile, the nonprofit Marketing Accountability Standards Board is working with companies like GM and Kimberly-Clark to standardize valuation methods for corporate brands. Another group, the International Integrated Reporting Council, is working with about 90 mostly European companies on a project to link sustainability reports and corporate financial statements so that both kinds of metrics appear in one place.

    The FASB is likely to get into the act soon. Its advisory council is scheduled to meet today to hash out the board’s priorities as it wraps up a decadelong effort to harmonize U.S. and international accounting standards. The council and accounting rule makers will hold preliminary talks on whether companies, investors and auditors “have the same views about areas where accounting can be improved,” says Russell Golden, who’s set to become FASB chairman in July.

     

    "The Many Ways That Cities Cook Their Bond Books:  The $3 trillion municipal debt market is rife with creative accounting," by Steve Malanga, The Wall Street Journal, May 31, 2013 ---
    http://online.wsj.com/article/SB10001424127887324659404578501241181682894.html?mod=djemEditorialPage_h

    It has been a busy few weeks for the Securities and Exchange Commission. In May, the SEC charged two cities—Harrisburg, Pa., and South Miami, Fla.—with securities fraud for allegedly deceiving investors in their municipal bonds.

    This follows similar fraud charges against states, New Jersey in 2010 and Illinois in March, after SEC investigators uncovered what they called "material omissions" and "false statements" in bond documents related to those state's pension funds.

    With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."

    The Harrisburg charges are part of a broader SEC effort to scrutinize state and local government issuers in the nation's $3 trillion municipal-bond market. "Anyone who follows municipal finance knows that budgets can sometimes be a work of fiction," says Anthony Figliola, a vice president at Empire Government Strategies, a Long Island-based consulting firm to local governments. "Harrisburg is the tip of the iceberg."

    And a mighty iceberg it is. The 2012 State of the States report, released in November by Harvard's Institute of Politics, the University of Pennsylvania's Fels Institute of Government and the American Education Foundation, found state and local governments are carrying more than $7 trillion in debt, an amount equal to nearly half the federal debt. Often, the report said, "States do not account to citizens in ways that are transparent, timely or accessible."

    Consider the practices of Stockton, Calif., which last June became the nation's biggest city to file for bankruptcy. In 2011, Stockton's new financial managers issued a blistering critique of past accounting practices and acknowledged that the city's previous financials had hidden significant costs, including the real cost of employee compensation and retirement obligations. Bob Deis, the new city manager, declared that Stockton's financials bore "eerie similarities to a Ponzi scheme."

    If so, the city's bondholders have been taken for a ride. In bankruptcy court earlier this year, a judge ruled that Stockton could suspend payments on its bonds even while continuing to fund its employee retirement system.

    Similarly, when another California city, San Bernardino, went bust last year, some city officials alleged that it had been filing inaccurate financial records for nearly 16 years. At best, officials said, the city's bookkeeping had been "unprofessional." The SEC began an investigation last fall. Meanwhile, the city has defaulted on bond payments, leaving investors in the lurch.

    One area that has come under special scrutiny is pension-fund accounting, because states have latitude in choosing how to value their retirement debts. The SEC noted that Illinois used accounting that funds a larger percentage of an employee's pension costs near the end of his career, a method that increases the risks that the system could go bust. The SEC said Illinois didn't properly reveal the risks posed by this sophisticated accounting wrinkle.

    The SEC accused New Jersey of failing to disclose to investors that it wasn't sticking to a plan to adequately fund its pension system. In this, the Garden State isn't alone. Many states underfund their pension systems, even by their own accounting standards.

    A June 2012 study by the Pew Center on the States found that 29 states didn't make their annual required contribution for pensions in 2010, the last year for which data were available. It isn't clear how many of the more than 3,000 local government pension systems follow the same practice, although a survey this January by Pew of 61 large cities found nearly half didn't make their full contributions.

    In the South Miami case the SEC zeroed in on a complex bond deal that changed over time in a way that threatened the tax-free status of the securities. The SEC essentially warned South Miami that municipalities that employ such schemes need to fully understand the consequences for investors. In this particular case, South Miami paid $260,000 to the Internal Revenue Service to preserve the tax-free status of the bonds for investors.

    Municipal investors have often ignored such questionable practices thanks to a generation of low default rates. Many also assume that even when a local government gets into financial trouble, bondholders are always first in line to be paid.

    But officials in some troubled cities are pushing back against the notion that investors should get the best deal among creditors. Harrisburg City Council members have balked at a state-proposed bailout plan because they claim it places much of the burden on taxpayers without penalizing investors. Last year, City Councilman Brad Koplinski called the plan's 1% increase in the state-imposed income tax on Harrisburg residents "a bad decision for the people of Harrisburg, people who did nothing to get our city into our fiscal crisis.''

    Investors will hear more of this talk as municipalities face growing budget pressures. Recently, former New York Lt. Gov. Richard Ravitch warned the municipal bond industry that the promises governments have made to repay investors may not take precedent over other obligations. States and cities face "a unique challenge," he said, "in trying to maintain services and meet their retirement commitments to workers," emphasizing that this was "not necessarily a good message" for investors.

    Continued in article

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Bob Jensen's threads on creative accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    "GSA Blows Quarter Billion Dollars on Breaking Lease; Lies to Congress About It," by John Ransom, Townhall, June 3, 2013 --- Click Here
    http://finance.townhall.com/columnists/johnransom/2013/06/03/gsa-blows-quarter-billion-dollars-on-breaking-lease-lies-to-congress-about-it-n1611531?utm_source=thdaily&utm_medium=email&utm_campaign=nl

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm 

     


    "Improvements Are Needed to Enhance the Internal Revenue Service’s Internal Controls," by Steve n T . Miller,  Acting Commissioner of Internal Revenue, May 13, 2013 ---
    http://www.gao.gov/assets/660/654563.pdf


    Audit and Accounting Guide for Not-for-Profit Entities
    From Ernst &Young on March 28, 2013

    The American Institute of Certified Public Accountants (AICPA) has issued a comprehensive revision of its Audit and Accounting Guide, Not-for-Profit Entities, for the first time in 15 years. Questions raised as the Guide was being updated have resulted in new guidance from the Emerging Issues Task Force (EITF) on two not-for-profit topics. Our To the Point publication summarizes the guidance from the AICPA and the EITF.

    http://www.ey.com/Publication/vwLUAssetsAL/TothePoint_BB2518_NotforProfit_27March2013/$FILE/TothePoint_BB2518_NotforProfit_27March2013.pdf


    Do you believe this?  I don't believe this was an accounting mistake at all.
    It seems like more of a case of hidden reserves.

    "$42.6 million hidden in city fund through accounting error:  The money was found in a Transportation Department special fund, making officials wonder whether other misplaced money can be found," by Laura J. Nelson, Los Angeles Times, May 8, 2013 ---
    http://www.latimes.com/news/local/la-me-misplaced-money-20130510,0,4280581.story

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Teaching Case from The Wall Street Journal Accounting Weekly Review on May 9, 2013

    City (Harrisburg, Pa.) Hit by SEC Fraud Charges
    by: Kris Maher and Michael Corkery
    May 07, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Disclosure, Disclosure Requirements, Governmental Accounting, Municipal Bonds, SEC, Securities and Exchange Commission

    SUMMARY: The SEC has charged the city of Harrisburg, Pennsylvania, for insufficient disclosures of importance to their municipal bond investors. "The SEC found that the city's 2009 budget misstated Harrisburg's credit as being rated Aaa by Moody's Investors Service even though Moody's had downgraded the city's general obligation rating to Baa1. The city didn't disclose a subsequent downgrade by Moody's in February 2010 until March 2011. ...Moreover, the SEC said the city didn't submit annual financial information or audited financial statements between January 2009 and March 2011...[so that] '...financial information and notices available to the market were incomplete and outdated'...." The article quotes the CEO of a private-equity firm saying that "'this isn't just Harrisburg, there are lots more issuers like it....'" The related article discusses the new Commonwealth of Massachusetts investor web site and the last several questions provide an opportunity for students to investigate that web site.

    CLASSROOM APPLICATION: The article may be used to introduce the critical nature of government reports for investors in state and municipal bonds.

    QUESTIONS: 
    1. (Introductory) In what report(s) do city and town governments describe their fiscal health?

    2. (Advanced) With what charge did the Securities and Exchange Commission (SEC) fault the city of Harrisburg, Pennsylvania? What specific actions by the city led to this SEC action?

    3. (Advanced) Why does the SEC have influence over the financial reporting actions of the City of Harrisburg?

    4. (Introductory) Refer to the related article. What has Massachusetts done to provide information to investors in its state-government issued bonds?

    5. (Introductory) Access the Massachusetts disclosure web site at http://www.massbondholder.com/ What is the purpose of this web site?

    6. (Introductory) Again refer to the Massachusetts web site. Under KEY INITIATIVES, click on "Ratings Report Archive." What is available there? How does this archive address an issue raised by the SEC in relation to Harrisburg, PA?

    7. (Introductory) Again refer to the Massachusetts web site. Under KEY RESOURCES, click on "Investor Tools and Resources." Then click on "Bond Secondary Market Trading Activity." This page is also available directly at http://www.massbondholder.com/investor-resources/bond-secondary-market-trading-activity Click on the first year listed (2013) and then select the first CUSIP number. What information is available there? How does this information provide "transparency" about the market for Massachusetts bonds? In your answer, be sure to discuss the meaning of "transparency."
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    MoneyBeat: Massachusets Sees Itself as the Anti-Harrisburg
    by Andrew Ackerman
    May 07, 2013
    Online Exclusive

    "City (Harrisburg, Pa.) Hit by SEC Fraud Charges," by Kris Maher and Michael Corkery, The Wall Street Journal, May 8, 2013 ---
    http://online.wsj.com/article/SB10001424127887324326504578467121184204706.html?mod=djem_jiewr_AC_domainid

    The Securities and Exchange Commission has put local government officials on notice that it is closely monitoring the way they describe their cities' fiscal health, charging Harrisburg, Pa., with securities fraud for allegedly failing to disclose information on its financial troubles.

    Harrisburg agreed to settle the charges without admitting or denying the findings, and no fine was levied against it or city officials. The SEC faulted Harrisburg for allegedly making misleading financial statements from 2009 to 2011 outside its securities disclosure documents related to bond offerings, including in the city's budget report and a mayor's state-of-the-city address.

    t is the first time the regulator has brought such charges, and investors say other municipalities could face sanctions for issuing incomplete or misleading information about their finances.

    As much as 20% of the nearly 50,000 issuers of municipal debt in the U.S. don't supply timely disclosures after their bonds have been issued, according to analyst estimates.

    "This isn't just Harrisburg, there are lots more issuers like it,'' said Laurence Gottlieb, chairman and CEO of Fundamental Advisors, a private-equity firm that invests in distressed municipal debt.

    The Pennsylvania capital has been mired in debt for years. Its fiscal woes stem largely from years of cost overruns related to a troubled incinerator project. The city of 49,500 was nearly pushed into bankruptcy in 2011. Republican Gov. Tom Corbett declared a state of fiscal emergency, and a state court appointed a receiver to oversee the city's finances.

    The SEC found that the city's 2009 budget misstated Harrisburg's credit as being rated Aaa by Moody's Investors Service MCO +0.52% even though Moody's had downgraded the city's general obligation rating to Baa1. The city didn't disclose a subsequent downgrade by Moody's in February 2010 until March 2011.

    The SEC also took issue with Harrisburg officials for doing what many public officials often do: Putting a good face on a difficult situation. For example, in the state of the city address in 2009, Harrisburg's then-mayor described the incinerator as an "additional challenge'' and an "issue that can be resolved." In its order on Monday, the SEC called the address misleading because it didn't go into detail about the impact the incinerator debt was having on the city's finances.

    Moreover, the SEC said the city didn't submit annual financial information or audited financial statements between January 2009 and March 2011. "Harrisburg's financial information and notices available to the market were incomplete and outdated," the SEC said.

    "I would expect the SEC is going to be inquiring of other financially troubled cities: Are they lipsticking the pig?" said Matt Fabian, a managing director at Municipal Market Advisors.

    Mayor Linda Thompson, who has held office since 2010, said in a prepared statement Monday she was happy to have the matter concluded and called the settlement "a turning point" for the troubled city.

    Ms. Thompson said the SEC's charges "are what they are," and added that the city has "completely revamped its policies and procedures…to ensure that accurate and complete financial information" is made available to investors and the public in a timely manner.

    In recent years, the SEC has been stepping up its investigations in the $3.7 trillion municipal-debt market. In an interview, Elaine Greenberg, chief of the SEC's Municipal Securities and Public Pensions unit, said policing financial disclosures by cities, states and other municipal borrowers is a priority.

    Earlier this year, the SEC charged the state of Illinois for failing to adequately disclose in bond documents the shaky condition of the state pension system.

    The agency brought a similar case against New Jersey in August 2010. The states agreed to settle the charges without admitting wrongdoing.

    But with the Harrisburg case, the SEC is going even further by policing the accuracy of speeches and presentations of government officials. "Public officials should take steps to avoid misleading investors,'' Ms. Greenberg said.

    In deciding not to fine Harrisburg, Ms. Greenberg said the SEC considered the city's difficult financial condition. She declined to discuss the specific reasons why the SEC didn't cite individual Harrisburg officials, but noted that the agency issued a separate report on Monday that was meant to be a broad warning to public officials in the U.S. about their disclosure obligations.

    "We're glad to see that the SEC didn't levy any fines on the city. That could have made it more challenging," said Cory Angell, a spokesman for Harrisburg's current receiver, William Lynch.

    Continued in article

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Question
    How does the U.S. government hide its true debt total?

    Answer
    Firstly, there are $100-$200 trillion in unbooked entitlements. Nobody has an accurate estimate of those future obligations, especially for the Medicare gorilla.

    The U.S. currently has "booked" National Debt slightly over $16 trillion that is a more accurate estimate of the debt coming due soon?
    Or is this an accurate number by any stretch of the imagination?

    "Why $16 Trillion Only Hints at the True U.S. Debt:  Hiding the government's liabilities from the public makes it seem that we can tax our way out of mounting deficits. We can't," by Chris Cox (former SEC Director) and Bill Archer (PwC), The Wall Street Journal, November 26, 2012 ---
    http://professional.wsj.com/article/SB10001424127887323353204578127374039087636.html?mod=djemEditorialPage_t&mg=reno64-wsj

    A decade and a half ago, both of us served on President Clinton's Bipartisan Commission on Entitlement and Tax Reform, the forerunner to President Obama's recent National Commission on Fiscal Responsibility and Reform. In 1994 we predicted that, unless something was done to control runaway entitlement spending, Medicare and Social Security would eventually go bankrupt or confront severe benefit cuts.

    Eighteen years later, nothing has been done. Why? The usual reason is that entitlement reform is the third rail of American politics. That explanation presupposes voter demand for entitlements at any cost, even if it means bankrupting the nation.

    A better explanation is that the full extent of the problem has remained hidden from policy makers and the public because of less than transparent government financial statements. How else could responsible officials claim that Medicare and Social Security have the resources they need to fulfill their commitments for years to come?

    As Washington wrestles with the roughly $600 billion "fiscal cliff" and the 2013 budget, the far greater fiscal challenge of the U.S. government's unfunded pension and health-care liabilities remains offstage. The truly important figures would appear on the federal balance sheet—if the government prepared an accurate one.

    But it hasn't. For years, the government has gotten by without having to produce the kind of financial statements that are required of most significant for-profit and nonprofit enterprises. The U.S. Treasury "balance sheet" does list liabilities such as Treasury debt issued to the public, federal employee pensions, and post-retirement health benefits. But it does not include the unfunded liabilities of Medicare, Social Security and other outsized and very real obligations.

    As a result, fiscal policy discussions generally focus on current-year budget deficits, the accumulated national debt, and the relationships between these two items and gross domestic product. We most often hear about the alarming $15.96 trillion national debt (more than 100% of GDP), and the 2012 budget deficit of $1.1 trillion (6.97% of GDP). As dangerous as those numbers are, they do not begin to tell the story of the federal government's true liabilities.

    The actual liabilities of the federal government—including Social Security, Medicare, and federal employees' future retirement benefits—already exceed $86.8 trillion, or 550% of GDP. For the year ending Dec. 31, 2011, the annual accrued expense of Medicare and Social Security was $7 trillion. Nothing like that figure is used in calculating the deficit. In reality, the reported budget deficit is less than one-fifth of the more accurate figure.

    Why haven't Americans heard about the titanic $86.8 trillion liability from these programs? One reason: The actual figures do not appear in black and white on any balance sheet. But it is possible to discover them. Included in the annual Medicare Trustees' report are separate actuarial estimates of the unfunded liability for Medicare Part A (the hospital portion), Part B (medical insurance) and Part D (prescription drug coverage).

    As of the most recent Trustees' report in April, the net present value of the unfunded liability of Medicare was $42.8 trillion. The comparable balance sheet liability for Social Security is $20.5 trillion.

    Were American policy makers to have the benefit of transparent financial statements prepared the way public companies must report their pension liabilities, they would see clearly the magnitude of the future borrowing that these liabilities imply. Borrowing on this scale could eclipse the capacity of global capital markets—and bankrupt not only the programs themselves but the entire federal government.

    These real-world impacts will be felt when currently unfunded liabilities need to be paid. In theory, the Medicare and Social Security trust funds have at least some money to pay a portion of the bills that are coming due. In actuality, the cupboard is bare: 100% of the payroll taxes for these programs were spent in the same year they were collected.

    In exchange for the payroll taxes that aren't paid out in benefits to current retirees in any given year, the trust funds got nonmarketable Treasury debt. Now, as the baby boomers' promised benefits swamp the payroll-tax collections from today's workers, the government has to swap the trust funds' nonmarketable securities for marketable Treasury debt. The Treasury will then have to sell not only this debt, but far more, in order to pay the benefits as they come due.

    When combined with funding the general cash deficits, these multitrillion-dollar Treasury operations will dominate the capital markets in the years ahead, particularly given China's de-emphasis of new investment in U.S. Treasurys in favor of increasing foreign direct investment, and Japan's and Europe's own sovereign-debt challenges.

    When the accrued expenses of the government's entitlement programs are counted, it becomes clear that to collect enough tax revenue just to avoid going deeper into debt would require over $8 trillion in tax collections annually. That is the total of the average annual accrued liabilities of just the two largest entitlement programs, plus the annual cash deficit.

    Nothing like that $8 trillion amount is available for the IRS to target. According to the most recent tax data, all individuals filing tax returns in America and earning more than $66,193 per year have a total adjusted gross income of $5.1 trillion. In 2006, when corporate taxable income peaked before the recession, all corporations in the U.S. had total income for tax purposes of $1.6 trillion. That comes to $6.7 trillion available to tax from these individuals and corporations under existing tax laws.

     

    In short, if the government confiscated the entire adjusted gross income of these American taxpayers, plus all of the corporate taxable income in the year before the recession, it wouldn't be nearly enough to fund the over $8 trillion per year in the growth of U.S. liabilities. Some public officials and pundits claim we can dig our way out through tax increases on upper-income earners, or even all taxpayers. In reality, that would amount to bailing out the Pacific Ocean with a teaspoon. Only by addressing these unsustainable spending commitments can the nation's debt and deficit problems be solved.

    Neither the public nor policy makers will be able to fully understand and deal with these issues unless the government publishes financial statements that present the government's largest financial liabilities in accordance with well-established norms in the private sector. When the new Congress convenes in January, making the numbers clear—and establishing policies that finally address them before it is too late—should be a top order of business.

    Mr. Cox, a former chairman of the House Republican Policy Committee and the Securities and Exchange Commission, is president of Bingham Consulting LLC. Mr. Archer, a former chairman of the House Ways & Means Committee, is a senior policy adviser at PricewaterhouseCoopers LLP.

    Jensen Comment
    Let's forget about this debt and entitlement nonsense.
    President Obama should appoint Nobel Laureate Professor Paul Krugman as his only economic advisor and print all the money we owe without having to worry about taxes and spending and cliffs. It's called Quantitative Easing but by any other name it's just printing greenbacks to scatter over the money supply ---
    http://en.wikipedia.org/wiki/Quantitative_easing

    Not because we will need the money, but let's also confiscate the wealth of the top 25% as punishment for their abuses of the tax and regulation laws. Greed is a bad thing, and they need to be knocked to ground level because of their greed.

     

    Bob Jensen's threads on entitlements ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm

    Added Jensen Comment
    Whether or not you love or hate the scholarship and media presentations of the University of Chicago's Milton Friedman, I think you have to appreciate his articulate response on this historic Phil Donohue Show episode. Many of the current dire warnings about entitlements were predicted by him as one of the cornerstones in his 1970's PBS Series on "Free to Choose." We just didn't listen as we poured on unbooked national debt (over $100  trillion and not counting) for future generations to deal with rather than pay as we went so to speak! .
    The Grand Old Scholar/Researcher on the subject of greed in economics
    Video:  Milton Friedman answers Phil Donohue's questions about capitalism.--- http://www.cs.trinity.edu/~rjensen/temp/MiltonFriedmanGreed.wmv

    Bob Jensen's health care messaging updates --- http://faculty.trinity.edu/rjensen/Health.htm


    "USDA Inflated the Number of Jobs Created by Stimulus, IG Says," by Patrick Burke, CNS News, December 21, 2012 ---
    http://cnsnews.com/news/article/usda-inflated-number-jobs-created-stimulus-ig-says

    Department of Agriculture improperly inflated the numbers of jobs created or saved by the 2009 economic stimulus, according to the agency’s own Office of Inspector General (OIG).

    “[We] identified job numbers that were inflated because award recipients reported cumulative job numbers instead of the number of jobs created or saved during the quarter being reported. In other instances, job numbers were underreported,” according to an OIG audit released Dec. 13.

    The report claims that without accurate job figures, it is “difficult” to know whether the 2009 2009 American Recovery and Reinvestment Act was effective in creating or saving jobs.

    “Without accurate data about the number of jobs USDA agencies retained or created through the use of Recovery Act Funds, it is difficult to measure how effective the Department was in accomplishing a main Recovery Act objective, which was to create and retain jobs.”

    Individual reporting errors were not identified because of the inadequate “analytical tools” that USDA agencies were using to corroborate job numbers, the IG said. In addition to inflating job numbers, there were also instances of underreporting.

    Before posting job data on Recovery.gov  -- the government transparency Web site -- award recipients provide information via FederalReporting.gov, where information is verified by government agencies.

    As of March 31, 2011, USDA agencies had posted 4,960 awards amounting to $9.29 billion to Recovery.gov.

    However, USDA agencies did not properly verify information received by award recipients, who did not always provide accurate job numbers, according to the inspector general.

    “OIG determined that inaccurate job numbers were reported to FederalReporting.gov because recipients did not always report correct information and USDA agencies did not adequately analyze the number of jobs that award recipients were reporting,” the report said. “Not all recipients were aware of the OMB-required methodology for calculating jobs; consequently, they made errors when they reported.”

    Moreover, USDA agency representatives told the OIG that errors were overlooked and there was inadequate analysis to recognize errors.

    The OIG told CNSNews.com that it is “possible” that some job reporting errors occurred in other quarters as well.

    “It is possible: some of the recipients explained that the errors were caused due to their misunderstanding the requirements for reporting the number of jobs created,” the OIG said in a statement.

    “If recipients incorrectly reported the number of jobs created in the quarter ending March 31, 2011, and they used the same process to compute the number of jobs created in previous quarters, then errors would probably exist in the reporting for previous quarters.”

    The report analyzed a sample of 99 stimulus awards for the quarter between Jan.1 , 2011 and March 31, 2011 –which accounted for approximately 375 of the 1,200 jobs that were reportedly saved or created in that same quarter.

    From the sample of 99 awards, 33 contained job reporting errors.

    During the quarter ended March 31, 2011, USDA reported 10,600 jobs were created or saved due to Stimulus funding.

    To properly review data analysis procedures, OIG interviewed USDA agency representatives, reviewed laws and regulations and then conducted a “detailed review” of the 99 awards in the sample.

    The report recommends that USDA agencies ensure that job numbers correctly correspond to awards, and award recipients only report job numbers for individual quarters.

    “Direct agencies to develop data tests and guidance to improve their reviews of the jobs information reported on FederalReporting.gov,” the report said.

    “This includes, but is not limited to, ensuring that the project description fields match the number of jobs reported, recipients with multiple awards are reporting accurately, and recipients are reporting only the jobs created or saved during the quarter being reported.”

    Continued in article

    Governmental Accounting is Done With Smoke and Mirrors ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Bob Jensen's fraud updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    "The Debt Bomb That Taxpayers Won't See Coming ," by Steven Malanga, The Wall Street Journal, March 29, 2013 ---
    http://online.wsj.com/article/SB10001424127887324077704578362101467799948.html

    Earlier this month, the Securities and Exchange Commission charged Illinois officials with making misleading statements to bond investors about the state's pension system. The agency detailed a long list of deceptive practices including failure to tell investors that the system was so underfunded that it risked bankruptcy.

    Illinois taxpayers, as well as the holders of its debt, will ultimately bear the burden of the officials' misdeeds. But there is nothing unique about the Prairie State. For years, elected officials in states and municipalities across the country have been imprudently piling up obligations that are imposing serious strains on budgets, prompting higher taxes and cutbacks in services.

    In January, city officials in Sacramento, California's capital, reported the results of a study they had commissioned on all the debt that the municipality had incurred. At a City Council meeting that the Sacramento Bee reported as "sobering," the city manager explained that Sacramento had racked up some $2 billion in obligations (mostly pensions and retiree health care). All this for a municipality of 477,000 residents with an annual general fund budget of just $366 million.

    Sacramento finances are already stretched—the city has cut some 1,200 workers, or 20% of its workforce, in the past several years. Servicing its debt in years to come will only add more woe, especially given the intractability of public unions. The budget report noted that "While reducing staff is clearly not the preferred method for reducing costs, the city has a very limited ability to reduce the cost of labor absent cooperation from the city's employee groups."

    According to studies by the Pew Center on the States, states and the biggest cities have made nearly three-quarters of a trillion dollars in promises to pay for retiree health-care insurance. Yet governments have set aside only about 5% of the money they'll need to pay for these promises.

    This year a Chicago city commission reported that retiree health-care expenditures would soar from $109 million in this year's budget to $541 million in a decade. After concluding that the expenditures were unaffordable, one member of the commission proposed that retirees be required to sign on to the Illinois Health Insurance Exchange being created under President Obama's Affordable Care Act. Health insurance would be cheaper if it is subsidized by the federal government.

    A December report by the States Project, a joint venture of Harvard's Institute of Politics and the University of Pennsylvania's Fels Institute of Government, estimated that state and local governments now owe in sum a staggering $7.3 trillion. Incredibly, the vast majority of this debt has never been approved by taxpayers, who are often unaware of the extent of their obligations.

    Most state constitutions and many municipal charters limit borrowing and mandate voter approval. No matter. Politicians evade the limits, issuing billions of dollars in municipal offerings never approved by voters, sometimes with disastrous consequences. Courts have rubber-stamped many of these schemes.

    The debt incurred by New Jersey for school projects is a case in point. In 2001, legislators in Trenton hatched a scheme to borrow a shocking $8.6 billion for refurbishing school buildings. The reaction to their plan in the press and among taxpayer groups was so negative that the politicians knew that voters would never approve it. So the legislature created an independent borrowing authority. Since it, and not taxpayers, would take on the debt, politicians claimed that there was no need for voters' consent.

    Taxpayer groups challenged the maneuver. The state Supreme Court brushed aside their objections, arguing that there was already precedent for such borrowing.

    New Jersey's Schools Construction Corp. quickly squandered half of the money on patronage and inefficient construction practices, so in 2005 the state borrowed another $3.9 billion. All of the debt is being repaid by taxpayers. The authority, which was dissolved several years ago, had no revenues of its own.

    Next door, in New York, a scant 5% of the Empire State's $63 billion in outstanding debt has ever been authorized by voters, according to the state comptroller. The rest has been engineered through independent authorities such as the Transitional Finance Authority.

    These authorities are designed to circumvent voters. Of the seven bond offerings that have gone before New York voters in the past 25 years, four have been defeated. But thanks to unsanctioned debt, New Yorkers bear the second-highest per capita debt burden in the nation, $3,258, according to a January report by the state comptroller. New Jersey is No. 1, at $3,964.

    To prevent the pile-up of hidden debt, taxpayers need to spearhead a revolt that will narrow the ability of officials to mortgage their future. Any such revolt will first of all seek an end to government sponsored defined-benefit pension plans, through which politicians promise benefits years hence to current employees in a manner that potentially leaves taxpayers on the hook for unlimited liabilities. Simpler, defined-contribution plans featuring individual retirement accounts would make government pension systems less expensive and their accounting more transparent.

    Continued in article

    Jensen Comment
    I was wondering why my tax exempt bond fund keeps paying relatively high interest rates each month. Yipes! Now I know.


    "The Budget Baseline Con:  How Washington fools the public about spending 'cuts.'," The Wall Street Journal, December 4, 2012 ---
    http://professional.wsj.com/article/SB10001424127887323401904578157233680080150.html?mod=djemEditorialPage_t&mg=reno64-wsj

    If the fiscal cliff talks make Lindsay Lohan look like a productive member of society, perhaps it's because President Obama and John Boehner are playing by the dysfunctional Beltway rules. The rules work if you like bigger government, but Republicans need a new strategy, which starts by exposing the rigged game of "baseline budgeting."

    Both the White House and House Republicans are pretending that their goal is "reducing the deficit," which they suggest means making real spending choices. They are talking about a "$4 trillion plan," or something, regardless of how that number is reached.

    Here's the reality: Those numbers have no real meaning because they are conjured in the wilderness of mirrors that is the federal budget process. Since 1974, Capitol Hill's "baseline" has automatically increased spending every year according to Congressional Budget Office projections, which means before anyone has submitted a budget or cast a single vote. Tax and spending changes are then measured off that inflated baseline, not in absolute terms.

    The most absurd current example is Mr. Obama's claim that his "$4 trillion" plan reduces the deficit by about $800 billion over 10 years by ending the wars in Iraq and Afghanistan. But those "savings," as he calls them, are measured against a White House budget office spending baseline that is fictional. Those wars are already being unwound and everyone knows the money will never be spent. But they are called "savings" to gull the public and make the deficit reduction add up to a large-sounding $4 trillion.

    The baseline scam also exists in many states, and no less a Democrat than New York Governor Andrew Cuomo denounced it in 2011 as a "sham" and "deceptive." He wrote in the New York Post that state spending was "dictated by hundreds of rates and formulas that are marbleized throughout New York State laws that govern different programs—formulas that have been built into the law over decades, without regard to fiscal realities, performance or accountability." Then he proceeded to continue baseline budgeting.

    In Washington, Democrats designed this system to make it easier to defend annual spending increases and to portray any reduction in the baseline as a spending "cut." Chris Wallace called Timothy Geithner on this "gimmick" on "Fox News Sunday" this week, only to have the Treasury Secretary insist it's real.

    Republicans used to object to this game, but in recent years they seem to have given up. In an October 2010 speech at the American Enterprise Institute, House Speaker Boehner proposed that "we ought to start at square one" and rewrite the 1974 budget act. But he then dropped the idea, and in the current debate the GOP is putting itself at a major disadvantage by negotiating off the phony baseline. In a press release Tuesday, his own office advertised the need for "spending cuts" that aren't even cuts.

    If Republicans really want to slow the growth in spending, they need to stop playing by Beltway rules and start explaining to America why Mr. Obama keeps saying he's cutting spending even as spending and deficits keep going up and up and up.

    Bob Jensen's threads on how governmental accounting is all done with smoke and mirrors ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    David M. Walker --- http://en.wikipedia.org/wiki/David_M._Walker_%28U.S._Comptroller_General%29

    Career as Comptroller General

    Walker served as Comptroller General of the United States and head of the Government Accountability Office (GAO) from 1998 to 2008. Appointed by President Bill Clinton, his tenure as the federal government's chief auditor spanned both Democratic and Republican administrations. While at the GAO, Walker embarked on a Fiscal Wake-up Tour,[1] partnering with the Brookings Institution, the Concord Coalition, and the Heritage Foundation to alert Americans to wasteful government spending.[2] Walker left the GAO to head the Peterson Foundation on March 12, 2008.[3] Labor-management relations became fractious during Walker's nine-year tenure as comptroller general. On September 19, 2007, GAO analysts voted by a margin of two to one (897–445), in a 75% turnout, to establish the first union in GAO's 86-year history.

    Peter G. Peterson Foundation

    In 2008, Walker was personally recruited by Peter G. Peterson, co-founder of the Blackstone Group, and former Secretary of Commerce under Richard Nixon, to lead his new foundation. The Foundation distributed the documentary film, I.O.U.S.A. which follows Walker and Robert Bixby, director of the Concord Coalition, around the nation, as they engage Americans in town-hall style meetings, along with luminaries such as Warren Buffett, Alan Greenspan, Paul Volcker and Robert Rubin.

    Peterson was cited by the New York Times as one of the foremost "philanthropists whose foundations are spending increasing amounts and raising their voices to influence public policy."[5] In philanthropy, Walker has advocated a more action-based approach to the traditional foundation: “I do believe, however, that foundations have been very cautious and somewhat conservative about whether and to what extent they want to get involved in advocacy.”[5] David Walker stepped down as President and CEO of the Peter G. Peterson Foundation on October 15, 2010 to establish his own venture, the Comeback America Initiative

    Campaign for fiscal responsibility

    Walker has compared the present-day United States to the Roman Empire in its decline, saying the U.S. government is on a "burning platform" of unsustainable policies and practices with fiscal deficits, expensive overcommitments to government provided health care, swelling Medicare and Social Security costs, the enormous expense of a prospective universal health care system, and overseas military commitments threatening a crisis if action is not taken soon]

    Walker has also taken the position that there will be no technological change that will mitigate health care and social security problems into 2050 despite ongoing discoveries.

    In the national press, Walker has been a vocal critic of profligate spending at the federal level. In Fortune magazine, he recently warned that "from Washington, we'll need leadership rather than laggardship." in another op-ed in the Financial Times, he argued that the credit crunch could portend a far greater fiscal crisis;[11] and on CNN, he said that the United States is "underwater to the tune of $50 trillion" in long-term obligations.

    He favorably compares the thrift of Revolutionary-era Americans, who, if excessively in debt, would "merit time in debtors' prison", with modern times, where "we now have something closer to debtors' pardons, and that's not good."

    Other responsibilities

    Prior to his appointment to the GAO, Walker served as a partner and global managing director of Arthur Andersen LLP and in several government leadership positions, including as a Public Trustee for Social Security and Medicare from 1990 to 1995 and as Assistant Secretary of Labor for Pension and Welfare Benefit Programs during the Reagan administration. Before his time at Arthur Andersen, Walker worked for Source Finance, a personnel agency, and before that was in Human Resources at accounting firm Coopers & Lybrand.

    Continued in article

    In 2010 David Walker was admitted to the Accounting Hall of Fame --- Click Here
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/david-michael-walker/

    "Former comptroller general urges fiscally responsible reforms," by Ken Tysiac, Journal of Accountancy, October 6, 2012 ---
    http://journalofaccountancy.com/News/20126578.htm

    The giant red digits on the “U.S. Burden Barometer” outside the auditorium where David Walker spoke Friday provided the numbers behind this prominent CPA’s message: The United States urgently needs significant government financial reform.

    Counting upward at a feverish pace, the barometer represented an estimate of what Walker, a former U.S. comptroller general, calls the “federal financial sinkhole,” combining explicit liabilities, commitments and contingencies, and obligations to Social Security and Medicare.

    Shortly before Walker began his presentation, the number stood at $70,821,389,917,073.

    “It’s 70.8 trillion dollars, going up 10 million a minute, a hundred billion a week,” Walker told an audience consisting primarily of CPAs at the University of North Carolina at Chapel Hill. “So the federal financial sinkhole is much bigger than the politicians admit. It’s growing rapidly by them doing nothing, and they’ve become very adept at doing nothing. And something has got to be done.”

    Walker, a political independent, headed the U.S. Government Accountability Office from 1998 to 2008. As CEO of the not-for-profit Comeback America Initiative, he is promoting fiscal responsibility and seeking solutions to federal, state, and local fiscal imbalances in the United States.

    His tour, which is barnstorming 16 states in 34 days, ends Tuesday and positions Walker as one of the leading sentinels in a growing chorus of concern over the economic direction of the United States at an important time. With a presidential election closing in on its final days, one of the most persistent questions both candidates face is how they will handle the economy, taxes, and the federal deficit.

    Educating the public about the deficit and the important, difficult, disciplined action that could bring it under control is Walker’s passion. He warns of the impending “fiscal cliff” the nation faces in January 2013 as the result of the scheduled expiration of various tax provisions, and says a U.S. debt crisis is possible within two years.

    He comes armed on his tour with statistics that demonstrate the financial peril that government spending and deficits have brought for the United States. His PowerPoint slides show that:

    • Federal spending as a percentage of GDP has grown from 2% in 1912 to 24% in 2012.
    • Total government debt in the U.S. is estimated to be 137.8% of the economy, when intra-governmental holdings are included, in 2012.
    • Publicly held federal debt as a percentage of GDP is projected to grow to 185% by 2035, according to one scenario in the Congressional Budget Office’s long-term outlook.


    “The federal government has grown too big, promised too much, lost control of the budget, waited too long to restructure, and it needs fundamental restructuring,” Walker said during an interview before the event. “Not nip and tuck. Radical reconstructive surgery done in installments over a period of time.”

    Walker showed that defense spending in the United States in 2010 exceeded the combined total spent by 15 other nations, including China, Russia, France, the U.K., Japan, Saudi Arabia, India, and Germany. And he showed that U.S. per capita health care costs ($7,960) were more than double the OECD average ($3,361) and far outpaced those of Canada ($4,363) and Germany ($4,218).

    He wants to reform budgeting, Social Security, health care, Medicare and Medicaid, defense spending, and the tax code.

    He envisions measures that tie debt to GDP targets as needed reforms of federal budget controls. He advocates suspending the pay of members of Congress if they fail to pass a budget. With regard to Social Security, he would raise the taxable wage base cap, gradually raise the retirement eligibility ages, and revise the benefit structure based on income.

    Walker would guarantee a basic level of health coverage for all citizens, revise payment practices to be evidence based, and phase out the tax exclusion for employer-provided health insurance, which he says estimates show will cost the federal government a total of more than $650 billion from 2010 to 2014. He would impose an annual budget for Medicare and Medicaid spending, and make Medicare premium subsidies more needs based.

    He would reform the military by requiring cost consideration in defense planning, “right-sizing” bases and force structure, and modernizing purchasing and compensation practices. He also would reform individual and corporate federal income taxes, increasing the effective tax paid by the wealthy and decreasing the number of citizens who pay no income tax.

    At an event whose sponsors included the AICPA, the North Carolina Association of Certified Public Accountants, and the N.C. Chamber of Commerce, Walker said CPAs have an important role to play in bringing about these changes.

    “I believe that CPAs have a disproportionate opportunity and an obligation to be informed and involved here,” Walker said. “They’re good with numbers. They’re respected by the public. And I think that our profession, really, ought to be leaders in this area.”

    The AICPA has long been a leading advocate for comprehensive reform that would simplify tax laws without reducing the productive capacity of the economy. In addition, the AICPA works as a proponent of personal financial literacy and fiscal responsibility through efforts such as 360 Degrees of Financial Literacy and What’s at Stake.”

    Anthony Pugliese, AICPA senior vice president–Finance, Operations and Member Value, said Walker’s message was on point with the Institute’s initiatives promoting financial literacy and responsibility at the consumer, business, and government levels.

    “We hope our members can make a difference. We know they can make a difference with the clients they serve and small business owners around the country and individual consumers,” Pugliese said. “We hope this message is spread, and I think we have a vital role to play in this.”

    Walker said that political changes need to be made in order to bring about all these other transformations that would put the United States on a better fiscal path. He encourages development of a strategic framework for the federal government and creation of a government transformation task force. He calls for Congressional redistricting reform, integrated and open primaries, campaign finance reform, and term limits.

    Continued in article

    Bob Jensen's threads on the pending economic collapse of the United States ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm


    "The looming shortfall in public pension costs," by Robert Novy-Marx and Josh Rauh, The Washington Post, October 10, 2012 --- Click Here
    http://www.washingtonpost.com/opinions/the-looming-shortfall-in-public-pension-costs/2012/10/19/5b394cdc-0ced-11e2-bd1a-b868e65d57eb_story.html?utm_source=Stanford+Business+Re%3AThink&utm_campaign=1451d355ee-RTIssue2&utm_medium=email

    How much will the underfunded pension benefits of government employees cost taxpayers? The answer is usually given in trillions of dollars, and the implications of such figures are difficult for most people to comprehend. These calculations also generally reflect only legacy liabilities — what would be owed if pensions were frozen today. Yet with each passing day, the problem grows as states fail to set aside sufficient funds to cover the benefits public employees are earning.

    In a recent paper, we bring the problem closer to home. We studied how much additional money would have to be devoted annually to state and local pension systems to achieve full funding in 30 years, a standard period over which governments target fully funded pensions. Or, to put a finer point on it, we researched: How much will your taxes have to increase?

    Robert Novy-Marx is an assistant professor of finance at the University of Rochester’s Simon Graduate School of Business. Joshua Rauh is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.

    "The Revenue Demands of Public Employee Pension Promises," by Robert Novy-Marx and Joshua D. Rauh, SSRN, September 16, 2012 ---
    http://papers.ssrn.com/SOL3/PAPERS.CFM?ABSTRACT_ID=1973668

    We calculate increases in contributions required to achieve full funding of state and local pension systems in the U.S. over 30 years. Without policy changes, contributions would have to increase by 2.5 times, reaching 14.1% of the total own-revenue generated by state and local governments. This represents a tax increase of $1,385 per household per year, around half of which goes to pay down legacy liabilities while half funds the cost of new promises. We examine sensitivity to asset return assumptions, wage correlations, the treatment of workers not currently in Social Security, and endogenous geographical shifts

    Bob Jensen's threads on underfunded pensions and bad accounting rules ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Question
    What do the following states sadly share in common"

    Hint
    You know it must be really bad if California did not make the list.

    "Nine States with Sinking Pensions," 247 Wall Street, October 18, 2012 --- Click Here
    http://247wallst.com/2012/10/18/nine-states-with-sinking-pensions/?utm_source=247WallStDailyNewsletter&utm_medium=email&utm_content=OCT182012A&utm_campaign=DailyNewsletter

    Several years after from the financial crisis of 2008, state pension funds continue to languish. According to data released this week by Milliman, Inc. and by the Pew Center on the States, there was a $859 billion gap between the obligations of the country’s 100 largest public pension plans and the funding of these pensions. Most of these are state funds, and state legislatures have attempted to respond to this growing crisis by making numerous reforms to try to combat this growing deficit.

    In 2010, only Wisconsin’s pension funds were fully funded. Nine states, meanwhile, were 60% funded or less — this would mean that at least 40% of the amount the state owes current and future retirees is not in the state’s coffers. In Illinois, just 45% of the state’s pension liabilities were funded. In some of these states, the gap between the outstanding liability and the amount funded was in the tens of billions of dollars. California alone had $113 billion in unfunded liability. Based on Pew’s report, “The Widening Gap Update,” 24/7 Wall St. identified the nine states with sinking pensions.

    Each year, actuaries determine how much a state should contribute to its pensions to keep them funded. Many states, for various reasons, did not pay the full recommended contributions for 2010, while others have been paying the recommended amount for years. In an interview with 24/7 Wall St., Milliman Inc. principal and consulting actuary Becky Sielman explained that despite states making the recommended payments, many large individual public retirement funds are still underfunded.

    Of the nine states with pensions that are underfunded by 40% or more, three paid more than 90% of the recommended contributions, and two, Rhode Island and New Hampshire, paid the full amount. Despite this, pension contributions were still generally higher in states that were better funded. Of the 16 states that were at least 80% funded — a level experts consider to be fiscally responsible — 11 contributed at least 97% of the recommended amount.

    In an interview with 24/7 Wall St., Pew Center on the States senior researcher David Draine explained why, despite paying the full amount, several states continued to be severely underfunded. He pointed out that meeting contributions was important. He added that states that made full contributions in 2010 were 84% funded on average, compared to those that did not, which were only 72% funded.

    To explain why several states that are making full contributions are still underfunded, Draine said much of it has to do with investment losses. “The 2000s have been a terrible period for pension investments that have fallen short of their expectations … that’s a big part of the growth in the funding gap.”

    Unfunded liability can also grow due to overly optimistic assumptions about investment growth, pension payments that become deferred, and an increase in benefits or an increase in the number of beneficiaries without a corresponding increase in contributions, Draine explained.

    Based on the Pew Center for the States report, “The Widening Gap Update,” 24/7 Wall St. identified the nine states with public pensions that were 60% or less funded as of 2010. From the report, we considered the total outstanding liability, the total amount funded, and the proportion of the recommended contribution each state made in 2010. We also reviewed the level of funding for the 100 largest pension funds in each state, provided by Milliman’s Public Pension Fund Study, which covered a period from June 30, 2009, to January 1, 2011.

    Continued in article


    From The Wall Street Journal Accounting Weekly Review on October 12, 2012

    Another California City Struggles With Finances
    by: Bobby White
    Oct 05, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Bankruptcy, Cost Management, Governmental Accounting

    SUMMARY: "The small agricultural town of Atwater, Calif., has declared a fiscal emergency, as is seeks to avoid becoming the fourth municipality in the state this year to file for bankruptcy...Atwater is the latest California town to publicly edge down the road toward bankruptcy. Under state law, a local government must declare a 'fiscal emergency' or go through a confidential negotiation process with its creditors before it files a petition under chapter 9 of the U.S. Bankruptcy Code."

    CLASSROOM APPLICATION: The article is useful for governmental accounting classes to highlight the particular managerial issues facing cities and towns. While the article focuses on California and specifics of state laws there impact the issues discussed, those specifics also help students to understand the constraints faced by many cities and towns in other locations.

    QUESTIONS: 
    1. (Introductory) Based on the discussion in the article, what towns in California face financial difficulties? What reasons led to this dire situation?

    2. (Advanced) What particular state law makes it difficult for California towns to cope with rapid financial changes?

    3. (Introductory) Beyond the factors affecting many California towns, what particular problems have beset the town of Atwater?

    4. (Advanced) What strategies did the town of Atwater use to cope with emerging financial problems? How did these strategies actually exacerbate the problems?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Another California City Struggles With Finances," by: Bobby White, The Wall Street Journal, October 5, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443493304578036781420348220.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    The small agricultural town of Atwater, Calif., has declared a fiscal emergency, as it seeks to avoid becoming the fourth municipality in the state this year to file for bankruptcy protection.

    Located about 100 miles east of San Francisco, Atwater is grappling with a $3 million budget deficit, declining city revenues and cost overruns for a new wastewater treatment plant.

    The town on Wednesday declared the emergency, which under state law allows it to restructure union contracts, including imposing salary reductions and benefit cuts without negotiations. "We're working hard to balance the budget and avoid bankruptcy," said Joan Faul, Atwater's mayor.

    She said the city of 28,000 people earlier this week laid off 14 employees, or about 16% of its workforce. She said the city was exploring options for increasing revenue, such as raising rates for water services and for garbage collection. The Atwater City Council is scheduled to meet Oct. 22 to discuss whether it should file for bankruptcy.

    Atwater is the latest California town to publicly edge down the road toward bankruptcy.Under state law, a local government must declare a "fiscal emergency" or go through a confidential negotiation process with its creditors before it files a petition under Chapter 9 of the U.S. Bankruptcy Code.

    Since June, three California cities—Stockton, San Bernardino and Mammoth Lakes—have filed for bankruptcy protection. The city of Vallejo emerged from bankruptcy last year after declaring Chapter 9 in 2008.

    The string of fiscal emergencies and bankruptcies highlights the continuing impact of the 2008 recession, which hit many of the cities hard by lowering property-tax revenues. At the same time, many towns are grappling with rising costs related to employees' pensions, health-care costs and union salaries. California cities face particular hurdles in raising taxes, for which they often have to seek voter approval.

    Declaring a fiscal emergency doesn't always lead to bankruptcy discussions. The California towns of La Mirada, Fairfield and Culver City are among those that declared fiscal emergencies this year and placed sales tax increases before voters; they didn't end up seeking Chapter 9.

    Still, Doug Scott, a managing director with Fitch Ratings Agency, said Atwater remained a bankruptcy candidate because the city has used restricted funds from its water and sewer service to pay other bills, a practice that has now made it difficult for the city to meet debt payments. Last month, Fitch downgraded Atwater's debt to noninvestment grade, citing poor handling of its respective funds. "We're concerned about the direction this city is headed," said Mr. Scott.

    Atwater has struggled since 2008 over how to pay for construction cost overruns for a new $90 million wastewater treatment facility. The city issued $85 million in bonds to pay for the construction, which wasn't enough.

    As Ms. Faul explained it, officials later used money designated for other services to pay the extra construction costs, but the practice began depleting funds. The 2008 economic downturn further hindered Atwater's ability to pay its bills by hitting property-tax revenues.

    Atwater has introduced city staff furloughs and hiring freezes to curb some of the losses. "We're doing everything we can to avoid bankruptcy," Ms. Faul said.

     

    Bob Jensen's threads on the sad state of governmental accounting are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    "Mayer Hoffman McCann Blows a Bunch of Hot GAAS (And a Serious Audit) ," Los Angeles Times via Jr. Deputy Accountant, December 22, 2010 ---
    http://www.jrdeputyaccountant.com/2010/12/mayer-hoffman-mccann-blows-bunch-of-hot.html

    "Murky Signals for Congress on Insider Trading," by Peter J Henning, The New York Times, November 25, 2011 ---
    http://dealbook.nytimes.com/2011/11/25/murky-signals-for-congress-on-insider-trading/

    . . .

    An insider trading investigation typically requires the S.E.C. to subpoena records to determine what information a person who traded or tipped had at a particular point in time, and who the person communicated with. Once it gathers the relevant documents, the S.E.C. usually takes the testimony of those who may have been involved in the transaction, which could require questioning representatives and senators about the likelihood of legislative action to establish the information was material.

    The House and Senate bills specifically prohibit trading on “pending or prospective legislative action,” which means a focal point of any insider trading inquiry will be on information generated as part of the legislative process. But that information is at the heart of the Speech or Debate Clause protection, which prevents any questioning of members of Congress or their staff about that process to preserve the independence of the legislative branch.

    Passing the legislation would do little good if the S.E.C. and the Justice Department would be stymied in trying to conduct an investigation by an assertion of the Speech or Debate Clause to stop the case dead in its tracks. Congress could try to waive the constitutional protection in advance as part of any law it passes, but it is not clear whether that would prevent an individual member from asserting it in a particular case in the future. Opening Congress to the possibility of a wide-ranging S.E.C. or Justice Department inquiry is unlikely to go over well with members suspicious of the motives of the executive branch.

    Passing a law for the sake of public perception when it could not be enforced would be the height of cynicism. Before extending the prohibition on insider trading based on legislative information, Congress will have to grapple with the question whether it is willing to open itself up to being investigated if any of its members and their staff misuse that information for personal gain.

     


    Who is Telling the Truth?  The Fact Wars" as written on the Cover of Time Magazine

    Jensen Comment
    Both U.S. presidential candidates are spending tends of millions of dollars to spread lies and deceptions.
    Both are alleged Christian gentlemen, a faith where big lies are sins jeopardizing the immortal soul.
    The race boils down to the sad fact that the biggest Christian liar will win the race for the presidency in November 2012.

    "Who is Telling the Truth?  The Fact Wars:  ," as written on the Cover of Time Magazine
    "Blue Truth-Red Truth: Both candidates say White House hopefuls should talk straight with voters. Here's why neither man is ready to take his own advice ,"
    by Michael Scherer (and Alex Altma), Time Magazine Cover Story, October 15, 2012, pp. 24-30 ---
    http://www.cs.trinity.edu/~rjensen/temp/PresidentialCampaignLies2012.htm

     



    The Wonk (Professor) Who Slays Washington

    Insider trading is an asymmetry of information between a buyer and a seller where one party can exploit relevant information that is withheld from the other party to the trade. It typically refers to a situation where only one party has access to secret information while the other party has access to only information released to the public. Financial markets and real estate markets are usually very efficient in that public information is impounded pricing the instant information is made public. Markets are highly inefficient if traders are allowed to trade on private information, which is why the SEC and Justice Department track corporate insider trades very closely in an attempt to punish those that violate the law. For example, the former wife of a partner in the auditing firm Deloitte & Touche was recently sentenced to 11 months exploiting inside information extracted from him about her husband's clients. He apparently did was not aware she was using this inside information illegally. In another recent case, hedge fund manager Raj Rajaratnam was sentenced to 11 years for insider trading.

    Even more commonly traders who are damaged by insiders typically win enormous lawsuits later on for themselves and their attorneys, including enormous punitive damages. You can read more about insider trading at
    http://en.wikipedia.org/wiki/Insider_trading

    Corporate executives like Bill Gates often announce future buying and selling of shares of their companies years in advance to avoid even a hint of scandal about exploiting current insider information that arises in the meantime. More resources of the SEC are spent in tracking possible insider information trades than any other activity of the SEC. Efforts are made to track trades of executive family and friends and whistle blowing is generously rewarded.

    Question
    Trading on insider information is against U.S. law for every segment of society except for one privileged segment that legally exploits investors for personal gains by trading on insider information. What is that privileged segment of U.S. society legally trades on inside information for personal gains?

    Hints:
    Congress is our only native criminal class.
    Mark Twain --- http://en.wikipedia.org/wiki/Mark_Twain

    We hang the petty thieves and appoint the great ones to public office.
    Attributed to Aesop

    Answer (Please share this with your students):
    Over the years I've been a loyal viewer of the top news show on television --- CBS Sixty Minutes
    On November 13, 2011 the show entitled "Insider" is the most depressing segment I've ever watched on television ---
    http://www.cbsnews.com/video/watch/?id=7387951n&tag=contentMain;contentBody#ixzz1dfeq66Ok
    Also see http://financeprofessorblog.blogspot.com/2011/11/congress-trading-stock-on-inside.html

    Jensen Comment

    Watch the "Insider" Video Now While It's Still Free ---
    http://www.cbsnews.com/video/watch/?id=7387951n&tag=contentMain;contentBody

    "They have legislated themselves as untouchable as a political class . . . "
    "The Wonk (Professor) Who Slays Washington," by Peter J. Boyer, Newsweek Magazine, November 21, 2011, pp. 32-37 ---
    http://www.thedailybeast.com/newsweek/2011/11/13/peter-schweizer-s-new-book-blasts-congressional-corruption.html

    In the Spring of 2010, a bespectacled, middle-aged policy wonk named Peter Schweizer fired up his laptop and began a months-long odyssey into a forbidding maze of public databases, hunting for the financial secrets of Washington’s most powerful politicians. Schweizer had been struck by the fact that members of Congress are free to buy and sell stocks in companies whose fate can be profoundly influenced, or even determined, by Washington policy, and he wondered, do these ultimate insiders act on what they know? Yes, Schweizer found, they certainly seem to. Schweizer’s research revealed that some of Congress’s most prominent members are in a position to routinely engage in what amounts to a legal form of insider trading, profiting from investment activity that, he says, “would send the rest of us to prison.”

    Schweizer, who is 47, lives in Tallahassee with his wife and children (“New York or D.C. would be too distracting—I’d never get any writing done”) and commutes regularly to Stanford, where he is the William J. Casey research fellow at the Hoover Institution. His circle of friends includes some bare-knuckle combatants in the partisan frays (such as conservative media impresario Andrew Breitbart), but Schweizer himself comes across more as a bookish researcher than the right-wing hit man liberal critics see. Indeed, he sounds somewhat surprised, if gratified, to have attracted attention with his findings. “To me, it’s troubling that a fellow at Stanford who lives in Florida had to dig this up.”
    It was in his Tallahassee office that Schweizer began what he thought was a promising research project: combing through congressional financial-disclosure records dating back to 2000 to see what kinds of investments legislators were making. He quickly learned that Capitol Hill has quite a few market players. He narrowed his search to a dozen or so members—the leaders of both houses, as well as members of key committees—and focused on trades that coincided with big policy initiatives of the sort that could move markets.

    While examining trades made around the time of the 2003 Medicare overhaul, Schweizer experienced what he calls his “Holy crap!” moment. The legislation, which created a new prescription-drug entitlement, promised to be a huge boon to the pharmaceutical industry—and to savvy investors in the Capitol. Among those with special insight on the issue was Massachusetts Sen. John Kerry, chairman of the health subcommittee of the Senate’s powerful Finance Committee. Kerry is one of the wealthiest members of the Senate and heavily invested in the stock market. As the final version of the drug program neared approval—one that didn’t include limits on the price of drugs—brokers for Kerry and his wife were busy trading in Big Pharma. Schweizer found that they completed 111 stock transactions of pharmaceutical companies in 2003, 103 of which were buys.

    “They were all great picks,” Schweizer notes. The Kerrys’ capital gains on the transactions were at least $500,000, and as high as $2 million (such information is necessarily imprecise, as the disclosure rules allow members to report their gains in wide ranges). It was instructive to Schweizer that Kerry didn’t try to shape legislation to benefit his portfolio; the apparent key to success was the shaping of trades that anticipated the effect of government policy.

    Continued in article

    Jensen Questions
    If all these transactions were only by chance profitable, why is it that the representatives, senators, and their trust investors always profited and never lost in dealings connected to inside information?

    More importantly why did representatives and senators who write the laws have to write themselves in as exempt from insider trading laws?

    Why aren't national leaders like Nancy Pelosi, John Kerry, and John Boehner who vigorously deny inside trading actively seeking to overturn laws that exempt representatives and senators from insider trading lawsuits? Why do they still hold themselves above their own law?

    Why have representatives and senators buried reform legislation concerning their insider trading exemption so deep in the legislative process that there's zero hop of reforming themselves against abuses of insider trading and exploitation of other investors?

    Watch the "Insider" Video Now While It's Still Free ---
    http://www.cbsnews.com/video/watch/?id=7387951n&tag=contentMain;contentBody

    THIS IS HOW YOU FIX CONGRESS!!!!!
    If you agree with the above, pass it on.
    Warren Buffett, in a recent interview with CNBC, offers one of the best quotes about the debt ceiling:"I could end the deficit in 5 minutes," he told CNBC. "You just pass a law that says that anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election. The 26th amendment (granting the right to vote for 18 year-olds) took only 3 months & 8 days to be ratified! Why? Simple! The people demanded it. That was in1971...before computers, e-mail, cell phones, etc. Of the 27 amendments to the Constitution, seven (7) took 1 year or less to become the law of the land...all because of public pressure.Warren Buffet is asking each addressee to forward this email to a minimum oftwenty people on their address list; in turn ask each of those to do likewise. In three days, most people in The United States of America will have the message. This is one idea that really should be passed around.*Congressional Reform Act of 2011......
    1. No Tenure / No Pension. A Congressman collects a salary while in office and receives no pay when they are out of office.

    2.. Congress (past, present & future) participates in Social Security. All funds in the Congressional retirement fund move to the Social Security system immediately. All future funds flow into the Social Security system,and Congress participates with the American people. It may not be used for any other purpose..

    3. Congress can purchase their own retirement plan, just as all Americans do...

    4. Congress will no longer vote themselves a pay raise. Congressional pay will rise by the lower of CPI or 3%.

    5. Congress loses their current health care insurance and participates in the same health care plan as the American people.

    6. Congress must equally abide by all laws they impose on the American people..

    7. All contracts with past and present Congressmen are void effective 1/1/12. The American people did not make this contract with Congressmen. Congressmen made all these contracts for themselves. Serving in Congress is an honor,not a career. The Founding Fathers envisioned citizen legislators, so ours should serve their term(s), then go home and back to work.


    If each person contacts a minimum of twenty people then it will only take
    three days for most people (in the U.S.) to receive the message. Maybe it is
    time.


    PLEASE PASS THIS ON

    Read more: http://www.cbsnews.com/video/watch/?id=7387951n&tag=contentMain;contentBody#ixzz1dfeq66Ok
     

    Holman Jenkins of The Wall Street Journal contends that in total representatives and senators do not perform better (possibly even worse) than average investors in the stock market ---
    http://online.wsj.com/article/SB10001424052970204190504577039834018364566.html?mod=djemEditorialPage_t
    What he does not mention is that opportunities to trade on inside information is generally infrequent and often limited to a few members of a particular legislative committee receiving insider testimony or preparing to release committee recommendations to the legislature.

    Jenkins misses the entire point of insider trading. If it was a daily event in the public or private sector it would be squashed even harder than it is now being squashed, because rampant insider trading would drive the public away from the financial and real estate markets. The trading markets survive this cancer because it is relatively infrequent when it does take place among corporate executives (illegally) or our legislators (legally).

     

    Feeling cynical?
    They say that patriotism is the last refuge
    To which a scoundrel clings.
    Steal a little and they throw you in jail,
    Steal a lot and they make you king.
    There's only one step down from here, baby,
    It's called the land of permanent bliss. 
    What's a sweetheart like you doin' in a dump like this?

    Lyrics of a Bob Dylan song forwarded by Amian Gadal [DGADAL@CI.SANTA-BARBARA.CA.US

    If the law passes in its current form, insider trading by Congress will not become illegal.
    "Congress's Phony Insider-Trading Reform:  The denizens of Capitol Hill are remarkable investors. A new law meant to curb abuses would only make their shenanigans easier," by Jonathan Macey, The Wall Street Journal, December 13, 2011 ---
    http://online.wsj.com/article/SB10001424052970203413304577088881987346976.html?mod=djemEditorialPage_t

    Members of Congress already get better health insurance and retirement benefits than other Americans. They are about to get better insider trading laws as well.

    Several academic studies show that the investment portfolios of congressmen and senators consistently outperform stock indices like the Dow and the S&P 500, as well as the portfolios of virtually all professional investors. Congressmen do better to an extent that is statistically significant, according to studies including a 2004 article about "abnormal" Senate returns by Alan J. Ziobrowski, Ping Cheng, James W. Boyd and Brigitte J. Ziobrowski in the Journal of Financial and Qualitative Analysis. The authors published a similar study of the House this year.

    Democrats' portfolios outperform the market by a whopping 9%. Republicans do well, though not quite as well. And the trading is widespread, although a higher percentage of senators than representatives trade—which is not surprising because senators outperform the market by an astonishing 12% on an annual basis.

    These results are not due to luck or the financial acumen of elected officials. They can be explained only by insider trading based on the nonpublic information that politicians obtain in the course of their official duties.

    Strangely, while insider trading by corporate insiders has long been the white collar crime equivalent of a major felony, the Securities and Exchange Commission has determined that insider trading laws do not apply to members of Congress or their staff. That is because, according to the SEC at least, these public officials do not owe the same legal duty of confidentiality that makes insider trading illegal by nonpoliticians.

    The embarrassing inconsistency was ignored for years. All of this changed on Nov. 13, 2011, after insider trading on Capitol Hill was the focus of CBS's "60 Minutes." The previously moribund "Stop Trading on Congressional Knowledge Act" (H.R. 1148), first introduced in 2006, was pulled off the shelf and reintroduced. The bill suddenly had more than 140 sponsors, up from a mere nine before the show.

    The "Stock" Act, as it is called, would make it illegal for members of Congress and staff to buy or sell securities based on certain nonpublic information. It would toughen disclosure obligations by requiring congressmen and their staffers to report securities trades of more than $1,000 to the clerk of the House (or the secretary of the Senate) within 90 days. And it would bring the new cottage industry in Washington, the so-called political intelligence consultants used by hedge funds, under the same rules that govern lobbyists. These political intelligence consultants are hired by professional investors to pry information out of Congress and staffers to guide trading decisions.

    Publicly, House members echo bill sponsor Rep. Louise Slaughter (D., N.Y) in saying things like: "We want to remove any current ambiguity" about whether insider trading rules apply to Congress. Or as co-sponsor Rep. Timothy Walz (D., Minn.) put it: "We are trying to set the bar higher for members of Congress."

    On closer examination, it appears that what Congress really wants is to keep making the big bucks that come from trading on inside information but to trick those outside of the Beltway into believing they are doing something about this corruption. For one thing, the rules proposed for Capitol Hill are not like those that apply to the rest of us. Ours are so broad and vague that prosecutors enjoy almost unfettered discretion in deciding when and whom to prosecute.

    Congress's rules would be clear and precise. And not too broad; in fact they are too narrow. For example, the proposed rules in the Stock bill are directed only at information related to pending legislation. It would appear that inside information obtained by a congressman during a regulatory briefing, or in another context unrelated to pending legislation, would not be covered.

    At a Dec. 6 House hearing, SEC enforcement chief Robert Khuzami opined that any new rules for Congress should not apply to ordinary citizens. He worried that legislators might "narrow current law and thereby make it more difficult to bring future insider trading actions against individuals outside of Congress."

    This don't-rock-the-boat approach serves the interests of the SEC because it maximizes the commission's power and discretion, but it's not the best approach. The sensible thing to do would be to rationalize the rules by creating a clear definition of what constitutes insider trading, and then apply those rules to everyone on and outside Capitol Hill.

    If the law passes in its current form, insider trading by Congress will not become illegal. I predict such trading will increase because the rules of the game will be clearer. Most significantly, the rule proposed for Congress would not involve the same murky inquiry into whether a trader owed or breached a "fiduciary duty" to the source of the information that required that he refrain from trading.

    Continued in article

    Bob Jensen's threads on Rotten to the Core ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm

     


    "Public Sector Pensions: 'Their Accounting Makes Enron Look Good'," Knowledge@Wharton, September 26, 2012 ---
    http://knowledge.wharton.upenn.edu/article.cfm?articleid=3080

    The growing debt crisis in public sector pensions -- governments face a $757 billion shortfall in funding their retirement promises, according to one estimate -- is coming at a time when unprecedented numbers of baby boomers are reaching retirement age. About 10,000 members of that generation are turning 65 every day, according to the Pew Research Data Center.

    In better-funded pension plans, the slew of retirements is a blip on the radar, a demographic shift that was foreseen decades earlier and properly funded. But in shakier systems, the retirements are being met with cuts to benefits across the board -- for new employees, current workers and retirees alike -- benefits that were once considered cast in stone. A generation of workers is now wondering if their pensions will still be able to pump out the funds they need to pay the bills in retirement.

    "That's a very common worry, and it's wholly justified," says Olivia Mitchell, a professor of business economics and public policy, and executive director of Wharton's Pension Research Council. "I think the whole prospect of retirement has grown much riskier than for those in previous generations. Employer-provided retiree medical plans are being cut; Medicare as we know it is facing insolvency. People hoped to retire on their little bit of savings that now is paying no interest, and Social Security is in bad shape. Homes aren't worth what people thought they would be, so nest eggs are a lot tinier.... It's not a very pretty picture for a lot of people."

    Distributing the Pain

    In defined benefit pension plans, retirees are paid a fixed monthly amount every month until they die. Often the payments are subject to cost-of-living raises, and most plans include a survivor's benefit if the employee's spouse outlives him or her.

    A defined contribution plan, like a 401(k), shifts the retirement risk to the employee. Employers allow workers to contribute a percentage of their salaries to the plan, and often match the contributions up to a certain threshold. The plans are more portable than pensions, allowing workers to move their investments as they switch jobs, but it is up to the workers to save, manage their investments and then make sure their nest eggs are sufficient for their retirement years.

    Defined benefit pensions are generally confined to the government sector now, as most private sector employers long ago abandoned them for defined contribution plans. But many state governments are currently facing pension funding obligations that are forcing lawmakers to consider making changes. The rule -- sometimes unwritten and at other times constitutionally codified -- had been that pension plan changes are limited to those who have not been hired yet, or to employees who are early in their public sector tenures.

    "You don't like to change the rules of the game for those who don't really have the ability to adjust. It's particularly painful to make changes to people who are in retirement already or approaching retirement," says Alicia Munnell, professor of management sciences at Boston College's Carroll School of Management and director of the school's Center for Retirement Research. "It is a worrisome thing to do."

    But that's exactly what happened in Rhode Island. In 2011, the state created a defined contribution system similar to a 401(k) plan and forced all its current employees to enter into a system that blended the two plans together. Cost-of-living raises for retirees were also suspended for five years.

    In other states, retiree costs are being managed by creating new, cheaper pension plans for new employees. In some cases, premiums are being driven up for retiree health care, which is generally not given the same protection as pensions.

    But the Rhode Island reforms -- which are being challenged in court -- are seen as a template for other cash-strapped states to model, giving rise to more fears that pension systems may not be as unshakable as once thought. "Any change will hurt," Munnell says. "If you were counting on your pension and the value is reduced, it can be a painful adjustment."

    Munnell also notes that the math in Rhode Island allowed for few options. By Pew Center estimates, the state had only 49 cents on hand for every dollar owed to its retirees in 2010. In some cities, the shortfall was even deeper. "The funding situation was so serious that if something wasn't done with pensions, all the money would go there," Munnell notes. "You wouldn't be able to have things like libraries or buses. When it gets that dire, you have to distribute the pain broadly. It's not fair in some sense to take away existing benefits, but when you're really suffering, you have to do things you wouldn't normally."

    Worse than Enron?

    The decisions that led to today's crossroads began decades ago.

    For most plans, a secure funding model with relatively low risk was never adopted, according to Kent Smetters, professor of business economics and public policy at Wharton. Instead, politicians allowed the funds to broaden their investment policies beyond government-backed bonds and at first dabble, then fully immerse themselves in, the stock market and progressively riskier investment vehicles.

    That allowed the plans to expand their retirement benefits while, at least on paper, requiring no more funding from the governments whose workers they served.

    Smetters argues that the most grievous pension funding error over the years has been assuming an unrealistically high discount rate, or the rate at which funds can discount their future liabilities. Also referred to as a fund's annual rate of return on its investments, most funds assume a 7.5% return on the low end and 8.5% on the high end. Many economists argue the fund liabilities should be discounted at a rate closer to 3% or 4%.

    Those assumptions open the funds up to higher levels of investment risk and dramatically understate the liabilities owed. According to the Center for Retirement Research at Boston College, public pension plans have on hand about 76 cents for every dollar they owe retirees. Under more conservative accounting standards proposed by the Government Accounting Standards Board -- an independent, seven-member nonprofit board that sets generally accepted accounting principles for the public sector -- that figure could drop to 57 cents on the dollar.

    "State and local pensions are not covered under any reasonable accounting standards," Smetters says. "Their accounting makes Enron look pretty good."

    Continued in article

    Bob Jensen's threads on pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    Some of the Worst Internal Controls in History
    "Fraud Case Spurs Show-Horse Sale," by Mark Peters, The Wall Street Journal, September 10, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444772804577623731324455136.html?mod=WSJ_hps_sections_news&mg=reno64-wsj

    The show-horse set will descend on this small city this month to bid on the crown jewel of what federal authorities allege to be a massive fraud: Hundreds of top-ranked quarter horses amassed by the former city comptroller accused of stealing tens of millions of dollars from public coffers.

    Rita Crundwell, 59 years old, was arrested by federal authorities in April and accused of stealing more than $53 million from this city of 15,700 whose finances she ran since the 1980s.

    Federal authorities said the alleged theft took place starting in 1990, and say that Ms. Crundwell, whose salary was around $80,000, also used the allegedly pilfered funds to buy sports cars, a boat, a home in Florida and a $2 million motor home.

    Ms. Crundwell has pleaded not guilty to one charge of wire fraud. After her arrest, she was released from federal custody and is scheduled to appear in U.S. District Court in Rockford, Ill., in October. She declined to comment through her lawyers.

    Authorities say that Ms. Crundwell used the allegedly stolen funds to furnish a horse ranch that housed nearly 400 quarter horses with names like Have Faith in Money, Jewels by Tiffany, and Secure with Cash.

    Ms. Crundwell worked for the city nearly all her life, becoming comptroller in 1983. Over the years, she also became known as a renowned breeder of horses that she bought and sold and showed. The government also is auctioning other of her assets, including the motor home and horse equipment.

    Authorities say Ms. Crundwell no longer can afford the $200,000 a month required to care for all the horses.

    Ms. Crundwell agreed to the sale, authorities say, which was ordered through a court process. Federal authorities believe that horses were purchased and possibly maintained with funds from the alleged fraud. Money from the auction eventually could go to Dixon as partial restitution, but proceeds will be held in escrow until the case concludes.

    Auctioneers said the size of the horse sale by a single owner is rare. A spokesman for the American Quarter Horse Association said the high caliber of the horses also makes it extraordinary.

    "In all my years in the business, we've never done anything quite like this," said Mike Jennings, a four-decade veteran of the horse-auction business who the government hired to oversee the Crundwell sale, scheduled to take place on Sept. 23 and 24, and online starting last Friday, though no sales will take place until this week.

    More than a thousand bidders, bargain hunters and onlookers are expected to attend the auction. Hotels in Dixon are sold out for the auction weekend, and city officials plan to run buses between downtown and the Crundwell ranch about four miles away.

    Ms. Crundwell built her empire on a horse farm here known as the RC Ranch. Her initials are on the peak of the main barn and in mosaic on the tile floor of her trophy room, where hundreds of ribbons and horse statuettes are displayed.

    On the walls are poster-size photographs of Ms. Crundwell, often in a white cowboy hat, showing her horses. She excelled in the beauty event known as halter, and holds more world championships than any other amateur owner. Eight years in a row, she was crowned top owner at the world championship show in Oklahoma City.

    Ms. Crundwell also was popular with some on the circuit. She sponsored events, rented stalls at shows, and hired trainers and other staff. "For years, people felt they weren't able to compete against Rita and stopped trying," said Amy Gumz, owner of Gumz Farms in western Kentucky.

    Ms. Crundwell's exit appears to be sparking new interest in the events she once dominated. That could help fuel demand at the upcoming auction where Mr. Jennings, the auctioneer, said the top horses could fetch hundreds of thousands of dollars.

    The quarter horse is the U.S.'s most popular breed, used widely for trail riding, ranching and equestrian events. The breed is also trained to race short distances—its name comes from the quarter-mile that quarter horses typically run. The competitive show world ranges from cowboys riding them to rope cattle, to muscular horses being paraded in a ring and judged on their beauty.

    In Dixon, Ms. Crundwell's hometown, many residents remain baffled by her arrest, which came after a colleague filling in while she was on vacation spotted alleged irregularities in the accounts. Dixon Mayor Jim Burke said because of the size and success of her horse operations Dixonites believed Ms. Crundwell's booming horse business financed her lifestyle.

    "She carefully cultivated this image of having a successful horse operation," Mr. Burke said.

    Dixon officials expect the auction to net several million dollars, which they hope will eventually end up with the city. Mr. Burke would like to use auction proceeds to pay off municipal debt and possibly to give residents rebates on water or other municipal bills.

    Continued in article

    How true can you get?
    As (Commissioner) Bridgeman left office last year, he praised (Controller) Rita Crundwell for being an asset to the city and said she "
    looks after every tax dollar as if it were her own," according to meeting minutes.

    As quoted by Caleb Newquest on April 27, 2012 ---
    http://goingconcern.com/post/heres-ominous-statement-former-dixon-city-finance-commissioner-made-about-accused-embezzler

    She was mostly just horsing around
    "Somehow the City of Dixon, Illinois Just Noticed (after six years) That $30 Million Was Missing," Going Concern, April 19, 2012 ---
    http://goingconcern.com/post/somehow-city-dixon-illinois-just-noticed-30-million-was-missing

    Rita Crundwell has been the CFO/comptroller of Dixon, Illinois since the 1980s; a typical tenure for even an unelected Illinois official. In those 30-ish years, it appears that she performed her duties adequately enough, but she was just put on unpaid leave. You see, at some point in 2006, it is alleged that Ms. Crundwell started helping herself to money that belonged to the citizens of Ronald Reagan's boyhood home. Prosecutors allege that this went for the last six years and that Crundwell made off with $30,236,503 (and 51¢). 

    Federal agents served warrants and seized contents of her bank accounts, seven trucks and trailers, a $2 million motor home  and a Ford Thunderbird—all of which prosecutors allege were paid for with money taken from city bank accounts by Crundwell. [...] Bank records obtained by the FBI allegedly show Crundwell illegally withdrew $30,236,503 from Dixon accounts since July 2006 , money she used, among other things, to buy a 2009 Liberty Coach Motor home for $2.1 million; a tractor truck for $147,000; a horse trailer for $260,000; and $2.5 million in credit card payments for items that included $340,000 in jewelry.

    So a decent haul, but a Ford Thunderbird? Good Christ, spring a bit for the Lincoln Continental at least. Questionable taste in automobiles aside, one can't help but wonder how Dixon - a city with a population of just ~15,000 - could not notice millions of dollars missing. But they did! It's strange because in a city of that size, people gossip about one another's $35 overdraft fees, never mind millions of dollars being spent on multi-million dollar motorhomes. Anyway, Crundwell (who has a thing for horses apparently) had a good thing going, but then made the mistake of taking a little extra vacation: 

    [L]ast year she took an additional 12 weeks of unpaid vacation. A city employee substituting for Crundwell examined bank statements and notified the mayor of activity in an account that, according to the complaint, he didn't know existed. Bank records list the primary account holder as the City of Dixon. An entity named RSCDA also is named on the account, with checks written on the account more expansively identifying that second account holder as "R.S.C.D.A., C/O Rita Crundwell."

    So basically the city discovere the missing cash by the virtue of dumb luck, which sometimes is what it takes for these things to get uncovered. Better late than, oh whatever... seriously, a Thunderbird?

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    When government internal controls are a sick joke
    "Wisconsin: 3 relatives suspected of cashing dead mother's Social Security checks for 30 years," by Dinesh Ramde, TwinCities.com, September 25, 2012 ---
    http://www.twincities.com/wisconsin/ci_21627111/wisconsin-checks-still-cashed-dead-mom

    Three Portage County residents are accused of cashing Social Security checks of a relative who has been missing for 30 years and is presumed dead, and authorities are investigating to see whether her remains are buried on her wooded property.

    If Marie Jost is still alive she'd be 100 years old. But authorities now suspect she died in about 1982, and they're accusing her son, daughter and son-in-law of continuing to cash her government checks in her absence.

    Investigators believe Jost might be buried on her Amherst property. Sheriff's Capt. Dale O'Kray said Tuesday that cadaver dogs have hit upon the scent of human remains, and authorities are using heavy machinery to explore the property and dig for evidence.

    "There's no indication she's been seen in the last 25 years and we have to have a starting point for where she might be," O'Kray said.

    Charles T. Jost, 66; Delores M. Disher, 69; and Ronald Disher, 71, each face four felony charges including being party to the crimes of theft and mail fraud. The charges carry a maximum combined penalty of 68 years in prison and a $310,000 fine.

    The Social Security Administration had sent three letters to Jost's home to verify she was still alive. After the third letter was sent, a man who identified himself as her son called to say Jost wasn't available.

    The agency then contacted Portage County authorities last month asking that deputies check on her. Deputies went to her property where Charles Jost allegedly told them Marie Jost and his 74-year-old brother Theodore "were riding in a vehicle someplace," according to the criminal complaint.

    When a deputy asked for permission to search the property, Charles Jost allegedly grew agitated and asked them to leave. The deputy then asked whether Marie Jost was still alive, and Charles Jost said he would talk to his lawyer and ended the conversation, the complaint said.

    Authorities obtained a search warrant and gathered evidence, but they haven't found anything to indicate whether Marie Jost is alive or dead, O'Kray said.

    There's not a real house on the 3-acre property. Charles Jost lives in a tarp-covered shack there, and four to five sheds are filled with years' worth of garbage, O'Kray said.

    "It's basically a 'Hoarders' episode gone bad," he said. "We have about 400 garbage bags of junk we had to remove to search the living areas."

    During an initial court appearance Monday a judge ordered that Charles Jost undergo a competency evaluation. A message left for Jost's defense attorney Tuesday was not immediately returned.

    Neighbors told authorities they had never seen an elderly woman at Charles Jost's home.

    A Social Security agent said Marie Jost had not used her Medicare benefits since 1980 when she had a stroke. The agent said Jost had been sent Social Security payments of more than $175,000 since she had made a Medicaid claim.

    Prosecutors say the Social Security checks were endorsed with an X, along with the printed names of Charles and Theodore Jost.

    Continued in article

    Jensen Comment
    I wonder if she also voted over the past 30 years?


    A billion here, a billion there, pretty soon it adds up to real money.
    Senator Everett Dirksen --- http://en.wikipedia.org/wiki/Everett_Dirksen

    "Labor Dept. Estimates $7.1 Billion in Overpayments to Unemployed," by Alice Gomstyn, ABC News, July 9, 2012 ---
    http://abcnews.go.com/Business/underemployed-overpaid-states-shell-unemployment/story?id=11118137#.T_2N_91SR9s

    While many Americans are feeling the pain of expired unemployment benefits, some have gotten a good chunk more than they were legally eligible for.

    Preliminary estimates released by the U.S. Department of Labor find that, in 2009, states made more than $7.1 billion in overpayments in unemployment insurance, up from $4.2 billion the year before. The total amount of unemployment benefits paid in 2009 was $76.8 billion, compared to $41.6 billion in 2008.

    Fraud accounted for $1.55 billion in estimated overpayments last year, while errors by state agencies were blamed for $2.27 billion, according to the Labor Department. The department's final report will be released next month.

    Some of the overpayments likely can be traced back to the overwhelming workloads facing state employment agencies during the recession, said George Wentworth, a policy analyst for the National Employment Law Project.

    "You've got a system that's been under siege like the unemployment insurance system has been for the last two years," Wentworth said. "You've got a lot of new staff coming into the system, there's been a lot of federal extensions [to unemployment insurance benefits] that have had to be programmed in and so on. There's just been a lot of change that states have had to handle. ... I just think the volume and the new staff have made the systems more susceptible to error."

    Continued in article

    Bob Jensen's Fraud Updates ---
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    What's New from GASB
    "Combinations: Coming Soon to a Government Near You?"
    SmartPros
    2012, No. 2
    http://accounting.smartpros.com/standard/Download/CPARGOV/q212.html

    Governmental:  As public sector consolidations increase, the Governmental Accounting Standards Board recently proposed that state and local governments report the nature - as well as the financial effects - of combinations. Warren Ruppel, a partner in the firm of Marks Paneth & Shron LLP, contrasts GASB's proposal with comparable guidance for commercial M&A and distinguishes the criteria for mergers, acquisitions, and transfers of operations.

    Other Governmental Accounting News
    http://accounting.smartpros.com/standard/Download/CPARGOV/q212.html

    "Pension Accounting for Dummies New government reporting rules are no better than the old ones," The Wall Street Journal, July 9, 2012 ---
    http://professional.wsj.com/article/SB10001424052702304782404577488933765069576.html?mg=reno64-wsj#mod=djemEditorialPage_t

    The Government Accounting Standards Board has issued new rules that aim to crystallize government pension liabilities. It failed on that count, but it did succeed, albeit inadvertently, in making the case for defined-contribution plans.

    GASB, as it's known in the trade, sets accounting guidelines for local governments. Since the board is run mainly by former public officials, its standards are often low. The board also usually takes several years to finalize rules, so it's often behind the times. Their new rules concerning how governments discount their pension liabilities are a case in point.

    Financial economists have recommended for decades that governments calculate pension liabilities using so-called "risk-free" rates pegged to high-grade municipal bonds or long-term Treasurys. The argument goes that since pensioners are de facto secured creditors—even bankruptcy judges have been reluctant to slash retirement benefits—pensions are riskless and therefore the liabilities should be discounted at risk-free rates.

    GASB's private cousin, the Financial Accounting Standards Board (FASB), began requiring corporations to discount their pension liabilities with high-quality fixed income assets in the 1980s. However, GASB let governments stick with their desired, er, expected rate of return, which is typically about 8%. Public pension funds have returned 5.7% on average since 2000. Achieving much higher returns over the long run would require markets to perform as well as they did in the 1980s and '90s. Would that be true.

    Governments have resisted climbing down from Fantasyland because using lower discount rates would explode their liabilities. When the Financial Accounting Standards Board introduced its risk-free rate guidelines, many companies shifted workers to 401(k)s because they didn't want to report larger liabilities. Such defined-contribution plans are by definition 100% pre-funded.

    Prodded by economists and investors, GASB began considering modifying its discount rate rules a few years ago. Public pension funds, lawmakers and unions, however, pushed back hard against suggestions that governments use risk-free rates, which could more than double their liabilities. No surprise, the government troika won.

    GASB's new rules allow governments to continue discounting their liabilities at their anticipated rate of return so long as they project enough future assets to cover their obligations. At the time they forecast they'll run out of assets, they must begin discounting their liabilities with a high-grade municipal bond rate. The idea is that governments would have to issue bonds to pay retirees when their pension funds go broke.

    But few pension funds project that they'll run dry since they're hooked up to a taxpayer IV. Those in really bad shape like Chicago's will likely rig their investment and actuarial assumptions to circumvent the new rules. FASB rejected similar guidelines in the 1980s because they were too easy to dodge. The point here is that it's impossible to get governments to come clean about their pension debt, and not just because the union allies controlling pension funds have a vested interest in obfuscating the liabilities.

    In reality, nobody knows how much taxpayers will owe because so much depends on inscrutable actuarial and economic factors like interest rates 30 years from now (not even the Federal Reserve purports to be that omniscient). Slight discrepancies in assumptions can yield huge variations in estimated liabilities. One advantage of defined-contribution plans is that they don't require governments to calculate their liabilities. There are none.

    Bob Jensen's threads on pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    When a city owes millions more in pension payments than its entire revenue stream something has to give
    “I don’t believe that this is the beginning of a tidal wave of insolvency across the country,” said Richard P. Larkin, director of credit analysis at the underwriting firm H. J. Sims. “I am worried, however, that this phenomenon may grow in California.”

    "Bankruptcy in California Isn’t Seen as a Trend (but maybe in California)," by Mary Williams Walsh, The New York Times, July 12, 2012 ---
    http://www.nytimes.com/2012/07/13/business/bankruptcy-in-california-isnt-seen-as-a-trend.html?_r=1

    As San Bernardino, Calif., moved toward bankruptcy this week, municipal bond analysts were questioning how widespread the fiscal distress may prove to be, but were not predicting a wave of defaults.

    San Bernardino’s vote to authorize a bankruptcy filing came after filings this summer by the California cities of Stockton and Mammoth Lakes. Those cities were following Vallejo, which emerged from bankruptcy in 2011, after a three-year struggle to reduce its debts to investors, retirees and others.

    “I don’t believe that this is the beginning of a tidal wave of insolvency across the country,” said Richard P. Larkin, director of credit analysis at the underwriting firm H. J. Sims. “I am worried, however, that this phenomenon may grow in California.”

    Over all, investors in municipal debt showed little sign of concern about the woes of either California or any other states. On Thursday the interest rate on the highest-quality 30-year municipal bonds fell below 3 percent for the first time ever, according to Daniel Berger, a senior market strategist at Municipal Market Data.

    The nation’s municipal bond market is “still viewed very much as a safe haven for investors scared about the events unfolding in Europe,” he said.

    He said yields on California’s 30-year bonds, now at 4.58 percent, had also fallen this year, although they did not enjoy the highest ratings.

    Heavy burdens of bond debt are not always the main cause of municipal bankruptcy — the rising cost of pensions and health care can also be major factors. But whether or not bonds are the trigger, they can be treated very differently under federal bankruptcy law than under the state laws that normally govern their issuance. General obligation bonds, for instance, are normally a city’s best credit, but they can become unsecured credit in municipal bankruptcy.

    The question of whether municipal bonds pose hidden risk flared up two years ago, when a noted securities analyst, Meredith Whitney, appeared on the television show “60 Minutes” and predicted hundreds of municipal defaults within the next year. Although her prediction did not come true, it caused a major sell-off of municipal bonds that continued for months. Lately, investors have been returning to the market, and this week traders said they saw only scattered signs that small investors were dumping San Bernardino’s debt after its announcement.

    Still, if more municipal bankruptcies are in store, chances are that at least some of them will be in California. Chapter 9 municipal bankruptcies are extremely rare, and large ones are almost nonexistent. Of the 641 cases that have been filed since 1937, most have involved relatively small municipal utilities, special-purpose districts and public hospital systems — not big, complicated cities or counties with lots of people and debts.

    Within that rarefied group, most have been cities and counties in California.

    “Municipalities operate with a lot of autonomy in home-rule states such as California, and that autonomy leads to the freedom to get into trouble,” analysts for Trident Municipal Research said in a report issued Wednesday.

    The firm cited the kind of fiscal mismanagement that brought Stockton and San Bernardino to the brink, among other factors. But California’s biggest risk may be the lasting effect of Proposition 13, the 1978 ballot initiative that drastically lowered property taxes and has made them difficult to increase since then. There is no equivalent check on the cost of operating a municipal government, so many California cities and counties are increasingly caught in a painful squeeze between their limited revenue and their rising fixed costs — especially labor costs.

    Many operate pension plans that relied on steady investment gains that have evaporated in recent years and now have no way to replace the lost money.

    Trident’s analysts suggested that San Jose might be one of the next California cities to seek refuge in bankruptcy court; its mayor has been outspoken about the need to reduce pension costs.

    California lawmakers, sensing trouble ahead, passed a law this year making it harder for cities to declare bankruptcy. In doing so, however, they may have given the most distressed cities a road map to Chapter 9, by requiring cities considering bankruptcy to first go through a 60-day mediation session with their creditors.

    San Bernardino was so intent on seeking shelter in bankruptcy that it said it wanted to avoid the mediation requirement. The new law has an exemption for cities that have declared fiscal emergencies, which San Bernardino has done several times.

    The state also increased the fiscal pressure on cities earlier this year when it closed some 400 special redevelopment authorities and seized billions of dollars in property tax money that their host cities had previously controlled.

    “San Bernardino estimates that this year they expect to lose $6 million” as a result, said Mr. Larkin, of H. J. Sims.

    Continued in article

    Bob Jensen's threads on pension accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions


    The Sad State of Governmental Accounting:  It's All Done With Smoke and Mirrors
    "A $447 Million Consumer Alert:  The Consumer Financial Protection Bureau pays 60% of its 958 employees more than $100,000. But Congress can't really tell how else the agency's money is spent," by Randy Neugebauer, The Wall Street Journal, September 19, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444620104578006182400443070.html?mg=reno64-wsj#mod=djemEditorialPage_t

    Should an unelected Washington bureaucrat be given tremendous power to lead a new federal agency, set its budget and spend more than $550 million with no oversight or disapproval? The Dodd-Frank Act signed into law by President Obama two years ago established the Consumer Financial Protection Bureau, whose director has precisely those vast powers. The bureau to date has avoided giving direct answers to congressional inquiries about how it is spending money.

    The Consumer Financial Protection Bureau—the brainchild of Elizabeth Warren, a law professor who is now a Senate candidate in Massachusetts—was created as an independent agency to regulate the offering and provision of consumer financial products or services. But consumer protection is only a small part of the story. Despite the bureau's broad powers, it is not subject to any of the traditional oversight powers of Congress, particularly the "power of the purse," which is the cornerstone of the appropriations process.

    The Consumer Financial Protection Bureau, which can draw more than $550 million annually from the U.S. Federal Reserve, has vast power in determining its budget. Once the director has decided that a money draw is "necessary," there is nobody with authority to prevent these funds from being paid out. Not congressional appropriators. Not the Fed. Not even the president's Office of Management and Budget.

    What's more, the bureau's transfer requests often come in the form of one-page letters lacking details as to how the money will be spent. By comparison, in order to procure permanent financing for a commercial construction loan in West Texas, 29 separate documents are required—including a business plan and a complete set of building specs. At a time when the federal debt is so high that we are borrowing 40 cents of every dollar we spend as a nation, shouldn't we expect some spending accountability from the Consumer Financial Protection Bureau?

    In official statements to the House Committee on Financial Services, the bureau has said it is "committed to promoting a culture of transparency and accountability" and to "using our resources wisely and carefully." The head of the bureau, Richard Cordray, who was installed by President Obama after a controversial "recess" appointment that bypassed Congress this January, has stated that he "fully support[s] . . . continued oversight of the Bureau's operation and budget."

    Unfortunately, the bureau's actions speak louder than its words. My House Subcommittee on Oversight and Investigations has tried unsuccessfully to gain greater visibility into the bureau's budgetary planning process. I have repeatedly asked to review the bureau's statutorily required financial operating plans and forecasts. These requests were denied. I have repeatedly requested that the bureau expand its Fiscal Year 2013 budget justification for $447,688,000 to more than a scanty 25 pages. These requests were denied.

    Where are the transparency and accountability measures that Mr. Cordray promised the American people? Congress is unable to carry out its constitutional oversight responsibilities if we can't analyze budget plans until after the money is spent.

    Another alarming issue is the salary rate of Consumer Financial Protection Bureau employees. Pursuant to the Dodd-Frank Act, the bureau's director may set and adjust employee pay to be comparable to the compensation and benefits provided by the Fed. This means the bureau's employees are paid outside of the traditional government scale.

    A review of the bureau's salaries as of Aug. 28, 2012, reveals that approximately 60% of its 958 employees make more than $100,000 a year. Five percent of its employees are out-earning U.S. cabinet secretaries by raking in $200,000 or more annually. The director's secretary alone is paid $165,139 a year.

    I look at hardworking Americans—who make a median annual salary of $50,054—and I wonder: Why is it necessary for a government agency, let alone one that was created to assist and protect consumers, to pay the majority of its employees six-figure salaries?

    Continued in article

    Jensen Comment
    The GAO has declared that many huge sink holes for fraud and waste are unauditable --- the Pentagon, the IRS, Medicare, and the list goes on and on. But the Congress that funds these programs is manipulated by special interest groups who do not want these audits. The new sink hole on the block is almost anything green


    "CALIFORNIA BUDGET WOES AND CHIMERICAL PENSION BELIEFS: GASB COULD HELP IF IT HAD THE WILL," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 2, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/708#more-708

    Ed Ketz writes about those "idiots in California"
    "Whither Berkeley? Whither California?" by J. Edward Ketz, SmartPros, November 2009 ---
    http://accounting.smartpros.com/x68185.xml

    Bob Jensen's threads on the sad state of pension accounting
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting


    Case for CVP Analysis (Especially for middle tier restaurants where demand is highly price elastic)

    From The Wall Street Journal Accounting Weekly Review on September 1, 2012

    Soaring Food Prices Put Restaurants in a Bind
    by: Julie Jargon
    Aug 29, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Business Segments, Managerial Accounting, Profit Margin, Segmented Income Statements

    SUMMARY: Restaurant chains are in a pickle, caught between soaring ingredient costs and fears that raising prices will turn off their budget-conscious customers, who generally remain pessimistic about the economy. Companies like McDonald's Corp., Buffalo Wild Wings Inc. and Chipotle Mexican Grill Inc. are taking different approaches to the dilemma. Some are trying to pass on rising costs to customers to avoid squeezing their profit margins. Others are holding the line on prices or emphasizing their existing low-cost menu items to keep consumers coming through the door. Research has shown that diners are ordering more "value" items and fewer premium-priced entrees and appetizers, indicating they are trying to manage the size of their restaurant bills more than we've seen in a while.

    CLASSROOM APPLICATION: This article offers a nice bridge between managerial and financial accounting. We can use this article to discuss how management is using segmented income statements to manage profit margins in this tight economy. The companies are also carefully managing fixed and variable costs as raw material prices of food increase in the face of low consumer confidence. This is a great opportunity to show how the information and tools we teach in class directly relate to management decisions, strategy, and profitability.

    QUESTIONS: 
    1. (Introductory) What challenges are restaurants facing? How are they impacted both on the expense side and sales side?

    2. (Advanced) How are fast food restaurants analyzing the situation using segmented income statements to address these challenging times? How does segmenting the business's product lines and customers help with the company's overall profit margins?

    3. (Advanced) What segment of the fast food business is most successful? How is McDonald's management approaching each segment to make it more profitable? How does a segmented income statement and budgeting aid in this analysis?

    4. (Advanced) In the restaurant business, which types of costs are easiest to control? Which are more difficult? Are these costs more likely to be fixed, variable, or mixed costs? How can management work with each of these types of costs to survive and perhaps thrive in these kinds of economic times?

    5. (Advanced) How are different types of restaurants (fast food, mid-range, fine dining) being affected differently under these conditions? How can each type of restaurant use managerial accounting concepts to improve profitability?

    6. (Advanced) How would a contribution format income statement help management to make these decisions?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

     

    "Soaring Food Prices Put Restaurants in a Bind," by: Julie Jargon, The Wall Street Journal, August 29, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444082904577606983275066266.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

    Restaurant chains are in a pickle, caught between soaring ingredient costs and fears that raising prices will turn off their budget-conscious customers, who generally remain pessimistic about the economy.

    Companies like McDonald's Corp., MCD +0.89% Buffalo Wild Wings Inc. BWLD -1.94% and Chipotle Mexican Grill Inc. CMG -0.48% are taking different approaches to the dilemma. Some are trying to pass on rising costs to customers to avoid squeezing their profit margins. Others are holding the line on prices or emphasizing their existing low-cost menu items to keep consumers coming through the door.

    The worst drought in decades has driven up prices for foods including corn, chicken and beef this summer. Further complicating matters for restaurants and other retailers, consumer confidence in August fell to its lowest level since November 2011, the Conference Board said Tuesday.

    Earlier this month McDonald's attributed flat global same-store sales in July to waning consumer sentiment, and market-research firm NPD Group predicted that restaurant traffic would be flat for the next two years, dialing back its previous forecast of a 1% gain.

    "Restaurant operators are in a position where they don't have much of a choice but to raise prices because they operate on such thin margins," said Darren Tristano, executive vice president of restaurant consulting firm Technomic Inc.

    The pressure is greater on some chains than others. Fine and causal-dining restaurants can better stomach commodity-cost increases because of their higher-priced menus and ability to adjust portion sizes. "But when you're McDonald's, a lot of your products are priced to be 'value' offerings, so there's not a lot of room to absorb cost increases," Mr. Tristano added.

    "I'd probably order more from the value menu if prices go up," said 33-year-old Norma Rangel-Aponte, who was eating a snack-size McFlurry ice-cream dessert at a Chicago McDonald's recently. To save money, she said, she sometimes orders a side salad and tops it with the chicken from a snack wrap, rather than ordering a more-expensive chicken salad.

    Restaurant chains were in similar straits a few years ago. Food costs were high during parts of the recession because of rising global protein demand. Some chains reacted by heavily discounting their dishes to keep customers coming back, but their profit margins suffered.

    Others boosted prices modestly on inexpensive menu items, hoping that consumers would swallow the increases without much resistance. In January 2009 McDonald's raised the price of a double cheeseburger, a fixture of its Dollar Menu, to $1.19 to help defray higher beef and cheese costs. A spokeswoman said Tuesday that the double cheeseburger remains on the regular McDonald's menu at a suggested retail price of $1.19 to $1.29, depending on location.

    RBC Capital Markets analyst Larry Miller said his research has shown that diners are ordering more "value" items and fewer premium-priced entrees and appetizers, indicating they are trying to manage the size of their restaurant bills more "than we've seen in a while." The potential for weak or flat sales growth combined with rising costs is "downright scary to us," he added.

    Some chains are once again stressing cheaper menu items, offering promotions to help bring customers back more often and testing the water with small price increases. McDonald's recently created an "Extra Value Menu" featuring such items as a 20-piece Chicken McNuggets for $4.99. Starbucks Corp. SBUX -0.20% reintroduced "treat receipts" that give morning customers a discount if they return in the afternoon.

    Continued in article

    Jensen Comment
    Meanwhile increases in food and fuel do not affect inflation indices since the government now deceives us about the inflationary spiral for food and fuel prices by ignoring prices increases in food and fuel when adjusting for inflation.

    Bob Jensen's threads on managerial and cost accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#ManagementAccounting

     


    The Hall of Fame Accountant Versus the Famous Keynesian Economist

    U.S. National Debt Clock --- http://www.usdebtclock.org/
    Also see http://www.brillig.com/debt_clock/

    Accounting Hall of Fame Citation for David Walker ---
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/david-michael-walker/

    "Walker Warns of Ballooning Government Debt," by Michael Cohn, Accounting Today, May 16, 2012 ---
    http://www.accountingtoday.com/debits_credits/Walker-Warns-Ballooning-Government-Debt-62674-1.html

    Former U.S. Comptroller General David Walker has been actively spreading the word for years about the dangers of the nation’s out-of-control budget deficit and national debt.

    Those views are finally getting taken seriously in Washington, with Republicans and Democrats in Congress and the Obama administration issuing their own plans for cutting the deficit, building on the proposals of various deficit commissions and think tanks. Walker delivered a speech Thursday at the American Institute of CPAs’ Spring Meeting of Council in Washington, a day after former Senator Alan Simpson, who co-chaired the Simpson-Bowles Commission, gave a humorous talk to AICPA Council members at an evening reception.

    Walker’s speech was far more serious in tone. “I’m still an active CPA and I’m proud to be a CPA,” he said. “How you keep score matters. We have a responsibility to lead the fight for truth.”

    He urged CPAs in the audience to take up the struggle to persuade the government to control the deficit. “The decisions that fail to be made by elected officials within the next three to five years will largely determine whether our collective future is better than our past,” he said. “We are approaching a tipping point. Some states and localities have passed the tipping point.”

    Walker is leading what he calls the Comeback America Initiative at www.keepingamericagreat.org. “In the last few years we have strayed from some of our values that made us great in the past: limited and effective government, personal responsibility and accountability, fiscal responsibility and equity, stewardship.”

    He worries about the integrity of the Social Security Trust Funds, quipping, “By the way you can’t trust them, they’re not funded.” He said the country has a progressive tax system, even though the progressivity is subject to debate. Warren Buffett’s effective tax rate is less than his, but over 40 percent of taxpayers pay no federal income taxes.

    Continued in the article

    Nobel Laureate Paul Krugman ---
    http://en.wikipedia.org/wiki/Paul_Krugman

    "Debt Is (Mostly) Money We Owe to Ourselves," by Paul Krugman, The New York Times, December 28, 2012 ---
    http://krugman.blogs.nytimes.com/2011/12/28/debt-is-mostly-money-we-owe-to-ourselves/#h[AacAag,1]

    . . .

    ¶People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

    ¶That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. And as Dean says, talking about leaving a burden to our children is especially nonsensical; what we are leaving behind is promises that some of our children will pay money to other children, which is a very different kettle of fish.

    Comment of Larry L on the above Krugman OpEd on December 28, 2012

    generally agree with the economic observations of Krugman and I understand what he is saying about internal-external transfers of wealth/debt.

    But, I have to disagree with him on the inter-generational argument. People focus on the size of the debt but they do NOT focus on HOW the money has been spent (the money we borrowed over the past generation).

    The reality is that Boomers borrowed to spend and NOT build. The lower taxes of the previous 30 years was a subsidy for personal spending (especially for the top 1%). The national debt is a representation of the money borrowed (but not earned) to pay for all sort of personal spending (and destructive wars). If you look at the sort of spendthrift nonsense at the top of the pyramid, this has been an incredibly wasteful use of our country's resources and infrastructure.

    So, while other countries may have a high debt level internally, most of that debt is being used to upgrade their physical infrastructure and intellectual property, increasing their productivity and therefore raise their incomes and standards of living. For them, the debt was well spent and will result in passing a better life to the next generation.

    The U.S. has done the exact opposite.

    Jensen Comment

    Of course there are some nations that behaved more like the U.S., including Portugual, Ireland, Greece, and Spain and not Italy.

    Increasingly the U.S. National Debt is owed to other nations, especially those in Asia and the Middle East. Hence, it's becoming much more than just something we owe to ourselves. And to keep those amounts we owe to outsiders, Krugman and the Head of the Federal Reserve (Bernanke) are leaning more and more on the Zimbabwe School of Economics that cuts down on the rate of increase in the National Debt by simply increasing the money supply (tantamount to printing more greenbacks not arising from taxes or borrowing). To date Bernanke has flooded our economy with over $2 trillion in this "free money."

    The problem of course is at some point free money spending policies of the government come home to roost with a sudden increase in prices. To combat inflation, the Fed will be forced to raise interest rates on the existing National Debt (fueled by annual trillion-dollar government spending deficits) to a point where interest on that debt may become an unsustainable chuck of the Federal budget.

    At that point the only way to meet some future entitlements obligations such as Social Security, Medicare, and other entitlements will either be to print more money and become increasingly like Zimbabwe or cut back drastically on promised paid to earlier generations.

    I think we in the United States should listen more to the accountant (David Walker) than the Economist who preaches very nearly unrestrained borrowing and printing. A quotation from http://en.wikipedia.org/wiki/Krugman#Economics_and_policy_recommendations

    Krugman was one of the most prominent advocates of the 2008–2009 Keynesian resurgence , so much so that economics commentator Noah Smith referred to it as the "Krugman insurgency."

    . . .

    Economist and former United States Secretary of the Treasury Larry Summers has stated Krugman has a tendency to favor more extreme policy recommendations because "it’s much more interesting than agreement when you’re involved in commenting on rather than making policy."

    According to Harvard professor of economics Robert Barro, Krugman "has never done any work in Keynesian macroeconomics" and makes arguments that are politically convenient for him. Nobel laureate Edward Prescott charged that Krugman "doesn't command respect in the profession", as "no respectable macroeconomist" believes that economic stimulus works.

    Krugman himself cleverly made tens of millions of dollars writing books and making high-priced speeches to the 99% while he himself basks in the 1%. Nice work if you can get it, and his fortune in no small way came from one time winning a Nobel Prize.

    Bob Jensen's threads on entitlements are at
    http://faculty.trinity.edu/rjensen/Entitlements.htm

     

    Government Accountability Office (GAO) Podcast [iTunes] http://www.gao.gov/podcast/watchdog.xml

    Video: Fora.Tv on Institutional Corruption & The Economy Of Influence ---
    http://www.simoleonsense.com/video-foratv-on-institutional-corruption-the-economy-of-influence/

    Video from the AICPA
    What's at Stake? A CPA's Insights into the Federal Government's Finances ---
    http://www.aicpa.org/Advocacy/Pages/CPAsInsight.aspx

    Bob Jensen's threads on the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    "Exposing the Medicare Double Count:  The same money can't be spent twice. ObamaCare tries to do precisely that, and the government will have to borrow the difference," by By Charles Blahous and James C. Capretta, The Wall Street Journal, May 1, 2012 ---
    http://online.wsj.com/article/SB10001424052702304299304577346332422834276.html?mod=djemEditorialPage_t

    One of the enduring mysteries of President Obama's health law is how its spending constraints and payroll tax hikes on high earners can be used to shore up Medicare finances and at the same time pay for a massive new entitlement program. Isn't this double counting?

    The short answer is: Yes, it is. You can't spend the same money twice. And so, thanks to the new health law, federal deficits and debt will be hundreds of billions of dollars higher in the next decade alone.

    Here's how it works. When Congress considers legislation that alters taxes or spending related to Medicare's Hospital Insurance Trust Fund, the changes are recorded not just on the Hospital Insurance Trust Fund's books, but also on Congress's "pay-as-you-go" scorecard.

    The "paygo" requirement is supposed to force lawmakers to find "offsets" for new tax cuts or entitlement spending, and thus protect against adding to future federal budget deficits. Putting the Medicare payroll tax hikes and spending constraints on the "pay-as-you-go" ledger was instrumental in getting the health law through Congress, because doing so fostered a widespread misperception that the law would reduce future deficits.

    But the same provisions add to the Hospital Insurance Trust Fund's reserves, which expands Medicare's spending authority. Medicare can only pay full benefits so long as its trust fund has sufficient reserves to meet these obligations. If the trust fund has insufficient resources, then spending must be cut automatically to ensure the fund does not go into deficit. The health law's Medicare provisions prevent these spending cuts from taking place for several more years.

    In short, the scoring convention is not widely understood and thus obscures the double-counting.

    Perhaps the easiest way to understand this is to look at Social Security. If we generate $1 in savings within that program, then that's $1 that Social Security can spend later. If we also claimed this same $1 to finance a new spending program, we would clearly be adding to the total federal deficit. There has long been bipartisan understanding of this aspect of Social Security, which is why Congress's paygo rules prohibit using Social Security savings as an offset to pay for unrelated federal spending.

    No such prohibition exists in the budget process against committing Medicare savings simultaneously to Medicare and to pay for a new federal program. It's this budget loophole, unique to Medicare, that gives the health law's spending constraints and payroll tax hikes the appearance of reducing federal deficits. But it is appearance, not reality. If you have only $1 of income and are obliged to pay a dollar each to two different recipients, then you will have to borrow another $1. This is effectively what the health law does. It authorizes far more in spending than it creates in savings.

    How much more? Charles Blahous's study, "The Fiscal Consequences of the Affordable Care Act," published last month by the Mercatus Center, found that the health law would add over $340 billion to federal deficits over the next 10 years. Over the longer term, deficits would run into the trillions.

    Medicare spending cuts and tax increases have always been double-counted—recorded both on the paygo scorecard and added to the Hospital Insurance Trust Fund. No budgetary rules were bent. But the fiscal stakes in the Affordable Care Act are extraordinarily high. The health law's Medicare hospital insurance spending cuts and tax hikes are now claimed to have eliminated most of the program's medium- and long-term deficits—even as they have also paved the way for the most expensive entitlement expansion in a generation.

    Continued in article

    Bob Jensen's threads on health care ---
    http://faculty.trinity.edu/rjensen/Health.htm

    Bob Jensen's threads on entitlements ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm


    "GASB issues guidance on deferred outflows and deferred inflows, plus technical corrections ," by Kentysiac, Journal of Accountancy, April 2, 2012 ---
    http://journalofaccountancy.com/Web/20125426.htm


    Fraud Beat
    "Contest for Funniest New Jersey Joke Has a Winner," by Jonathan Weil, Bloomberg, March 22, 2012 ---
    http://www.bloomberg.com/news/2012-03-22/contest-for-funniest-new-jersey-joke-has-a-winner.html

    Did you hear the latest joke about New Jersey? A group of investigative journalists this week released a report calling it the least corruptible state in the country. How did that happen?

    Easy. We bribed them.

    ll kidding aside, this is a state where in 2009 three mayors, two assemblymen and five rabbis were among 44 charged in a single money-laundering and bribery sting by the Federal Bureau of Investigation. One of those mayors, Peter Cammarano, was from Hoboken, where I live. He was sentenced to 24 months in prison. Five years before his arrest, another former Hoboken mayor, Anthony Russo, pleaded guilty to corruption charges. His son now sits on the city council.

    In New Jersey, we expect corruption. It’s built into the system. We have 566 municipalities, the most per capita of any state. Local governments tax the citizenry dry, while preserving the opportunities for graft that flow from operating redundant public services. The state legislature likes it this way and always has. Whadayagonnado?

    So it was quite a story this week when the Center for Public Integrity, a Washington-based nonprofit, ranked New Jersey as the state with the lowest corruption risk in the U.S. (Local corruption didn’t count, it said. Only “corruption risk” in state government did.) There’s a simple explanation for how the group reached its conclusion, too: Its methodology was awful. Answering Questions

    Here’s how the center got the New Jersey data for its nationwide “State Integrity Investigation.” Last year, it hired Colleen O’Dea, a freelance journalist who worked for about 26 years at the Daily Record in Morris County, to answer a list of 330 questions about New Jersey state government. Each called for a numerical score. O’Dea, 49, said she interviewed 26 people for the assignment, five in person. The center paid her $5,000.

    The center also hired a former local newspaper editor to review her work. From there, the center provided O’Dea’s responses to another Washington-based nonprofit called Global Integrity. That group fed the answers into an algorithm, said Randy Barrett, a Center for Public Integrity spokesman. The results from the algorithm were used to generate letter grades in 14 categories and an overall score for New Jersey of 87 percent, or a B+.

    The center hired reporters for every other state, too, along with “peer reviewers” to read their responses. Each reporter got the same list of queries. The center called this investigative reporting. Really, though, it was just a bunch of people answering questionnaires.

    For example, O’Dea gave New Jersey a top score of 100 percent when asked to evaluate this statement: “In practice, the state-run pension funds disclose information about their investment and financial activity in a transparent manner.”

    How did she decide that? The questionnaire said to give a high score if such information was available online at little or no cost. Her notes, posted on the center’s website, say she asked someone at the New Jersey State League of Municipalities about this. “Very transparent,” her notes said. The center gave the state an “A” in the category of “state pension-fund management,” based partly on O’Dea’s answer to that question.

    Now consider that, in August 2010, New Jersey became the only state ever sued for fraud by the Securities and Exchange Commission. The SEC said the state for years lied to municipal- bond investors about the underfunded condition of its two largest pension plans. New Jersey settled without admitting or denying the agency’s claims. Making a Difference

    When I asked O’Dea in a telephone interview if she knew about the SEC lawsuit, she said she didn’t. Later, she e-mailed me to say that she had, in fact, been aware of it, and that “the state has since owned up to the issue.”

    Either way, it’s hard to believe New Jersey deserves an A for how it manages its pension funds. Yet for all we know, this grade could have made the difference between finishing No. 1 in the rankings or not. The center ranked Connecticut No. 2 with an overall grade of B, or 86 percent, one point behind New Jersey.

    Another example from the survey: “In practice, the state- run pension funds have sufficient staff and resources with which to fulfill their mandate.” O’Dea gave another top score. This time she listed a second source, in addition to the fellow from the league of municipalities: a spokesman at the New Jersey Department of the Treasury. He told her the answer was yes.

    And so forth. The center gave New Jersey’s insurance department a B+. One of the inputs was the 100 percent score O’Dea awarded in response to this statement: “In practice, the state insurance commission has a professional, full-time staff.”

    Her notes listed two sources: Someone from the Independent Insurance Agents and Brokers of New Jersey, and a spokesman for the New Jersey Department of Banking and Insurance. Both said the statement was true. (Imagine that.) O’Dea said the sources she chose “seemed to logically have knowledge of the question.”

    Continued in article

    Jensen Comment
    All jokes aside, President Obama's home town is still the most corrupt city in the United States

    "Chicago Called Most Corrupt City In Nation," CBS Chicago TV, February 14, 2012 ---
    http://chicago.cbslocal.com/2012/02/14/chicago-called-most-corrupt-city-in-nation/

    A former Chicago alderman turned political science professor/corruption fighter has found that Chicago is the most corrupt city in the country.

    He cites data from the U.S. Department of Justice to prove his case. And, he says, Illinois is third-most corrupt state in the country.

    University of Illinois professor Dick Simpson estimates the cost of corruption at $500 million.

    It’s essentially a corruption tax on citizens who bear the cost of bad behavior (police brutality, bogus contracts, bribes, theft and ghost pay-rolling to name a few) and the costs needed to prosecute it.

    “We first of all, we have a long history,” Simpson said. “The first corruption trial was in 1869 when alderman and county commissioners were convicted of rigging a contract to literally whitewash City Hall.”

    Corruption, he said, is intertwined with city politics

    “We have had machine politics since the Great Chicago Fire of 1871,” he said. “Machine politics breeds corruption inevitably.”

    Simpson says Hong Kong and Sydney were two similarly corrupt cities that managed to change their ways. He says Chicago can too, but it will take decades.

    He’ll be presenting his work before the new Chicago Ethics Task Force meeting tomorrow at City Hall.

    University of Illinois at Chicago Report on Massive Political Corruption in Chicago
    "Chicago Is a 'Dark Pool Of Political Corruption'," Judicial Watch, February 22, 2010 ---
    http://www.judicialwatch.org/blog/2010/feb/dark-pool-political-corruption-chicago

    A major U.S. city long known as a hotbed of pay-to-play politics infested with clout and patronage has seen nearly 150 employees, politicians and contractors get convicted of corruption in the last five decades.

    Chicago has long been distinguished for its pandemic of public corruption, but actual cumulative figures have never been offered like this. The astounding information is featured in a lengthy report published by one of Illinois’s biggest public universities.

    Cook County, the nation’s second largest, has been a “dark pool of political corruption” for more than a century, according to the informative study conducted by the University of Illinois at Chicago, the city’s largest public college. The report offers a detailed history of corruption in the Windy City beginning in 1869 when county commissioners were imprisoned for rigging a contract to paint City Hall.

    It’s downhill from there, with a plethora of political scandals that include 31 Chicago alderman convicted of crimes in the last 36 years and more than 140 convicted since 1970. The scams involve bribes, payoffs, padded contracts, ghost employees and whole sale subversion of the judicial system, according to the report. 

    Elected officials at the highest levels of city, county and state government—including prominent judges—were the perpetrators and they worked in various government locales, including the assessor’s office, the county sheriff, treasurer and the President’s Office of Employment and Training. The last to fall was renowned political bully Isaac Carothers, who just a few weeks ago pleaded guilty to federal bribery and tax charges.

    In the last few years alone several dozen officials have been convicted and more than 30 indicted for taking bribes, shaking down companies for political contributions and rigging hiring. Among the convictions were fraud, violating court orders against using politics as a basis for hiring city workers and the disappearance of 840 truckloads of asphalt earmarked for city jobs. 

    A few months ago the city’s largest newspaper revealed that Chicago aldermen keep a secret, taxpayer-funded pot of cash (about $1.3 million) to pay family members, campaign workers and political allies for a variety of questionable jobs. The covert account has been utilized for decades by Chicago lawmakers but has escaped public scrutiny because it’s kept under wraps. 

    Judicial Watch has extensively investigated Chicago corruption, most recently the conflicted ties of top White House officials to the city, including Barack and Michelle Obama as well as top administration officials like Chief of Staff Rahm Emanual and Senior Advisor David Axelrod. In November Judicial Watch sued Chicago Mayor Richard Daley's office to obtain records related to the president’s failed bid to bring the Olympics to the city.

    Bob Jensen's threads on the sad state of governmental accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

    Bob Jensen's threads on political corruption are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/fraudUpdates.htm

     


    U.S. Government Still Pays Two Civil War Pensions ---
    http://blog.eogn.com/eastmans_online_genealogy/2012/02/us-government-still-pays-two-civil-war-pensions.html
    Thank you Bruce Gunning for the heads up.


    Best and Worst Run States in America — An Analysis Of All 50

    From the AICPA CPA Letter Daily on December 7, 2011
    For the second year, 24/7 Wall St. ranked the 50 states according to how well they are run. Factors included the state's financial health, standard of living, education system, employment rate, crime rate and how efficiently the state uses its resources to provide government services. 24/7 Wall St. determined that Wyoming is the best-run state and California is the worst run. 24/7 Wall St.
    http://247wallst.com/2011/11/28/best-and-worst-run-states-in-america-an-analysis-of-all-50/

    Jensen Comment
    The best-run state is Wyoming. The worst-run state is California  Most of the Top Ten best-run states have relatively low populations. Small seems to be better in terms of state government efficiency, although social programs and cold weather in those states tend to repel welfare and Medicaid recipients from around the nation. It's difficult to draw liberal versus conservative explanations for best-run states since liberal states of Vermont and Minnesota are mixed in the Top Ten along with the conservative states of Wyoming, Utah, and the two Dakota states.

    Minnesota has the least debt per capita, but the union-run state of Massachusetts has the most debt per capita. This is somewhat interesting because both Minnesota and Massachusetts are viewed as liberal states (more so in the days of Hubert Humphrey and Walter Mondale). The relatively conservative southern states tend to be below the median on state debt per capita. The western states are more variable. I accuse Taxachusetts of being union-run in part because Boston refuses to allow Wal-Mart stores until Wal-Mart becomes unionized.

    When it comes to debt per capita there is less denominator effect than I suspected beforehand, although small populations become a huge factor behind the high debt loads per capita in Alaska, Rhode Island, and Delaware. Alaska can also afford a higher debt load because of vast untapped natural resources.

    I watched two very liberal commentators from Boston on television last night arguing that more debt load in Taxachusetts to support increased spending for social programs was a good investment of that state's economy. This seems to be questionable given where Taxachusetts already stands in relation to debt per capita.

    Bob Jensen's threads on state taxation are at
    http://faculty.trinity.edu/rjensen/Bookbob1.htm#010304Taxation
    You have to scroll down to find the state tax comparisons.


    Bringing Low Cost Education and Training to the Masses

    "MIT’s New Free Courses May Threaten (and Improve) the Traditional Model, Program’s Leader Says," by Jeffrey R. Young, Chronicle of Higher Education, February 6, 2012 --- Click Here
    http://chronicle.com/blogs/wiredcampus/mits-new-free-courses-may-threaten-the-traditional-model-programs-leader-says/35245?sid=wc&utm_source=wc&utm_medium=en

    The recent announcement that Massachusetts Institute of Technology would give certificates around free online course materials has fueled further debate about whether employers may soon welcome new kinds of low-cost credentials. Questions remain about how MIT’s new service will work, and what it means for traditional college programs.

    On Monday The Chronicle posed some of those questions to two leaders of the new project: L. Rafael Reif, MIT’s provost, and Anant Agarwal, director of MIT’s Computer Science and Artificial Intelligence Laboratory. They stressed that the new project, called MITx, will be run separately from the institute’s longstanding effort to put materials from its traditional courses online. That project, called OpenCourseWare, will continue just as before, while MITx will focus on creating new courses designed to be delivered entirely online. All MITx materials will be free, but those who want a certificate after passing a series of online tests will have to pay a “modest fee.”

    Q. I understand you held a forum late last month for professors at MIT to ask questions about the MITx effort. What were the hottest questions at that meeting?
     

    Mr. Agarwal: There were a few good questions. One was, How will you offer courses that involve more of a soft touch? More of humanities, where it may not be as clear how to grade answers?

    Mr. Reif: One particular faculty member said, How do I negotiate with my department head to get some time to be doing this? Another one is, Well, you want MIT to give you a certificate, how do we know who the learner is? How do we certify that?

    Q. That is a question I’ve heard on some blogs. How do you know that a person is who they say they are online? What is your answer to that?
     

    Mr. Agarwal: I could give a speech on this question. … In the very short term students will have to pledge an honor code that says that they’ll do the work honestly and things like that. In the medium term our plan is to work with testing companies that offer testing sites around the world, where they can do an identity check and they can also proctor tests and exams for us. For the longer term we have quite a few ideas, and I would say these are in the so-called R&D phase, in terms of how we can electronically check to see if the student is who they say they are, and this would use some combination of face recognition and other forms of technique, and also it could involve various forms of activity recognition.

    Q. You refer to what’s being given by MITx as a certificate. But there’s also this trend of educational badges, such as an effort by Mozilla, the people who make the Firefox Web browser, to build a framework to issue such badges. Is MIT planning to use that badge platform to offer these certificates?
     

    Mr. Agarwal: There are a lot of experiments around the Web as far as various ways of badging and various ways of giving points. Some sites call them “karma points.” Khan Academy has a way of giving badges to students who offer various levels of answering questions and things like that. Clearly this is a movement that is happening in our whole business. And we clearly want to leverage some of these ideas. But fundamentally at the end of the day we have to give a certificate with a grade that says the student took this course and here’s how they did—here’s their grade and we will give it to them. … But there are many, many ways the Internet is evolving to include some kind of badging and point systems, so we will certainly try to leverage these things. And that’s a work in progress.

    Q. So there will be letter grades?

     

    Mr. Agarwal: Correct.

    Q. So you’ve said you will release your learning software for free under an open-source license. Are you already hearing from institutions that are going to take you up on that?
     

    Mr. Agarwal: Yes, I think there’s a lot of interest. Our plan is to make the software available online, and there has been a lot of interest from a lot of sources. Many universities and other school systems have been thinking about making more of their content available online, and if they can find an open platform to go with I think that will be very interesting for a lot of people.

    Q. If you can get this low-cost certificate, could this be an alternative to the $40,000-plus per year tuition of MIT for enough people that this will really shake up higher education? That may not threaten MIT, but could it threaten and even force some colleges to close if they have to compete with a nearly free certificate from your online institution?
     

    Mr. Reif: First of all this is not a degree, this is a certificate that MITx is providing. The second important point is it’s a completely different educational environment. The real question is, What do employers want? I think that for a while MITx or activities like MITx—and there is quite a bit of buzz going on around things like that—will augment the education students get in college today. It’s not intended to replace it. But of course one can think of, “What if in a few years, I only take two MITx-like courses for free and that’s enough to get me a job?” Well, let’s see how well all this is received and how well or how badly the traditional college model gets threatened.

    In my personal view, I think the best education that can be provided is that in a college environment. There are many things that you cannot teach very well online. Let me give you, for instance, an example of something that is important: ethics and integrity and things like that. You walk on the MIT campus and by taking a course with Anant Agarwal and meeting him and other professors like him you get the sense of ethics and integrity. Is it easy to transfer that online in a community? Maybe it is, but it’s going to take a bit of research to figure out how to do that.

    Continued in article

    The Game Changer
    More on Porsches versus Volkswagens versus Competency Based Learning
    Bringing Low Cost Education and Training to the Masses
    Both a 1950 VW bug and a 1950 Porsche can be driven from Munich to Berlin. A Porsche (MIT degree) can make the trip faster, more comfortable (the VW didn't even have a heater), and safer on the autobahn.  But the VW can achieve the same goal at a lower cost to own and drive.

    As fate would have it, the day after I wrote about Hitler's Volkswagen versus Porsche analogy with meeting higher education needs of the masses at very low cost, the following article appeared the next day of February 3. Ryan Craig and I went about make the same point from two different angles.

    Part of my February 2, 2012 message read as follows:

    . . .

    But the MITx design is not yet a Volkswagen since MIT provides high quality lectures, videos, and course materials without yet setting academic standards. MIT is instead passing along the academic standard setting to the stakeholders. For example, when an engineering student at Texas A&M graduates with a 3.96 grade average, the Texas A&M system has designed and implemented the academic quality controls. In the MITx certificate program, the quality controls must be designed by the employers or graduate school admissions officers not part of the Texas A&M system..

    My earlier example is that a student in the MITx program may learn a great deal about Bessel functions --- http://en.wikipedia.org/wiki/Bessel_functions 
    But obtaining a MITx certificate for completing a Bessel function module says absolutely nothing about whether the certificate holder really mastered Bessel functions. It's up to employers and graduate school admissions officers to introduce filters to test the certificate holder's mastery of the subject.

    I hope that one day the MITx program will also have competency-based testing of its MITx certificate holders --- that would be the second stage of a free MITx Volkswagen model.

    Bob Jensen

    "A Policy Wonk Brings Data on College Costs to the Table," by Goldie Blumenstyk, Chronicle of Higher Education, February 5, 2012 ---
    http://chronicle.com/article/A-College-Cost-Policy-Wonk/130662/

    The dozen higher-education leaders summoned to the White House in December to talk about college affordability included 10 prominent college presidents and the head of one of the nation's most visible education foundations.

    And the 12th person, the person seated right across from the president to open and frame the discussion? A self-made number cruncher named Jane Wellman, whose outspoken devotion to the power of data has helped raise some uncomfortable questions about the way states and colleges spend their higher-education dollars.

    That Roosevelt Room meeting helped shape some of the college-cost-control proposals Mr. Obama announced last month. It also provided a notable reminder of the national influence Ms. Wellman and her Delta Cost Project now wield.

    With sophisticated analyses and an often-sardonic delivery, Ms. Wellman has been a pull-no-punches critic of fiscal policies that starve the institutions educating the biggest proportion of students—"public universities are getting screwed, and the community colleges in particular are getting screwed," she says.

    She is just as dismissive of the "trophy-building exercises" of public and private institutions that elevate their research profiles by hiring professors who never teach or that dole out merit aid to enhance their admissions pedi­grees. And don't even get her started on the climbing-wall craze or colleges whose swimming pools "have those fake rivers for people to raft on."

    But most of all, through the Delta Project and other consulting work, she's been an advocate for using financial information and other data to highlight spending patterns and bring into greater relief the true costs of academic and administrative decisions. In higher education, she says, policy makers and administrators too often present "an analytically correct road to complete ground fog."

    Her antidote, created in 2006, was the Delta Project on Postsecondary Costs, Productivity, and Accountability, an independent, grant-backed organization that produces the annual "Trends in College Spending" and other reports. Over the past several years, the Delta Project's reports have highlighted the spending shift from instruction to administration, the rising cost of employee benefits, and how community colleges have been disproportionately hurt by public disinvestment.

    Notably, the reports are formatted to reflect the diversity of institutions—the comparisons are organized by sector, so community colleges aren't compared with research universities—and to reflect several categories of spending, not simply revenues and expenses. Ms. Wellman says that's deliberate. Too many of the generalizations about higher-education costs are "based on one part of the elephant," she says. "I wanted to neutralize that."

    She has also been eager to bust open some of the rationalizations that college leaders trot out, such as that higher education's rising costs are justified because of uniquely high personnel expenditures. "Everybody spends 80 percent on payroll, unless you're a lumber mill," she says.

    That mix of bluntness and evidence is what's brought the Delta Project, and her, credibility and fans.

    "It's the only place in higher ed that's really laser-focused on the question 'How much do you get for how much you put in?'" says Travis Reindl, program director for the education division of the National Governors Association. "She has made the cost issue more approachable than anybody else I can think of, especially for people who don't eat, sleep, and breathe this stuff."

    A Background in Policy

    But after five years, Ms. Wellman and the Delta Project are undergoing a transition. Under an arrangement Ms. Wellman masterminded, the organization last month merged its database of financial information into the National Center for Education Statistics and moved the policy-analysis side of its work to the American Institutes for Research, where it will continue to produce reports as the Delta Cost Project AIR.

    Ms. Wellman, 62, will remain an adviser to the project, but will also devote more time to her role as executive director of the Na­tional Association of System Heads, a group for presidents and chancellors of public university and community-college systems. She says the new role will give her a different kind of platform to articulate "the moral imperative" of financing the institutions attended by a majority of students—including those who are the neediest.

    It's a natural step for her, says Charles B. Reed, chancellor of the California State University system: "Jane has a vision, and I think it's because of the work she's created in the Delta Project."

    Ms. Wellman's interest in higher education began largely by accident. She dropped out of the University of California at Berkeley in the late 1960s to get a job and establish residency as an in-state student. As she tells it, she "ended up typing for David Breneman," who was then finishing his dissertation before going on to become a nationally known scholar on the economics of higher education. The subject matter "resonated with my political interest," says Ms. Wellman.

    She stayed at Berkeley for a master's in higher education and then began working as policy analyst, first for the University of California system and later as staff director for the Ways and Means Committee in the California State Assembly. (The man who would become her husband was working there, too, for a committee on prisons.) She was frustrated by a lot of what she saw, both in Sacramento and when she moved to Washington, in the early 1990s, and worked for two and a half years as a lobbyist for the National Association of Independent Colleges and Universities. Her higher-education colleagues would say things like "Complexity is our friend" when preparing to talk budgets to legislators­—and to bury them with numbers.

    By the mid-2000s, after about a decade of consulting for the Cal State system and working on government and association commissions on college costs—and seeing all of them "go to naught"—she decided it was time "to create the data set and the methodology that I knew was possible" to bring more clarity to the issues of spending.

    "We were hugely helped by the recession," she says. "At any other time, I would have gotten much more pushback from the institutions."

    Data for Everybody

    Richard Staisloff, a consultant on college finance who teaches with Ms. Wellman at an executive doctoral program in education at the University of Pennsylvania, says her contribution comes in "myth busting." Often, he says, she makes it clear that where students are is not where money is being spent. "It's hard to run from the data," says Mr. Staisloff.

    Mr. Reindl remembers getting together for coffee with Ms. Wellman here in Washington and listening as "she sketched out on a Starbucks napkin" her plans for the Delta Project (she chose the name since it's the mathematical symbol for "change"). Those ideas have taken root, he says. When people like Jay Nixon, the governor of Missouri and a Demo­crat, talk about state spending and degrees per dollar spent, "that's really out of Delta, and that's a governor talking," he says. "She has made it not only OK to talk about outcomes and resources in the same sentence, she's made it necessary."

    At least one critic of rising college costs, however, questions whether she's too much of an "establishment figure" to be an effective re­former. Richard Vedder, a professor of economics at Ohio University (and a blogger for The Chroni­cle), says her data are good, but "Jane doesn't tell us what to do about it." He says he wishes she'd do more to tie her information to data on what students are learning. "Where does Academically Adrift fit into the picture?" he asks.

    Continued in article

    Jensen Comment
    Having taught managerial and cost accounting for over 40 years, it seems to me that Jane Wellman is overlooking some systemic problems of cost accounting, cost allocations, and cost aggregations that can make her numbers very misleading ---
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#BadNews

    Bob Jensen's threads on on other questionable attempts to derive and compare costs of alternative degree tracks in colleges and universities and the "worth" of professors ---
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm#CostAccounting ---
     

     

    For all the hubbub about massive online classes offered by elite universities, the real potential game-changer in higher education is competency-based learning.
    Ryan Craig. February 3, 2012

    "Adventures in Wonderland, by Ryan Craig, Inside Higher Ed, February 3, 2012 ---
    http://www.insidehighered.com/views/2012/02/03/essay-massive-online-courses-not-game-changing-innovation

    "Will MITx Disrupt Higher Education?" by Robert Talbert, Chronicle of Higher Education, December 20, 2011 ---
    http://chronicle.com/blognetwork/castingoutnines/2011/12/20/will-mitx-disrupt-higher-education/?sid=wc&utm_source=wc&utm_medium=en

    "MIT Expands 'Open' Courses, Adds Completion Certificates," Inside Higher Ed, December 19, 2011 ---
    http://www.insidehighered.com/quicktakes/2011/12/19/mit-expands-open-courses-adds-completion-certificates

    "MIT’s New Free Courses May Threaten (and Improve) the Traditional Model, Program’s Leader Says," by Jeffrey R. Young, Chronicle of Higher Education, February 6, 2012 --- Click Here
    http://chronicle.com/blogs/wiredcampus/mits-new-free-courses-may-threaten-the-traditional-model-programs-leader-says/35245?sid=wc&utm_source=wc&utm_medium=en

     

    Bob Jensen's threads on open source video and course materials from prestigious universities ---
    http://faculty.trinity.edu/rjensen/000aaa/updateee.htm#OKI

    Bob Jensen's threads on education technology in general ---
    http://faculty.trinity.edu/rjensen/000aaa/0000start.htm

    THE COLLEGE OF 2020: STUDENTS  ---
    https://www.chronicle-store.com/Store/ProductDetails.aspx?CO=CQ&ID=76319&PK=N1S1009

    Bob Jensen's threads on higher education controversies ---
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm

    Bob Jensen's threads on online training and education alternatives ---
    http://faculty.trinity.edu/rjensen/Crossborder.htm


    It's troubling enough to study one university's financial reports. It's a nightmare to compare universities.
    "So You Want to Examine Your University's Financial Reports?"  by Charles Schwartz, Chronicle of Higher Education, February 7, 2012 ---
    http://chronicle.com/article/So-You-Want-to-Examine-Your/130672/

    With financial difficulties facing many universities, some faculty members feel the urge to take a critical look into their own institution's audited financial reports and see what they can learn.

    The impulse is admirable, but some guidance is needed before you enter such unfamiliar territory. Having spent some time looking at such things at my own institution (the University of California, which provides an enormous amount of financial data online), I must warn about the dreadful pitfalls awaiting any newcomer.

    When you wade into those financial reports, you should understand that the numbers are invariably correct. What you need to be skeptical about are the words and labels attached to the numbers. There is, of course, a large amount of jargon. For example, if you wanted to find out how much money is spent on administration and management, you might start with "institutional support," which covers high-level administration on the campus; then there is "academic administration," (a subcategory of "academic support"), which covers the deans' offices; and then there are lower levels of administrative services buried in every other category.

    It turns out that the trickiest category is the one you would think faculty members understand the best: expenditures for "instruction." Let me show you some data for my own university, looking at its two most famous campuses. This chart comes from page eight of the latest UC Annual Financial Report.

    Operating Expenses by Function, 2010-11 ($ in Millions)

      Total Instruction Research Medical Centers
    UC Berkeley $2,026 $ 566 $ 533 0
    UC Los Angeles $4,563 $1,240 $ 702 $1,285

     

    UCLA has a medical school and associated hospitals; Berkeley doesn't. That mostly explains the large difference in total expenditures between the two institutions. Otherwise, one thinks of the two campuses as quite comparable in size and academic quality. So why is there such a disparity in the expenditures for instruction? The answer is not easy to find by simply reading the audited financial report.

    The answer starts to appear when you search more detailed financial reports (the best resource at my university is called Campus Financial Schedules) and find tables relating revenues to expenditures. For UCLA there is a contribution of $530 million for instruction that comes from "sales and services of educational activities."

    What is that? It turns out that faculty members in the medical school not only teach and carry out research but are also doctors who treat patients. That activity, called "clinical practice," is a lucrative business that is conducted by the university. In the accounting system, such revenues are lumped into the category "sales and services of educational activities." Part of that money is used to cover costs of the clinical practice (offices, supplies, personnel); and a large part of it is paid out to the medical faculty members on top of their regular academic salaries. It just happens that the accounting system lumps all of those payments to faculty members under the heading of "expenditures for instruction." Who knew?

    Does that have any troublesome consequences? Yes. There is a famous national repository for detailed data on the nation's colleges and universities: the U.S. Department of Education's Integrated Postsecondary Education Data System (IPEDS). One of the things you can get from that lovely online source is the per-student expenditure for instruction, for any college or university, in any year. And if you look up that data for Berkeley and UCLA, you will find that the latter amount is twice as big as the former. IPEDS uses data supplied by the individual campuses, the very same data that I mentioned above. Nobody seems to be aware of how misleading those numbers can be if the campus you ask about happens to be in the medical-services business. (By the way, not all campuses with medical enterprises use the same accounting procedures I described.) IPEDS is seriously distorted.

    Continued in article

    Jensen Comment
    Think of college and university financial reports as being fund-based accounting reports similar to municipal, state, and federal government financial reports. Reporting standards are so messed up for such financial reporting that it's usually possible to hide anything from the public simply by overwhelming them with a truck load of information that is not indexed or otherwise linked in a comprehensible manner.

    The Sad State of Not-for-Profit accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

    Issues in Computing a College's Cost of Degrees Awarded and "Worth" of Professors ---
    http://faculty.trinity.edu/rjensen/HigherEdControversies.htm#CostAccounting

     


    "Hatch to push pension legislation this year," by Bernie Becker, The Hill, January 10, 2011 ---
    http://thehill.com/blogs/on-the-money/budget/203403-hatch-to-push-pension-legislation-this-year

    Sen. Orrin Hatch (R-Utah) said Tuesday that he would push legislation this year to revamp pension systems for state and local government workers.

    Hatch, ranking member of the Senate Finance Committee, noted in a statement and a newly released report that public pension programs are more than $4 trillion in debt, and said he would work to ensure that the federal government did not have to bail out state or local entities.

    And while the Utah Republican did not offer many details on his planned legislation, or when it would be released, Hatch did suggest that state and local governments need to scrap their current use of defined-benefit plans.

    Under that sort of plan, retirees are guaranteed a certain monthly payment, which often takes into account the length of their tenures and salaries before retirement.

    “The public pension crisis plaguing our nation demands a real solution,” Hatch said in the statement. “Over the coming weeks, I will be putting forward ideas to reform public pension programs in a meaningful way that doesn’t leave taxpayers on the hook.”

    The announcement from Hatch comes after groups on the left and right have spent months arguing over benefits for public workers, following pushes by Republican governors in places including Wisconsin to limit collective-bargaining rights.

    In the report released Tuesday, Hatch declared that the current issues with public pensions were caused by more than just the 2008 financial crisis, as some analysts have said.

    To bolster that claim, the report notes that, even before the 2008 crisis, roughly 40 percent of state and local pension plans could not fund 80 percent of their liabilities, a level experts generally consider healthy.

    Hatch also used the example of his own state to underscore his point that governments need to move away from defined-benefit plans, saying that Utah had ably administered its program and still saw debt on its plan balloon to $3.45 billion in 2010.

    “When a prudently managed pension plan can create a financial crisis for the taxpayers of a state or municipality, it is time to question whether the risk to taxpayers associated with the defined benefit pension structure is appropriate,” the report stated. “Defined benefit plans pose unacceptable financial and service degradation risks for taxpayers and retirees.”

    But Dean Baker, co-director of the left-leaning Center for Economic and Policy Research (CEPR), took issue with both the argument from Hatch that states and localities need to move away from defined-benefit plans, and that blaming the fiscal crisis for the current pension issues understated the problems.

    Baker told The Hill that, while states might in some cases be billions in the hole when it comes to pension liabilities, they will also likely be able to make that shortfall up over 20 or 30 years.

    “It’s just cheap rhetoric,” Baker said about the Hatch report. “There are state and local governments where, at least on average, they’re not going to face a particularly big burden.”

    Baker also noted that defined-benefit plans are less volatile for workers than other retirement plans.

    Continued in article


    "GASB Plan Concerns Treasurers: NAST Members Share Qualms About Five-Year Projections," by Joan Quigley, The Bund Buyer, December 7, 2011 ---
    http://www.bondbuyer.com/issues/120_234/gasb-state-five-year-projections-1033938-1.html

    State treasurers voiced concerns about a proposal unveiled Tuesday by the Governmental Accounting Standards Board that recommends they provide five-year projections of cash flows and information about future financial obligations.

    The concerns surfaced here at the Issues Conference on Public Funds Management, sponsored by the National Association of State Treasurers.

    The NAST gathering coincided with GASB’s release of so-called preliminary views in a document entitled “Economic Condition Reporting: Financial Projections.”

    The proposal, which GASB is floating for public comment and hearings, would require issuers to provide the cash-flow projections if they wanted a clean audit.

    GASB said users of governments’ financial statements need this information to assess an entity’s financial health.

    Several state treasurers at the conference who had not reviewed the board’s proposal and had only read about it in media accounts expressed reservations.

    “We do have a basic concern about what sort of future fiscal projections are expected, with what detail and with what caveats they would be presented,” said Nancy Kopp, the treasurer of Maryland.

    She noted that if such projections had been required in 2006, they would have proven wrong after the 2008 financial crisis.

    “It’s when you get to projections and hypothetical information, we get most concerned,” she said.

    The treasurer’s office of Maryland currently posts projections on its website based on present law and economic assumptions.

    “But these are unaudited, best-guess assumptions,” Kopp said.

    Another state treasurer, who moderated the pension panel, said she had qualms about the proposal’s impact on small municipalities.

    Continued in article

    Bob Jensen's threads about the sad state of governmental accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     

     


    The motto of Judicial Watch is "Because no one is above the law". To this end, Judicial Watch uses the open records or freedom of information laws and other tools to investigate and uncover misconduct by government officials and litigation to hold to account politicians and public officials who engage in corrupt activities.
    Judicial Watch --- http://www.judicialwatch.org/

    Judicial Watch Announces List of Washington's "Ten Most Wanted Corrupt Politicians" for 2009 ---
    http://www.judicialwatch.org/news/2009/dec/judicial-watch-announces-list-washington-s-ten-most-wanted-corrupt-politicians-2009


    "Finding more flaws in HUD’s accounting of HOME program," by Debbie Cenziper, The Washington Post, November 7, 2011 ---
    http://www.washingtonpost.com/investigations/finding-more-flaws-in-huds-accounting-of-home-program/2011/10/13/gIQAkTlctM_story.html

    The calls started in mid-May, two weeks before a looming congressional hearing.

    Staff members across the vast U.S. Department of Housing and Urban Development were racing to check in with hundreds of local agencies to determine the status of housing construction projects for the poor.

    Within days, the massive scramble came to a conclusion: HUD told Congress that its $32 billion HOME Investment Partnerships Program was doing just fine.

    Those findings followed reports by The Washington Post that HUD had routinely failed to track the progress of its affordable-housing projects and that hundreds of deals involving hundreds of millions of dollars showed signs of delay or appeared to be in limbo. HUD officials defended the program, saying most projects are successfully completed.

    But HUD’s attempt to demonstrate that success to Congress resulted in reports to lawmakers that, to judge by federal records and interviews with dozens of local housing agencies in charge of the projects, contain discrepancies and contradictions that suggest continuing problems with the program.

    Indeed, the delays vexing the HOME program are larger than previously reported. In recent weeks, local housing agencies have confirmed that about 75 construction projects drew and spent $40 million in HOME funds with little or nothing built. That is in addition to the nearly 700 potentially delayed projects The Post identified earlier this year.

    “The data that HUD has provided to this committee is completely unreliable,” said Rep. Randy Neugebauer (R-Tex.), chairman of the House Financial Services subcommittee on oversight and investigations, which has been probing the HOME program. “HUD has almost no way of knowing whether taxpayer dollars have been wasted or used for their intended purpose.”

    In its recent accounts to Congress, HUD reported as complete at least 17 construction projects that did not deliver all of the units that had been promised. One was in Newark, where a developer received nearly $700,000 in HOME funding but completed only four of 11 units, leaving behind partially completed houses and barren lots, records and interviews show.

    “We would not have characterized it as satisfactorily completed,” said Newark housing chief Michael Meyer.

    HUD also reported that at least 16 projects were completed months or even years before low-income buyers purchased the units, local housing officials said. HUD’s regulations state that homeowner projects are complete only after the homes are sold.

    Members of Congress have found similar inconsistencies. At a hearing last week, several Republican members of the House Financial Services Committee said they had tracked down reportedly completed projects in their districts and found, among other things, a vacant lot and a shuttered building.

    “Where’s the money? Where are the units that were promised? Has HUD demanded repayments for units that were not built?” said Rep. Judy Biggert (R-Ill.), who chairs the Financial Services subcommittee on insurance, housing and community opportunity.


    Hoopla is the German translation for Oops!
    "Germany Discovers Extra $78 Billion On Major Accounting Error," Reuters via Huffington Post, October 29. 2011 ---
    http://www.huffingtonpost.com/2011/10/29/germany-accounting-error_n_1065158.html

    Germany is 55.5 billion euros ($78.7 billion) richer than it thought due to an accountancy error at the bad bank of nationalized mortgage lender Hypo Real Estate (HRE), the finance ministry said.

    Europe's largest economy now expects its ratio of debt to gross domestic product to be 81.1 percent for 2011, 2.6 percentage points less than previously forecast, it said.

    The HRE-linked bad bank FMS Wertmanagement FMSWA.UL was set up after HRE was nationalized in 2009, so that HRE could transfer the worst non-performing assets to an off-balance sheet bank guaranteed by the German state.

    "Apparently it was due to sums incorrectly entered twice," said a ministry spokesman on Friday, adding the reason for the error still needed to be clarified.

    The government nonetheless welcomed the news which pointed to a further reduction of Germany's debt mountain, which remains above the European Union's Maastricht requirement for 60 percent of GDP.

    However, the opposition Social Democrats (SPD) expressed astonishment at the extent of the accountancy error, for which they see the government as responsible.

    "This is not a sum that the Swabian housewife hides in a biscuit tin and forgets," said SPD parliamentary leader Thomas Oppermann. "To overlook such a sum is completely irresponsible."

    Swabians, from the south-west of Germany, are renowned for their savings skills.

    Of the total sum uncovered at FMS, 24.5 billion euros is for 2010 and 31 billion euros is for 2011.

    Continued in article

    From the IFAC:  Public Sector/Sovereign Debt Crises Point to Accounting Weaknesses
    http://www.ifac.org/issues-insights/public-sector/sovereign-debt

    The financial and sovereign debt crises have brought to light the need for better financial reporting by governments worldwide, and the need for improvements in the management of public sector resources.

    Many governments operate on a cash-basis and do not account for many significant items, such as liabilities for public sector pensions and financial instruments. Accrual accounting is a fundamental tenet of strong accounting and reporting for public companies, and so it should be for governments as well. IFAC advocates the adoption of accrual accounting in the public interest—which will result in a more comprehensive and accurate view of financial position, and help ensure that governments and other public sector entities are transparent and accountable.

    A fundamental way to protect the public interest is to develop, promote, and enforce internationally recognized standards as a means of ensuring the credibility of information upon which investors and other stakeholders depend.
    The International Public Sector Accounting Standards Board (IPSASB), an independent standard-setting board supported by IFAC, has developed and issued a suite of 31 accrual standards, and a cash-basis standard for countries moving toward full accrual accounting.

    Bob Jensen's threads on the sad state of governmental accounting and Accountability are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting

     


    Audit Failure: The GAO Reported No Problems Amidst All This Massive Fraud

    Note that most of these particular workers retire long before age 65 and are fraudulently collecting full Social Security and Medicare benefits intended for truly disabled persons
    "The Public-Union Albatross What it means when 90% of an agency's workers (fraudulently)  retire with disability benefits," by Philip K. Howard, The Wall Street Journal, November 9, 2011 ---
    http://online.wsj.com/article/SB10001424052970204190704577024321510926692.html?mod=djemEditorialPage_t

    The indictment of seven Long Island Rail Road workers for disability fraud last week cast a spotlight on a troubled government agency. Until recently, over 90% of LIRR workers retired with a disability—even those who worked desk jobs—adding about $36,000 to their annual pensions. The cost to New York taxpayers over the past decade was $300 million.

    As one investigator put it, fraud of this kind "became a culture of sorts among the LIRR workers, who took to gathering in doctor's waiting rooms bragging to each [other] about their disabilities while simultaneously talking about their golf game." How could almost every employee think fraud was the right thing to do?

    The LIRR disability epidemic is hardly unique—82% of senior California state troopers are "disabled" in their last year before retirement. Pension abuses are so common—for example, "spiking" pensions with excess overtime in the last year of employment—that they're taken for granted.

    Governors in Wisconsin and Ohio this year have led well-publicized showdowns with public unions. Union leaders argue they are "decimat[ing] the collective bargaining rights of public employees." What are these so-called "rights"? The dispute has focused on rich benefit packages that are drowning public budgets. Far more important is the lack of productivity.

    "I've never seen anyone terminated for incompetence," observed a long-time human relations official in New York City. In Cincinnati, police personnel records must be expunged every few years—making periodic misconduct essentially unaccountable. Over the past decade, Los Angeles succeeded in firing five teachers (out of 33,000), at a cost of $3.5 million.

    Collective-bargaining rights have made government virtually unmanageable. Promotions, reassignments and layoffs are dictated by rigid rules, without any opportunity for managerial judgment. In 2010, shortly after receiving an award as best first-year teacher in Wisconsin, Megan Sampson had to be let go under "last in, first out" provisions of the union contract.

    Even what task someone should do on a given day is subject to detailed rules. Last year, when a virus disabled two computers in a shared federal office in Washington, D.C., the IT technician fixed one but said he was unable to fix the other because it wasn't listed on his form.

    Making things work better is an affront to union prerogatives. The refuse-collection union in Toledo sued when the city proposed consolidating garbage collection with the surrounding county. (Toledo ended up making a cash settlement.) In Wisconsin, when budget cuts eliminated funding to mow the grass along the roads, the union sued to stop the county executive from giving the job to inmates.

    No decision is too small for union micromanagement. Under the New York City union contract, when new equipment is installed the city must reopen collective bargaining "for the sole purpose of negotiating with the union on the practical impact, if any, such equipment has on the affected employees." Trying to get ideas from public employees can be illegal. A deputy mayor of New York City was "warned not to talk with employees in order to get suggestions" because it might violate the "direct dealing law."

    How inefficient is this system? Ten percent? Thirty percent? Pause on the math here. Over 20 million people work for federal, state and local government, or one in seven workers in America. Their salaries and benefits total roughly $1.5 trillion of taxpayer funds each year (about 10% of GDP). They spend another $2 trillion. If government could be run more efficiently by 30%, that would result in annual savings worth $1 trillion.

    What's amazing is that anything gets done in government. This is a tribute to countless public employees who render public service, against all odds, by their personal pride and willpower, despite having to wrestle daily choices through a slimy bureaucracy.

    One huge hurdle stands in the way of making government manageable: public unions. The head of the American Federation of State, County and Municipal Employees recently bragged that the union had contributed $90 million in the 2010 off-year election alone. Where did the unions get all that money? The power is imbedded in an artificial legal construct—a "collective-bargaining right" that deducts union dues from all public employees, whether or not they want to belong to the union.

    Some states, such as Indiana, have succeeded in eliminating this requirement. I would go further: America should ban political contributions by public unions, by constitutional amendment if necessary. Government is supposed to serve the public, not public employees.

    America must bulldoze the current system and start over. Only then can we balance budgets and restore competence, dignity and purpose to public service.

    Audit Failure:  The GAO Reported No Problems Amidst All This Fraud
    This is what a union site claims about the Long Island Rail Road workers for disability ---
    http://www.railroad.net/forums/viewtopic.php?f=63&t=55668&start=300

    What you won't read in Newsday or the New York Times from non-copyrighted labor source:

    GAO Audit Gives Railroad Occupational Disability Program a Clean Bill of Health

    The United States Government Accountability Office (GAO) just issued its second review of the Railroad Retirement Board Occupational Disability Program. And once again it found no problems.

    “This was a major accomplishment for rail labor,” says TCU President Bob Scardelletti. “Occupational Disability is a vitally important program for members who need it. It’s the best in the country, and this Report will help keep it that way.”

    The increased government attention on Occupational Disability began when New York politicians and newspapers began a full scale campaign targeting Long Island Rail Road workers’ alleged abuse of the program. After extensive scandalous press reports, public hearings, wild allegations, and a congressionally requested GAO investigation, no improprieties were found.

    The Railroad Retirement Board did institute some oversight measures specific to Long Island Rail Road to make sure that no abuses were occurring, reflecting the fact that the rate of applications for occupational disability were higher than on any other railroad. But these oversight procedures wound up finding that all Long Island applications that were approved were properly reviewed, legitimate and in accordance with existing law and regulations. And that fact was endorsed by the first GAO audit of Long Island Rail Road claims in a report released in September, 2009.

    Not satisfied with the GAO’s findings, two Congressman – John Mica of Florida and Bill Shuster of Pennsylvania – on March 18, 2009 formally requested the GAO to “conduct a systematic review of RRB’s occupational disability program”, not just limited to Long Island Rail Road.

    The Congressmen’ request prompted yet another GAO review of the occupational disability program. In their just-issued response to the two Congressmen, the GAO reported they found no improprieties and made no recommendations.

    Once again efforts to find fault with the occupational disability have come up empty,” says President Scardelletti. “That’s because the program is functioning as it was intended – to be a last resort for rail workers who because of illness or injury can no longer perform their jobs. It is a necessary benefit and it is not abused by those who unfortunately must apply for it. We will continue to do everything in our power to preserve it as is.

    Jensen Comment
    The program seems to be "working as intended." Either 90% of all the railroad's workers are becoming disabled on the job or the system is "intended" to defraud the taxpayers. One sign of that it was a fraud is that the same doctor (now indicted) was receiving millions of dollars from the union to sign phony disability claims.

    And there are some who advocate that the GAO take over the private sector auditing because there will be less fraud, greater independence, and more competent auditors than anything the Big Four and other auditing firms can come up with. Baloney!

     

    Disability Entitlements: Being Declared Disabled has More Benefits Than Working
    Between the ages of 0 and 200, disability pay and medical payments go on virtually forever
    The system is racked with fraud
    Cost averages $1,500 annually for each and every taxpayer in the U.S.
    "College Enrollment Fell Slightly in 2010," by Catherine Rampell, The New York Times (Economix)

    In the worst economic times of the 1950s and ’60s, about 9 percent of men in the prime of their working lives (25 to 54 years old) were not working. At the depth of the severe recession in the early 1980s, about 15 percent of prime-age men were not working. Today, more than 18 percent of such men aren’t working.

    That’s a depressing statistic: nearly one out of every five men between 25 and 54 is not employed. Yes, some of them are happily retired. Some are going to school. And some are taking care of their children. But most don’t fall into any of these categories. They simply aren’t working. They’re managing to get by some other way.

    For growing numbers of these men, the federal disability program is a significant source of support. Disabled workers — men and women — received $115 billion in benefits last year and another $75 billion in medical costs. (Disability recipients become eligible for Medicare two years after starting to receive benefits.) That $190 billion sum is the equivalent of about $1,500 in taxes for each American household.

    Yet disability usually goes unlargely uncovered by the media. Lately, it hasn’t. Motoko Rich of The Times and Damian Paletta of The Wall Street Journal have both written richly detailed articles recently.

    Continued in article

     


    Bad News for the World
    Germany will not bail out French banks or Rhode Island's Public Pensions

    Question
    What happens when you get more retirees on a pension plan than there are workers contributing to that plan?

    "The Little State With a Big Mess," by Mary Williams Walsh, The New York Times, October 21, 2011 ---
    http://www.nytimes.com/2011/10/23/business/for-rhode-island-the-pension-crisis-is-now.html?hp

    ON the night of Sept. 8, Gina M. Raimondo, a financier by trade, rolled up here with news no one wanted to hear: Rhode Island, she declared, was going broke.

    Maybe not today, and maybe not tomorrow. But if current trends held, Ms. Raimondo warned, the Ocean State would soon look like Athens on the Narragansett: undersized and overextended. Its economy would wither. Jobs would vanish. The state would be hollowed out.

    It is not the sort of message you might expect from Ms. Raimondo, a proud daughter of Providence, a successful venture capitalist and, not least, the current general treasurer of Rhode Island. But it is a message worth hearing. The smallest state in the union, it turns out, has a very big debt problem.

    After decades of drift, denial and inaction, Rhode Island’s $14.8 billion pension system is in crisis. Ten cents of every state tax dollar now goes to retired public workers. Before long, Ms. Raimondo has been cautioning in whistle-stops here and across the state, that figure will climb perilously toward 20 cents. But the scary thing is that no one really knows. The Providence Journal recently tried to count all the municipal pension plans outside the state system and stopped at 155, conceding that it might have missed some. Even the Securities and Exchange Commission is asking questions, including the big one: Are these numbers for real?

    “We’re in the fight of our lives for the future of this state,” Ms. Raimondo said in a recent interview. And if the fight is lost? “Either the pension fund runs out of money or cities go bankrupt.”

    All of this might seem small in the scheme of national affairs. After all, this is Little Rhody (population: 1,052,567). But the nightmare scenario is that Ms. Raimondo has seen the future of America, and it is Rhode Island. As Wall Street fixates on the financial disaster in Greece, a fiscal wreck is playing out right here. And the odds are that it won’t be the last. Before this is over, many Americans may be forced to rethink what government means at the state and local level.

    Economists have talked endlessly about a financial reckoning for the United States, of a moment in the not-so-far-away when the nation’s profligate ways catch up with it. But for Rhode Island, that moment is now. The state has moved to safeguard its bond investors, to avoid being locked out of the credit markets. Last week, the General Assembly went into special session and proposed rolling back benefits for public employees, including those who have already retired. Whether the plan will succeed is anyone’s guess.

    Central Falls, a small city north of Providence, didn’t wait for news from the Statehouse. In August, the city filed for bankruptcy rather than keep its pension promises to its retired firefighters and police officers.

    Illinois, California, Connecticut, Oklahoma, Michigan — the list of stretched states runs on. In Pennsylvania, the capital city, Harrisburg, filed for bankruptcy earlier this month to avoid having to use prized assets to pay off Wall Street creditors. In New Jersey, Gov. Chris Christie wants to roll back benefits, too.

    In most places, as in Rhode Island, the big issue is pensions. By conventional measures, state and local pensions nationwide now face a combined shortfall of about $3 trillion. Officials argue that, by their accounting, the total is far less. But with pensions, hope often triumphs over experience. Until this year, Rhode Island calculated its pension numbers by assuming that its various funds would post an average annual return on their investments of 8.25 percent; the real number for the last decade is about 2.4 percent. A phrase that gets thrown around here, à la Rick Perry describing Social Security, is “Ponzi scheme.”

    That evening in September, Ms. Raimondo walked into the Cranston Portuguese Club to face yet another angry audience. People like Paul L. Valletta Jr., the head of Local 1363 of the firefighters union.

    “I want to get the biggest travesty out of the way here,” Mr. Valletta boomed from the back of the hall. “You’re going after the retirees! In this economic time, how could you possibly take a pension away?”

    Someone else in the audience said Rhode Island was reneging on a moral obligation.

    Ms. Raimondo, 40, stood her ground. Rhode Island, she said, had a choice: it could pay for schoolbooks, roadwork, care for the elderly and so on, or it could keep every promise to its retirees.

    “I would ask you, is it morally right to do nothing, and not provide services to the state’s most vulnerable citizens?” she asked the crowd. “Yes, sir, I think this is moral.”

    FOR many Americans, the Ocean State conjures images of Newport mansions and Narragansett chic. The overall reality is more prosaic. Rhode Island today is a place where the roads and bridges rank among the worst in the nation and where jobs are particularly hard to find. Unemployment rose faster during the 2008-9 recession than in any other state. The official jobless rate is now 10.6 percent, versus the national average of 9.1 percent.

    The textile mills and jewelry manufacturers that once employed thousands here have dwindled away. The big employers today are in health care and education, both of which rely heavily on government spending that has been drying up.

    Many states and cities can credibly say their pension plans are viable, even when those plans are not fully funded. That is because state retirement funds, like Social Security, pay out benefits bit by bit, over many years.

    But unlike, say, California, with its large, diverse economy, Rhode Island is so small that there is little margin for error. Leaving the state, to escape its taxes, is almost as easy as moving to the other side of town. Efforts to balance the state budget by shrinking the public work force have left Rhode Island with a problem like the one that plagues General Motors: the state has more public-sector retirees than public-sector workers.

    Continued in article

    The Sad State of Governmental Accounting and Accountability ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting
     


    Questions
    Although all 50 states are in deep financial troubles, what state is in the worst shape at the moment and is unable to pay its bills?
    Hint: The state in deepest trouble is not California, although California is in dire straights!

    How did accountants hide the pending disaster?

    Watch the Video
    This module on 60 Minutes on December 19 was one of the most worrisome episodes I've ever watched
    It appears that a huge number of cities and towns and some states will default on bonds within12 months from now
    "State Budgets: The Day of Reckoning Steve Kroft Reports On The Growing Financial Woes States Are Facing," CBS Sixty Minutes, December 19, 2010 ---
    http://www.cbsnews.com/stories/2010/12/19/60minutes/main7166220.shtml

    The problem with that, according to Wall Street analyst Meredith Whitney, is that no one really knows how deep the holes are. She and her staff spent two years and thousands of man hours trying to analyze the financial condition of the 15 largest states. She wanted to find out if they would be able to pay back the money they've borrowed and what kind of risk they pose to the $3 trillion municipal bond market, where state and local governments go to finance their schools, highways, and other projects.

    "How accurate is the financial information that's public on the states? And municipalities," Kroft asked.

    "The lack of transparency with the state disclosure is the worst I have ever seen," Whitney said. "Ultimately we have to use what's publicly available data and a lot of it is as old as June 2008. So that's before the financial collapse in the fall of 2008."

    Whitney believes the states will find a way to honor their debts, but she's afraid some local governments which depend on their state for a third of their revenues will get squeezed as the states are forced to tighten their belts. She's convinced that some cities and counties will be unable to meet their obligations to municipal bond holders who financed their debt. Earlier this year, the state of Pennsylvania had to rescue the city of Harrisburg, its capital, from defaulting on hundreds of millions of dollars in debt for an incinerator project.

    "There's not a doubt in my mind that you will see a spate of municipal bond defaults," Whitney predicted.

    Asked how many is a "spate," Whitney said, "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

    Municipal bonds have long been considered to be among the safest investments, bought by small investors saving for retirement, and held in huge numbers by big banks. Even a few defaults could affect the entire market. Right now the big bond rating agencies like Standard & Poor's and Moody's, who got everything wrong in the housing collapse, say there's no cause for concern, but Meredith Whitney doesn't believe it.

    "When individual investors look to people that are supposed to know better, they're patted on the head and told, 'It's not something you need to worry about.' It'll be something to worry about within the next 12 months," she said.

    No one is talking about it now, but the big test will come this spring. That's when $160 billion in federal stimulus money, that has helped states and local governments limp through the great recession, will run out.

    The states are going to need some more cash and will almost certainly ask for another bailout. Only this time there are no guarantees that Washington will ride to the rescue.

    Continued in article

    The Sad State of Government Accounting and Accountability ---
    http://faculty.trinity.edu/rjensen/theory02.htm#GovernmentalAccounting


    The Government' Recipe for Off-Budget Debt
    "US Government 'hiding true amount of debt'," by Gregory Bresiger, news,com ---
    http://www.news.com.au/business/breaking-news/us-government-hiding-true-amount-of-debt/story-e6frfkur-1225926567256#ixzz106MjZzOz 

    The Congressional Budget Office estimates the debt will be at $US16.5 trillion in two years, or 100.6 per cent of GDP.

    But these numbers are incomplete.

    They do not count off-budget obligations such as required spending for Social Security and Medicare, whose programs represent a balloon payment for the Government as more Americans retire and collect benefits.

    In the case of Social Security, beginning in 2016, the US Government will be paying out more than it is collecting in taxes.

    Without basic measures - such as payment cuts or higher payroll taxes - the system could be on the road to bankruptcy,

    Jensen Comment
    Governments don't declare bankruptcy that would leave allow them to default on debt obligations. Instead they print money wholesale an pay off their debts in hyper-inflated dollars.

    "Downhill With the G.O.P.," by Paul Krugman, The New York Times, September 25, 2010 ---
    http://www.nytimes.com/2010/09/24/opinion/24krugman.html?src=ISMR_HP_LO_MST_FB
    Jensen Comment
    I agree with some of Krugman's assessment, but I strongly disagree that the solution to saving the United States is to massive more deficit financing. Does this Nobel Laureate know how to compute interest cash flow on the nearly $100 trillion of debt?


    How Accountants Hide the Pension Bomb in the Public Sectors

    "The Hidden State Financial Crisis:  My latest research into opaque state financial statements suggests taxpayers will be surprised by how much pensions are underfunded.," by Meredith Whitney, The Wall Street Journal, May 18, 2011 ---
    http://online.wsj.com/article/SB10001424052748703421204576329134261805612.html?mod=djemEditorialPage_t

    Next month will be pivotal for most states, as it marks the fiscal year end and is when balanced budgets are due. The states have racked up over $1.8 trillion in taxpayer-supported obligations in large part by underfunding their pension and other post-employment benefits. Yet over the past three years, there still has been a cumulative excess of $400 billion in state budget shortfalls. States have already been forced to raise taxes and cut programs to bridge those gaps.

    Next month will also mark the end of the American Recovery and Reinvestment Act's $480 billion in federal stimulus, which has subsidized states through the economic downturn. States have grown more dependent on federal subsidies, relying on them for almost 30% of their budgets.

    The condition of state finances threatens the economic recovery. States employ over 19 million Americans, or 15% of the U.S. work force, and state spending accounts for 12% of U.S. gross domestic product. The process of reining in state finances will be painful for us all.

    The rapid deterioration of state finances must be addressed immediately. Some dismiss these concerns, because they believe states will be able to grow their way out of these challenges. The reality is that while state revenues have improved, they have done so in part from tax hikes. However, state tax revenues still remain at roughly 2006 levels.

    Expenses are near the highest they have ever been due to built-in annual cost escalators that have no correlation to revenue growth (or decline, as has been the case recently). Even as states have made deep cuts in some social programs, their fixed expenses of debt service and the actuarially recommended minimum pension and other retirement payments have skyrocketed. While over the past 10 years state and local government spending has grown by 65%, tax receipts have grown only by 32%.

    Off balance sheet debt is the legal obligation of the state to its current and past employees in the form of pension and other retirement benefits. Today, off balance sheet debt totals over $1.3 trillion, as measured by current accounting standards, and it accounts for almost 75% of taxpayer-supported state debt obligations. Only recently have states been under pressure to disclose more information about these liabilities, because it is clear that their debt burdens are grossly understated.

    Since January, some of my colleagues focused exclusively on finding the most up-to-date information on ballooning tax-supported state obligations. This meant going to each state and local government's website for current data, which we found was truly opaque and without uniform standards.

    What concerned us the most was the fact that fixed debt-service costs are increasingly crowding out state monies for essential services. For example, New Jersey's ratio of total tax-supported state obligations to gross state product is over 30%, and the fixed costs to service those obligations eat up 16% of the total budget. Even these numbers are skewed, because they represent only the bare minimum paid into funding pension and retirement plans. We calculate that if New Jersey were to pay the actuarially recommended contribution, fixed costs would absorb 37% of the budget. New Jersey is not alone.

    The real issue here is the enormous over-leveraging of taxpayer-supported obligations at a time when taxpayers are already paying more and receiving less. In the states most affected by skyrocketing debt and fiscal imbalances, social services continue to be cut the most. Taxpayers have the ultimate voting right—with their feet. Corporations are relocating, or at a minimum moving large portions of their businesses to more tax-friendly states.

    Boeing is in the political cross-hairs as it is trying to set up a facility in the more business-friendly state of South Carolina, away from its current hub of Washington. California legislators recently went to Texas to learn best practices as a result of a rising tide of businesses that are building operations outside of their state. Over time, individuals will migrate to more tax-friendly states as well, and job seekers will follow corporations.

    Continued in article

    Jensen Comment
    Some accountants naively assume that the new IASB-FASB agreement on fair value accounting will make pension obligations more transparent, especially if the GASB follows suit. What they don't really understand is that obligations that are not recognized in the first place are not going to be made more transparent with fair value accounting if they're hidden in the first place. For ten years Arnold Swartzenagger disclosed four kids and hid a fifth kid from his wife and the rest of the world. With pensions it's more like disclosing one kid and hiding four from the world.

    Arnold pretty well ruined parts of his life when the that which was hidden was finally revealed. The same thing will happen to local, state, and national governments in the U.S. if hidden pension obligations are ever revealed. It will ruin everything in future elections if voters really understand how bad the hidden entitlements have really become ---
    http://faculty.trinity.edu/rjensen/Entitlements.htm

    Questions
    Although all 50 states are in deep financial troubles, what state is in the worst shape at the moment and is unable to pay its bills?
    Hint: The state in deepest trouble is not California, although California is in dire straights!

    How did accountants hide the pending disaster?

    Watch the Video
    This module on 60 Minutes on December 19 was one of the most worrisome episodes I've ever watched
    It appears that a huge number of cities and towns and some states will default on bonds within12 months from now
    "State Budgets: The Day of Reckoning Steve Kroft Reports On The Growing Financial Woes States Are Facing," CBS Sixty Minutes, December 19, 2010 ---
    http://www.cbsnews.com/stories/2010/12/19/60minutes/main7166220.shtml

    The problem with that, according to Wall Street analyst Meredith Whitney, is that no one really knows how deep the holes are. She and her staff spent two years and thousands of man hours trying to analyze the financial condition of the 15 largest states. She wanted to find out if they would be able to pay back the money they've borrowed and what kind of risk they pose to the $3 trillion municipal bond market, where state and local governments go to finance their schools, highways, and other projects.

    "How accurate is the financial information that's public on the states? And municipalities," Kroft asked.

    "The lack of transparency with the state disclosure is the worst I have ever seen," Whitney said. "Ultimately we have to use what's publicly available data and a lot of it is as old as June 2008. So that's before the financial collapse in the fall of 2008."

    Whitney believes the states will find a way to honor their debts, but she's afraid some local governments which depend on their state for a third of their revenues will get squeezed as the states are forced to tighten their belts. She's convinced that some cities and counties will be unable to meet their obligations to municipal bond holders who financed their debt. Earlier this year, the state of Pennsylvania had to rescue the city of Harrisburg, its capital, from defaulting on hundreds of millions of dollars in debt for an incinerator project.

    "There's not a doubt in my mind that you will see a spate of municipal bond defaults," Whitney predicted.

    Asked how many is a "spate," Whitney said, "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

    Municipal bonds have long been considered to be among the safest investments, bought by small investors saving for retirement, and held in huge numbers by big banks. Even a few defaults could affect the entire market. Right now the big bond rating agencies like Standard & Poor's and Moody's, who got everything wrong in the housing collapse, say there's no cause for concern, but Meredith Whitney doesn't believe it.

    "When individual investors look to people that are supposed to know better, they're patted on the head and told, 'It's not something you need to worry about.' It'll be something to worry about within the next 12 months," she said.

    No one is talking about it now, but the big test will come this spring. That's when $160 billion in federal stimulus money, that has helped states and local governments limp through the great recession, will run out.

    The states are going to need some more cash and will almost certainly ask for another bailout. Only this time there are no guarantees that Washington will ride to the rescue.

    Continued in article

    "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

    Here's a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don't want to raise contributions. Cutting benefits is out of the question. To be honest, you'd really rather not even admit there's a problem, lest taxpayers get upset.

    What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that's the essence of the managers' recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn't bother applying.

    Public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

    The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized. Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That's nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it's likely these gargantuan shortfalls will have to be borne by unsuspecting taxpayers.

    Some public pension administrators have a strategy, though: Keep taxpayers unsuspecting. The Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System declare in a recent solicitation for actuarial services that "If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration."

    Scott Miller, legal counsel of the Montana Public Employees Board, was more straightforward: "The point is we aren't interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory."

    While corporate pension funds are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, public employee pensions are not. However, financial economists are united in believing that market-based techniques for valuing private sector investments should also be applied to public pensions.

    Because the power of compound interest is so strong, discounting future benefit costs using a pension plan's high expected return rather than a low riskless return can significantly reduce the plan's measured funding shortfall. But it does so only by ignoring risk. The expected return implies only the "expectation" -- meaning, at least a 50% chance, not a guarantee -- that the plan's assets will be sufficient to meet its liabilities. But when future benefits are considered to be riskless by plan participants and have been ruled to be so by state courts, a 51% chance that the returns will actually be there when they are needed hardly constitutes full funding.

    Public pension administrators argue that government plans fundamentally differ from private sector pensions, since the government cannot go out of business. Even so, the only true advantage public pensions have over private plans is the ability to raise taxes. But as the Congressional Budget Office has pointed out in 2004, "The government does not have a capacity to bear risk on its own" -- rather, government merely redistributes risk between taxpayers and beneficiaries, present and future.

    Market valuation makes the costs of these potential tax increases explicit, while the public pension administrators' approach, which obscures the possibility that the investment returns won't achieve their goals, leaves taxpayers in the dark.

    For these reasons, the Public Interest Committee of the American Academy of Actuaries recently stated, "it is in the public interest for retirement plans to disclose consistent measures of the economic value of plan assets and liabilities in order to provide the benefits promised by plan sponsors."

    Nevertheless, the National Association of State Retirement Administrators, an umbrella group representing government employee pension funds, effectively wants other public plans to take the same low road that the two Montana plans want to take. It argues against reporting the market valuation of pension shortfalls. But the association's objections seem less against market valuation itself than against the fact that higher reported underfunding "could encourage public sector plan sponsors to abandon their traditional pension plans in lieu of defined contribution plans."

    The Government Accounting Standards Board, which sets guidelines for public pension reporting, does not currently call for reporting the market value of public pension liabilities. The board announced last year a review of its position regarding market valuation but says the review may not be completed until 2013.

    This is too long for state taxpayers to wait to find out how many trillions they owe.

    "Whither Berkeley? Whither California?" by J. Edward Ketz, SmartPros, November 2009 ---
    http://accounting.smartpros.com/x68185.xml

    When people ignore economic realities and are foolish enough to make and adhere to ill-conceived and faulty budgets, well, they get what they deserve. Take California, for example.

    The state has greatly reduced its cash infusions to the University of California system, and recently the university’s regents voted to increase fees (California’s code word for “tuition”) 32%. This has led to a strike at Berkeley and to student demonstrations and to the take-over of some buildings there and at Santa Cruz. This planned tuition hike comes on the heels of layoffs and furloughs and salary cutbacks of many university employees.

    Recently, the Academic Senate at Berkeley voted to end financial support for the Department of Intercollegiate Athletics. The Senate even had the gall to ask the Athletics department to repay a loan of $5.8 million. Nothing is sacred anymore! But nothing to fear—I bet the regents will save Berkeley football before it saves the classics department.

    The state of affairs at Berkeley will be watched all over because many other public universities are not much different. It is only a matter of time when they too will be faced with the question of how to endure economic sacrifice.

    But, it won’t be all bad. Such difficult times provide moments when society can rethink its goals and strategic priorities. How many research universities do we really need in this country? How many administrators do we really need to protect the interests of Croatian students or to assist those who wish to preserve the heritage of Bon Jovi or to supply counselors for those trying to give up Law and Order? And does every town with a population of at least 1,000 really need a branch campus?

    The state of California itself is much worse off than Berkeley. Given the state’s penchant to provide welfare to everybody who can generate a creative excuse for an entitlement, it was only a matter of time before the state’s budget was so out of whack even Alec Baldwin and Barbara Streisand could acknowledge it.

    State legislators and governors over the last 10 to 20 years are to blame. Not only do they not understand the word “NO” when it comes to spending, they were very short-sighted when it came to revenue generation. They thought the dot-com slush funds would continue to be created out of nothing, though physics and economics indicate otherwise. They then did want virtually every politician does—they are so without original ideas!—they raised taxes on corporations and rich people. Unfortunately, the legislators and governors forgot that corporations and rich people can move, and indeed enough of them have left the state, leaving California in serious trouble.

    The woes are so great that it is easy to predict that California will become the first state in U.S. history to declare bankruptcy. I put the odds at least at 50 percent in 2010.

    Then the fun begins. California, before or shortly after entering Chapter 11, will ask for help from Washington. While the Obama administration and the Congress likely will administer CPR to the state finances, they really should just admit that the state is insolvent. The moral hazard is huge. If Washington provides assistance, there will be 49 states that will quickly follow suit.

    The bankruptcy process itself will be interesting because nobody will know what to do with a state. Creditors might try to win concessions about the state’s budgeting process or membership to state agencies that make economic decisions. They will also attempt to rewrite existing contracts.

    The biggest effect will be on bond yields. Any bankruptcy will shoot rates up and this will make future governmental borrowing hard and expensive for all governmental units.

    Taxpayers will face a major nightmare. Taxes will skyrocket for those who are not fortunate enough to be retired. Maybe taxpayers will even wake up and realize that they have elected nothing but economic idiots for quite some time. But what do you expect from a state that thinks actors actually know something?

    I just love California dreamin’.

    Bob Jensen's threads on pension schemes to hide debt ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Pensions


    Teaching Case About a Former Grant Thornton Client
    CLASSROOM APPLICATION: The article may be used in an auditing or accounting class. Auditing questions relate to the responsibility for financial statements versus the audit report, issues delaying issuance of financial statements and audit reports, and auditor changes. Accounting questions relate to eliminations as done for consolidation of financial statements in order to avoid double counting of assets.

    From The Wall Street Journal Accounting Weekly Review on July 15, 2011

    Pensions Want Look Into Fund's Records
    by: Josh Barbanel, Steve Eder, and Jean Eaglesham
    Jul 13, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Auditor Changes, Auditor/Client Disagreements, Hedge Funds, Investment Banking, Investments

    SUMMARY: "Three Louisiana public pension funds say they are assembling a team of experts to examine the books and financial statements of a New York hedge-fund firm [Fletcher Asset Management] they invested with after the firm responded to redemption requests with promissory notes rather than cash....The executive directors of the Louisiana pension funds said the response...'gives rise to questions regarding the liquidity' of the Fletcher fund...'and the accuracy of the financial statements'...." The article states that the financial statements "were issued by two independent auditing firms." The related article provides a few more details on accounting issues with respect to the hedge fund and the reported amounts of assets under management after including "feeder funds." "Fletcher reports it has more than $500 million of assets under management....Yet its primary investment vehicle held just $187.8 million of securities...and these made up 95% of the firm's market investments....This would translate to a 2009 year-end total for the firm's market investments of about $198 million, more than half of it the Louisiana pension funds' money....A lawyer who supervises Fletcher's SEC filings said it 'should be appropriate' to include the value of each feeder fund in the asset total...because each fund is actively managed and can invest in outside securities, said the lawyer...Mr. Fletcher gave an example: If investors put $2 in one Fletcher fund, and this fund borrowed $1, and then put the money in a second Fletcher fun, that would make $5 the firm managed, he said."

    CLASSROOM APPLICATION: The article may be used in an auditing or accounting class. Auditing questions relate to the responsibility for financial statements versus the audit report, issues delaying issuance of financial statements and audit reports, and auditor changes. Accounting questions relate to eliminations as done for consolidation of financial statements in order to avoid double counting of assets.

    QUESTIONS: 
    1. (Introductory) Summarize the agreement, as described in the main article and the related one, offered to Louisiana pension fund managers by Fletcher Asset Management.

    2. (Introductory) What is so unusual about the agreement that would lead some who reviewed its documentation--at the request of the WSJ-to say they "had never seen such an arrangement"?

    3. (Introductory) What action are the three Louisiana pension funds now jointly undertaking? What "experts" do you believe they will hire?

    4. (Advanced) For what report is an outside auditor responsible? Who is responsible for issuing financial statements? Explain a common misperception about these responsibilities and note how that misperception is evident in this article.

    5. (Advanced) What factors may lead to delayed issuance of financial statements and a related audit report? In your answer, note any examples of these factors described in the articles.

    6. (Introductory) Refer to the related article. What difference leads to measuring assets under management at $500 million according to Fletch Asset Management's reporting and $200 million under "a more orthodox way of measuring assets under management"? Given the different measurements of assets under management, how substantial is the total of the three Louisiana pension funds' investment in the Fletcher Asset Management funds?

    7. (Advanced) How do consolidation accounting procedures help to resolve the problem of double counting evidenced in the calculation and discussion to the question above?

    8. (Advanced) Refer to the statement by "a lawyer who supervises Fletcher's SEC filings" that "'it should be appropriate' to include the value of each feeder fund in the asset total...because each fund is actively managed and can invest in outside securities...." What criteria would you offer to decide on whether to separately count an investment fund's holdings in total assets under management? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Highflier Tells Clients to Wait
    by Steve Eder and Josh Barbanel
    Jul 07, 2011
    Online Exclusive

    "Pensions Want Look Into Fund's Records," by: Josh Barbanel, Steve Eder, and Jean Eaglesham, The Wall Street Journal, July 13, 2011 ---
    http://online.wsj.com/article/SB10001424052702303678704576442022138940088.html?mod=djem_jiewr_AC_domainid

    Three Louisiana public pension funds say they are assembling a team of experts to examine the books and financial statements of a New York hedge-fund firm they invested with after the firm responded to redemption requests with promissory notes rather than cash.

    Separately, the Securities and Exchange Commission has opened a probe into the fund firm, Fletcher Asset Management, according to a person familiar with the matter. It isn't clear what the regulator is looking at.

    A spokeswoman for Fletcher didn't immediately respond to a request for comment. An SEC spokeswoman declined to comment.

    In a joint statement Tuesday, the executive directors of the Louisiana pension funds said the response they received to their redemption requests "gives rise to questions regarding the liquidity" of the Fletcher fund in which they invested "and the accuracy of the financial statements" issued by two independent auditing firms.

    A representative for one audit firm, Grant Thornton LLP, which no longer has the Fletcher account, declined to comment. Representatives for a second, EisnerAmper, on Tuesday didn't respond to requests for comment.

    The three pension systems separately invested a total of $100 million with Fletcher in 2008. They were offered a minimum return of 12% a year. In March, two funds put in redemption requests for a total of about $32 million.

    The statement from the pension-fund executives said the investments have accrued the expected return as verified by the auditors. But the firm's decision to pay the redemption in notes in lieu of immediate cash prompted them to take a deeper look at Fletcher's books, the statement said.

    Previously, Fletcher in a statement told The Wall Street Journal it wasn't required to distribute redemptions in cash and that it made the payments in accordance with its agreement with the pension funds.

    In their statement Tuesday, executives from the three pension funds said Fletcher Asset Management has fully cooperated during the "preliminary assessments conducted by the retirement systems."

    A Wall Street Journal article last week highlighted a number of unusual practices at the firm, including the 12% offered to the pension funds. In the arrangement, the return is backed by the holdings of other investors. Fletcher hasn't delivered its 2009 audit for the fund in which the Louisiana pension funds are invested.

    Alphonse Fletcher Jr., a former Wall Street trader who founded the asset-management firm in 1991, said in interviews earlier this year that his firm fully and clearly discloses its practices and has acted in accordance with its legal obligations to the pension funds.

    Fletcher recently told investors that its 2009 audit has been delayed because the firm needs to "finalize the valuation of one of the fund's investments," according to pension-fund records. On Monday, Fletcher said in a statement the audit is expected by the end of July.

    The pension-fund executives said in their statement that Fletcher initially indicated the redemption requests two of the funds made would be "accommodated" at the end of a 60-day notice period.

    "Just prior to the expiration" of that notice period, the executives wrote, Fletcher informed the pension boards "that they would receive the requested distribution, but the cash distribution would first require an orderly liquidation of assets held by" the fund. The note gives Fletcher as long as two years to accomplish the liquidation, according to the pension funds' statement, which said the note is payable at 5% interest a year.

    Mr. Fletcher, 45 years old, made a splash on Wall Street in the 1990s when he opened his own firm, which reported 300%-a-year returns. Questions about his finances have arisen in a suit he filed earlier this year in state court in New York against the board of the famed Dakota co-operative apartment complex alongside New York's Central Park, where he owns several apartments. Mr. Fletcher accused the co-op board of unfairly rejecting his request to buy an additional apartment and alleged racial discrimination. The case is pending.

    Tuesday's statement came as Louisiana state officials and lawmakers called for a possible revamp of public-pension investment rules and a review of the Fletcher investment.

    In an interview after the Journal's article last week, Louisiana Legislative Auditor Daryl Purpera said he would meet with key lawmakers to discuss legislation for new, more-strict investment guidelines for public pension funds across the state.

    State officials and lawmakers said one proposal might be to consolidate investment decisions for large and smaller public pension funds.

    Another option, they said, would be to set uniform investment guidelines for pension funds in the state.

    At present, they say, pension boards in Louisiana typically set investment guidelines and review investments independently, including the three boards with Fletcher investments—Firefighters' Retirement System of Louisiana, Municipal Employees' Retirement System of Louisiana, and the New Orleans Firefighters' Pension and Relief Fund.

    Continued in article

    Bob Jensen's threads on the accounting for pensions and post-retirement benefits ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions 

     


    Sunlight Foundation's Party Time! (sunlight and transparency in government) ---  http://politicalpartytime.org/ 


    Oops! Those so-called "assets" should've been placed on the right hand side of the balance sheet.
    Don't put your "trust" in the U.S. Congress
    It's a little like taking money from your safety deposit box and writing your self IOUs to someday put your money back in the box
    In the case of Social Security trust funds the government owes itself $2.5 trillion
    It's time for the Fed to turn the crank on bigger bills in the printing presses --- 600 $1billion dollar bills just won't cut it Ben

    "Are The Social Security Trust Funds A Mirage?" by Alex Blumberg and Chana Joffe-Walt, NPR Audio, November 19, 2010 ---
    http://www.npr.org/blogs/money/2010/11/18/131420919/are-the-social-security-trust-funds-a-mirage

    Proposals to fix the deficit are coming fast and furious in Washington these days. One major target: Social Security.

    Whether you favor cutting Social Security may depend on how you view the Social Security trust funds, which currently contain $2.5 trillion for retirement benefits. That's $2.5 trillion that, according to some people, don't actually exist.

    Here's the back story.

    If you look at your paycheck, in the spot where it lists deductions, there's a line that says "FICA." That's the money that gets taken out of your check to pay for Social Security.

    For the past 25 years or so, the amount of money the government has raised through those taxes has been greater than what it's been spending to fund Social Security.

    The surplus came largely from the baby boomers — and we're going to need that extra money when they retire and start collecting Social Security.

    This is where the $2.5 trillion trust funds come in.

    The government has invested all that money in Treasury bonds, which are traditionally considered among the safest investments in the world.

    But a Treasury bond, remember, is the way the government borrows money. So the government is lending the Social Security surplus to itself. And the obligation to repay those loans is the trust funds.

    "They are nothing like any trust fund that any one of us would think of," says Maya MacGuineas of the New America Foundation. "It conjures up an image of really holding savings, and it doesn't do that at all."

    But there's another way to think about what the government is doing here.

    The federal government owes $2.5 trillion to the Social Security trust funds. And if the government doesn't pay that money, it will default on its debt — something the U.S. has never done in its history.

    By the middle of the next decade, the Social Security surplus will turn into yearly deficits as more Baby Boomers retire. And the government will have to come up with hundreds of billions of dollars a year to cover its obligations to the trust fund.

    At that point, the debate over whether or not the trust funds exist becomes a moot.

    "The policy choices that we have to make good on Social Security obligations are exactly the same with the trust fund or if we'd never had the trust fund," MacGuineas says. "Raise taxes, cut Social Security benefits, cut other government spending, or borrow the money. That's the only way to repay the money."

    Smoke and Mirrors
    The Sad State of Government Accounting and Accountability
    http://faculty.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

     


    "A Low, Dishonest Decade: The press and politicians were asleep at the switch.," The Wall Street Journal, December 22, 2009 ---
    http://online.wsj.com/article/SB10001424052748703478704574612013922050326.html?mod=djemEditorialPage

    Stock-market indices are not much good as yardsticks of social progress, but as another low, dishonest decade expires let us note that, on 2000s first day of trading, the Dow Jones Industrial Average closed at 11357 while the Nasdaq Composite Index stood at 4131, both substantially higher than where they are today. The Nasdaq went on to hit 5000 before collapsing with the dot-com bubble, the first great Wall Street disaster of this unhappy decade. The Dow got north of 14000 before the real-estate bubble imploded.

    And it was supposed to have been such an awesome time, too! Back in the late '90s, in the crescendo of the Internet boom, pundit and publicist alike assured us that the future was to be a democratized, prosperous place. Hierarchies would collapse, they told us; the individual was to be empowered; freed-up markets were to be the common man's best buddy.

    Such clever hopes they were. As a reasonable anticipation of what was to come they meant nothing. But they served to unify the decade's disasters, many of which came to us festooned with the flags of this bogus idealism.

    Before "Enron" became synonymous with shattered 401(k)s and man-made electrical shortages, the public knew it as a champion of electricity deregulation—a freedom fighter! It was supposed to be that most exalted of corporate creatures, a "market maker"; its "capacity for revolution" was hymned by management theorists; and its TV commercials depicted its operations as an extension of humanity's quest for emancipation.

    Similarly, both Bank of America and Citibank, before being recognized as "too big to fail," had populist histories of which their admirers made much. Citibank's long struggle against the Glass-Steagall Act was even supposed to be evidence of its hostility to banking's aristocratic culture, an amusing image to recollect when reading about the $100 million pay reportedly pocketed by one Citi trader in 2008.

    The Jack Abramoff lobbying scandal showed us the same dynamics at work in Washington. Here was an apparent believer in markets, working to keep garment factories in Saipan humming without federal interference and saluted for it in an op-ed in the Saipan Tribune as "Our freedom fighter in D.C."

    But the preposterous populism is only one part of the equation; just as important was our failure to see through the ruse, to understand how our country was being disfigured.

    Ensuring that the public failed to get it was the common theme of at least three of the decade's signature foul-ups: the hyping of various Internet stock issues by Wall Street analysts, the accounting scandals of 2002, and the triple-A ratings given to mortgage-backed securities.

    The grand, overarching theme of the Bush administration—the big idea that informed so many of its sordid episodes—was the same anti-supervisory impulse applied to the public sector: regulators sabotaged and their agencies turned over to the regulated.

    The public was left to read the headlines and ponder the unthinkable: Could our leaders really have pushed us into an unnecessary war? Is the republic really dividing itself into an immensely wealthy class of Wall Street bonus-winners and everybody else? And surely nobody outside of the movies really has the political clout to write themselves a $700 billion bailout.

    What made the oughts so awful, above all, was the failure of our critical faculties. The problem was not so much that newspapers were dying, to mention one of the lesser catastrophes of these awful times, but that newspapers failed to do their job in the first place, to scrutinize the myths of the day in a way that might have prevented catastrophes like the financial crisis or the Iraq war.

    The folly went beyond the media, though. Recently I came across a 2005 pamphlet written by historian Rick Perlstein berating the big thinkers of the Democratic Party for their poll-driven failure to stick to their party's historic theme of economic populism. I was struck by the evidence Mr. Perlstein adduced in the course of his argument. As he tells the story, leading Democratic pollsters found plenty of evidence that the American public distrusts corporate power; and yet they regularly advised Democrats to steer in the opposite direction, to distance themselves from what one pollster called "outdated appeals to class grievances and attacks upon corporate perfidy."

    This was not a party that was well-prepared for the job of iconoclasm that has befallen it. And as the new bunch muddle onward—bailing out the large banks but (still) not subjecting them to new regulatory oversight, passing a health-care reform that seems (among other, better things) to guarantee private insurers eternal profits—one fears they are merely presenting their own ample backsides to an embittered electorate for kicking.


    Before reading this module you may want to read about Governmental Accounting at http://en.wikipedia.org/wiki/Governmental_accounting

    "Don't Like the Numbers? Change 'Em If a CEO issued the kind of distorted figures put out by politicians and scientists, he'd wind up in prison," by Stanford Economics Professor Michael J. Boskin, The Wall Street Journal, January 14, 2010 ---
    http://online.wsj.com/article/SB10001424052748704586504574654261655183416.html?mod=djemEditorialPage

    Politicians and scientists who don't like what their data show lately have simply taken to changing the numbers. They believe that their end—socialism, global climate regulation, health-care legislation, repudiating debt commitments, la gloire française—justifies throwing out even minimum standards of accuracy. It appears that no numbers are immune: not GDP, not inflation, not budget, not job or cost estimates, and certainly not temperature. A CEO or CFO issuing such massaged numbers would land in jail.

    The late economist Paul Samuelson called the national income accounts that measure real GDP and inflation "one of the greatest achievements of the twentieth century." Yet politicians from Europe to South America are now clamoring for alternatives that make them look better.

    A commission appointed by French President Nicolas Sarkozy suggests heavily weighting "stability" indicators such as "security" and "equality" when calculating GDP. And voilà!—France outperforms the U.S., despite the fact that its per capita income is 30% lower. Nobel laureate Ed Prescott called this disparity the difference between "prosperity and depression" in a 2002 paper—and attributed it entirely to France's higher taxes.

    With Venezuela in recession by conventional GDP measures, President Hugo Chávez declared the GDP to be a capitalist plot. He wants a new, socialist-friendly way to measure the economy. Maybe East Germans were better off than their cousins in the West when the Berlin Wall fell; starving North Koreans are really better off than their relatives in South Korea; the 300 million Chinese lifted out of abject poverty in the last three decades were better off under Mao; and all those Cubans risking their lives fleeing to Florida on dinky boats are loco.

    In Argentina, President Néstor Kirchner didn't like the political and budget hits from high inflation. After a politicized personnel purge in 2002, he changed the inflation measures. Conveniently, the new numbers showed lower inflation and therefore lower interest payments on the government's inflation-linked bonds. Investor and public confidence in the objectivity of the inflation statistics evaporated. His wife and successor Cristina Kirchner is now trying to grab the central bank's reserves to pay for the country's debt.

    America has not been immune from this dangerous numbers game. Every president is guilty of spinning unpleasant statistics. President Richard Nixon even thought there was a conspiracy against him at the Bureau of Labor Statistics. But President Barack Obama has taken it to a new level. His laudable attempt at transparency in counting the number of jobs "created or saved" by the stimulus bill has degenerated into farce and was just junked this week.

    The administration has introduced the new notion of "jobs saved" to take credit where none was ever taken before. It seems continually to confuse gross and net numbers. For example, it misses the jobs lost or diverted by the fiscal stimulus. And along with the congressional leadership it hypes the number of "green jobs" likely to be created from the explosion of spending, subsidies, loans and mandates, while ignoring the job losses caused by its taxes, debt, regulations and diktats.

    The president and his advisers—their credibility already reeling from exaggeration (the stimulus bill will limit unemployment to 8%) and reneged campaign promises (we'll go through the budget "line-by-line")—consistently imply that their new proposed regulation is a free lunch. When the radical attempt to regulate energy and the environment with the deeply flawed cap-and-trade bill is confronted with economic reality, instead of honestly debating the trade-offs they confidently pronounce that it boosts the economy. They refuse to admit that it simply boosts favored sectors and firms at the expense of everyone else.

    Rabid environmentalists have descended into a separate reality where only green counts. It's gotten so bad that the head of the California Air Resources Board, Mary Nichols, announced this past fall that costly new carbon regulations would boost the economy shortly after she was told by eight of the state's most respected economists that they were certain these new rules would damage the economy. The next day, her own economic consultant, Harvard's Robert Stavis, denounced her statement as a blatant distortion.

    Scientists are expected to make sure their findings are replicable, to make the data available, and to encourage the search for new theories and data that may overturn the current consensus. This is what Galileo, Darwin and Einstein—among the most celebrated scientists of all time—did. But some climate researchers, most notably at the University of East Anglia, attempted to hide or delete temperature data when that data didn't show recent rapid warming. They quietly suppressed and replaced the numbers, and then attempted to squelch publication of studies coming to different conclusions.

    The Obama administration claims a dubious "Keynesian" multiplier of 1.5 to feed the Democrats' thirst for big spending. The administration's idea is that virtually all their spending creates jobs for unemployed people and that additional rounds of spending create still more—raising income by $1.50 for each dollar of government spending. Economists differ on such multipliers, with many leading figures pegging them at well under 1.0 as the government spending in part replaces private spending and jobs. But all agree that every dollar of spending requires a present value of a dollar of future taxes, which distorts decisions to work, save, and invest and raises the cost of the dollar of spending to well over a dollar. Thus, only spending with large societal benefits is justified, a criterion unlikely to be met by much current spending (perusing the projects on recovery.gov doesn't inspire confidence).

    Even more blatant is the numbers game being used to justify health-insurance reform legislation, which claims to greatly expand coverage, decrease health-insurance costs, and reduce the deficit. That magic flows easily from counting 10 years of dubious Medicare "savings" and tax hikes, but only six years of spending; assuming large cuts in doctor reimbursements that later will be cancelled; and making the states (other than Sen. Ben Nelson's Nebraska) pay a big share of the cost by expanding Medicaid eligibility. The Medicare "savings" and payroll tax hikes are counted twice—first to help pay for expanded coverage, and then to claim to extend the life of Medicare.

    One piece of good news: The public isn't believing much of this out-of-control spin. Large majorities believe the health-care legislation will raise their insurance costs and increase the budget deficit. Most Americans are highly skeptical of the claims of climate extremists. And they have a more realistic reaction to the extraordinary deterioration in our public finances than do the president and Congress.

    As a society and as individuals, we need to make difficult, even wrenching choices, often with grave consequences. To base those decisions on highly misleading, biased, and even manufactured numbers is not just wrong, but dangerous.

    Squandering their credibility with these numbers games will only make it more difficult for our elected leaders to enlist support for difficult decisions from a public increasingly inclined to disbelieve them.

    Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He chaired the Council of Economic Advisers under President George H.W. Bush

     The Most Criminal Class is Writing the Laws ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

     


    Before reading this module you may want to read about Governmental Accounting at http://en.wikipedia.org/wiki/Governmental_accounting

    Never ending fraud in Medicare billings: 
    Unaudited overpayments, unqualified items, and criminal vendors

    One spending sinkhole can be traced to large medical-equipment suppliers, device makers, and pharmaceutical companies, which government auditors and industry veterans describe as a recalcitrant bunch. Medical manufacturers know public agencies generally pay first and ask questions later—if ever. Medicare receives 4.4 million claims daily; fewer than 3% are reviewed before being paid within the legally required 30 days.

    "A Hole in Health-Care Reform: Overbilling by medical-equipment suppliers, device makers, and drug companies has cost taxpayers billions. New legislation will do little to stem the tide," by Chad Terhune, Business Week, December 10, 2009 ---
    http://www.businessweek.com/magazine/content/09_51/b4160046945722.htm?link_position=link3 

    President Barack Obama and his Democratic allies on Capitol Hill say that a vast expansion of health coverage can be funded by squeezing out waste and fraud rather than cutting benefits. Whether that turns out to be true may help determine the success of the sweeping reform package being debated by Congress. Slashing costs is no easy task, and stopping fraud is even tougher. No less than $47 billion in Medicare spending went to dubious claims in the year ended Sept. 30, according to the U.S. Health & Human Services Dept. That's 10.7% of the $440 billion program that subsidizes care for the elderly. Medicaid, the government program for the poor, lets billions trickle away at roughly the same rate. The $10 million annual increase that Congress is allocating to fight fraud may not be enough to do the trick.

    One spending sinkhole can be traced to large medical-equipment suppliers, device makers, and pharmaceutical companies, which government auditors and industry veterans describe as a recalcitrant bunch. Medical manufacturers know public agencies generally pay first and ask questions later—if ever. Medicare receives 4.4 million claims daily; fewer than 3% are reviewed before being paid within the legally required 30 days.

    One way to get a sense of the scale of the seepage—and the challenge facing the Administration—is to look at whistleblower lawsuits filed under the federal False Claims Act. That law allows company employees to sue on behalf of the government to recover improperly claimed federal funds.

    A suit filed by William A. Thomas, a former senior sales manager at Siemens Medical Solutions USA, one of the nation's largest medical suppliers and a unit of German engineering giant Siemens (SI), offers a case study in the difficulty of containing costs. Thomas, a 15-year Siemens Medical veteran, alleges in federal court in Philadelphia that for years the company overbilled the Veterans Affairs Dept. and other government agencies by hundreds of millions of dollars for MRI and CT scan machines and other expensive equipment. These high-tech systems—used to examine everything from damaged knees to suspected cancers—cost $500,000 to $3 million apiece, sometimes more. Thomas, who retired from Siemens in 2008, claims that with no justification other than larger profits, his former employer charged its government customers far more than private-sector buyers for the same equipment.

    "Billions and billions could be saved with the right government regulation and oversight applied to health care," Thomas, 56, says in an interview. "But I think corporations will continue running circles around the federal government."

    In court filings, Siemens has denied any wrongdoing and has sought to have the Thomas suit dismissed. A company spokesman, Lance Longwell, declined to elaborate for this article, citing the litigation.

    The Thomas suit illustrates some of the vagaries of False Claims Act cases, hundreds of which are filed every year against government contractors in a range of industries. As the plaintiff, Thomas stands to pocket up to 30% of any court recovery, with the rest going to the Treasury. The Justice Dept., which can intervene in such suits to help steer them, announced last year that it will stay out of the case against Siemens for now. Yet Thomas' allegations have helped drive a parallel criminal investigation of Siemens' equipment marketing practices by the Defense Dept. and the U.S. Attorney's Office in Philadelphia.

    In April federal investigators searched for records at the headquarters of Siemens Medical in Malvern, Pa., a suburb of Philadelphia. Ed Bradley, special agent-in-charge of the Defense Criminal Investigative Service, confirmed that the investigation is continuing but declined to comment further.

    Longwell, the Siemens Medical spokesman, says the company is cooperating with criminal investigators. In March, just weeks before the search of its offices, Siemens won a new $267 million contract to provide radiology equipment to the U.S.

    Page 1 2 Next Page Reader Discussion

    BW Extras Podcasts Mandel on Economics Behind the Cover CEO Guide to Tech more… RSS Feeds Most Popular Top News Innovation Trends more… E-mails Asia Insider MBA Express BW.com Insider more… Blogs Blogspotting Hot Property Tech Beat more… Business ExchangeTrack and share business topics across the Web. Advertising in a Recession Entrepreneurship in a Recession Enterprise Rent-A-Car Buying a Foreclosed Home Plug-in Hybrids Most Popular Stories Read E-mailed Discussed Apple Sues Nokia, Claims Infringement Why Tech Bows to Best Buy If You Don't Buy a House Now, You're Stupid or Broke Forecast for 2010: The Coming Cloud 'Catastrophe' Kindle vs. Nook RSS Feed: Most Read Stories

    If You Don't Buy a House Now, You're Stupid or Broke - BusinessWeek Can KKR Make Like Berkshire Hathaway? - BusinessWeek Why Tech Bows to Best Buy - BusinessWeek GM Will Sell Opel to Magna After All - BusinessWeek A Vehicle for Your Business - BusinessWeek RSS Feed: Most E-mailed Stories

    Why Tech Bows to Best Buy Tiger Woods' Handicap as a Pitchman AT&T Possible Price Moves May Backfire Americans Are Furious at Wall Street China's 'Made in China' Problem RSS Feed: Most Discussed Stories

    Most Popular Multimedia Slide Shows 25 Products That Might Just Change The World Fifty Ugliest Cars of the Past 50 Years Best Internships of 2009 The 25 Coolest Sneaker Designs of 2009 Best Places to Raise Your Kids: 2010 RSS Feed: Most Popular Slide Shows

    Ads by Google Medicare Health Plans Introducing AARP® MedicareComplete® Provided Through SecureHorizons®. AARPMedicarePlans.com/Advantage Whistleblower Reward How to claim your share for fighting fraud on the government www.FraudFighters.net Declined Qui Tam? FCA attorneys with outstanding verdicts and settlements. Info at: www.Whistleblower.info Health Care Petition Don't Let Special Interests Derail Reform. Sign the Official Petition! www.DSCC.org

    BW Mall - Sponsored Links Recruiting in the Finance Industry? Software for Recruiting, Applicant Tracking, Onboarding, CRM and more! FREE DEMO Secure Recruiting Platfrom Complete SaaS Talent Platform Software (Pre/Post-Hire) View a FREE DEMO now! Free Polycom Videoconferencing Webinar On December 16 Learn How Polycom Can Help You Improve Business Collaboration. Sign up - Microsoft Dynamics CRM Online Get up to 6 months of Microsoft Dynamics CRM at NO CHARGE! Sign up Today! Online PHR Certificate Program w/ Villanova Univ SHRM Approved HR Certificate Program from Villanova University. 100% Online - Find Out More Now! Buy a link now!

    Ontario. The world's most highly skilled workforce.

    Jensen Comment
    The GAO has declared that many huge sink holes for fraud and waste are unauditable --- the Pentagon, the IRS, Medicare, and the list goes on and on. But the Congress that funds these programs is manipulated by special interest groups who do not want these audits. The new sink hole on the block is almost anything green.

    What is happening to America?

    Bob Jensen's threads on health care are at
    http://www.businessweek.com/magazine/content/09_51/b4160046945722.htm?link_position=link3


    University of Illinois at Chicago Report on Massive Political Corruption in Chicago
    "Chicago Is a 'Dark Pool Of Political Corruption'," Judicial Watch, February 22, 2010 ---
    http://www.judicialwatch.org/blog/2010/feb/dark-pool-political-corruption-chicago

    A major U.S. city long known as a hotbed of pay-to-play politics infested with clout and patronage has seen nearly 150 employees, politicians and contractors get convicted of corruption in the last five decades.

    Chicago has long been distinguished for its pandemic of public corruption, but actual cumulative figures have never been offered like this. The astounding information is featured in a lengthy report published by one of Illinois’s biggest public universities.

    Cook County, the nation’s second largest, has been a “dark pool of political corruption” for more than a century, according to the informative study conducted by the University of Illinois at Chicago, the city’s largest public college. The report offers a detailed history of corruption in the Windy City beginning in 1869 when county commissioners were imprisoned for rigging a contract to paint City Hall.

    It’s downhill from there, with a plethora of political scandals that include 31 Chicago alderman convicted of crimes in the last 36 years and more than 140 convicted since 1970. The scams involve bribes, payoffs, padded contracts, ghost employees and whole sale subversion of the judicial system, according to the report. 

    Elected officials at the highest levels of city, county and state government—including prominent judges—were the perpetrators and they worked in various government locales, including the assessor’s office, the county sheriff, treasurer and the President’s Office of Employment and Training. The last to fall was renowned political bully Isaac Carothers, who just a few weeks ago pleaded guilty to federal bribery and tax charges.

    In the last few years alone several dozen officials have been convicted and more than 30 indicted for taking bribes, shaking down companies for political contributions and rigging hiring. Among the convictions were fraud, violating court orders against using politics as a basis for hiring city workers and the disappearance of 840 truckloads of asphalt earmarked for city jobs. 

    A few months ago the city’s largest newspaper revealed that Chicago aldermen keep a secret, taxpayer-funded pot of cash (about $1.3 million) to pay family members, campaign workers and political allies for a variety of questionable jobs. The covert account has been utilized for decades by Chicago lawmakers but has escaped public scrutiny because it’s kept under wraps. 

    Judicial Watch has extensively investigated Chicago corruption, most recently the conflicted ties of top White House officials to the city, including Barack and Michelle Obama as well as top administration officials like Chief of Staff Rahm Emanual and Senior Advisor David Axelrod. In November Judicial Watch sued Chicago Mayor Richard Daley's office to obtain records related to the president’s failed bid to bring the Olympics to the city.

    Bob Jensen's threads on the sad state of governmental accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

    Bob Jensen's threads on political corruption are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/fraudUpdates.htm

     


    "Taxpayers distrustful of government financial reporting," AccountingWeb, February 22, 2008 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=104680

    The federal government is failing to meet the financial reporting needs of taxpayers, falling short of expectations, and creating a problem with trust, according to survey findings released by the Association of Government Accountants (AGA). The survey, Public Attitudes to Government Accountability and Transparency 2008, measured attitudes and opinions towards government financial management and accountability to taxpayers. The survey established an expectations gap between what taxpayers expect and what they get, finding that the public at large overwhelmingly believes that government has the obligation to report and explain how it generates and spends its money, but that that it is failing to meet expectations in any area included in the survey.

    The survey further found that taxpayers consider governments at the federal, state, and local levels to be significantly under-delivering in terms of practicing open, honest spending. Across all levels of government, those surveyed held "being open and honest in spending practices" vitally important, but felt that government performance was poor in this area. Those surveyed also considered government performance to be poor in terms of being "responsible to the public for its spending." This is compounded by perceived poor performance in providing understandable and timely financial management information.

    The survey shows:

  • The American public is most dissatisfied with government financial management information disseminated by the federal government. Seventy-two percent say that it is extremely or very important to receive this information from the federal government, but only 5 percent are extremely or very satisfied with what they receive.

     

  • Seventy-three percent of Americans believe that it is extremely or very important for the federal government to be open and honest in its spending practices, yet only 5 percent say they are meeting these expectations.

     

  • Seventy-one percent of those who receive financial management information from the government or believe it is important to receive it, say they would use the information to influence their vote.

    Relmond Van Daniker, Executive Director at AGA, said, "We commissioned this survey to shed some light on the way the public perceives those issues relating to government financial accountability and transparency that are important to our members. Nobody is pretending that the figures are a shock, but we are glad to have established a benchmark against which we can track progress in years to come."

    He continued, "AGA members working in government at all levels are in the very forefront of the fight to increase levels of government accountability and transparency. We believe that the traditional methods of communicating government financial information -- through reams of audited financial statements that have little relevance to the taxpayer -- must be supplemented by government financial reporting that expresses complex financial details in an understandable form. Our members are committed to taking these concepts forward."

    Justin Greeves, who led the team at Harris Interactive that fielded the survey for the AGA, said, "The survey results include some extremely stark, unambiguous findings. Public levels of dissatisfaction and distrust of government spending practices came through loud and clear, across every geography, demographic group, and political ideology. Worthy of special note, perhaps, is a 67 percentage point gap between what taxpayers expect from government and what they receive. These are significant findings that I hope government and the public find useful."

    This survey was conducted online within the United States by Harris Interactive on behalf of the Association of Government Accountants between January 4 and 8, 2008 among 1,652 adults aged 18 or over. Results were weighted as needed for age, sex, race/ethnicity, education, region, and household income. Propensity score weighting was also used to adjust for respondents' propensity to be online. No estimates of theoretical sampling error can be calculated.

    You can read the Survey Report, including a full methodology and associated commentary.

  • "The Government Is Wasting Your Tax Dollars! How Uncle Sam spends nearly $1 trillion of your money each year," by Ryan Grim with Joseph K. Vetter, Readers Digest, January 2008, pp. 86-99 --- http://www.rd.com/content/the-government-is-wasting-your-tax-dollars/4/

    1. Taxes:
    Cheating Shows. The Internal Revenue Service estimates that the annual net tax gap—the difference between what's owed and what's collected—is $290 billion, more than double the average yearly sum spent on the wars in Iraq and Afghanistan.

    About $59 billion of that figure results from the underreporting and underpayment of employment taxes. Our broken system of immigration is another concern, with nearly eight million undocumented workers having a less-than-stellar relationship with the IRS. Getting more of them on the books could certainly help narrow that tax gap.

    Going after the deadbeats would seem like an obvious move. Unfortunately, the IRS doesn't have the resources to adequately pursue big offenders and their high-powered tax attorneys. "The IRS is outgunned," says Walker, "especially when dealing with multinational corporations with offshore headquarters."

    Another group that costs taxpayers billions: hedge fund and private equity managers. Many of these moguls make vast "incomes" yet pay taxes on a portion of those earnings at the paltry 15 percent capital gains rate, instead of the higher income tax rate. By some estimates, this loophole costs taxpayers more than $2.5 billion a year.

    Oil companies are getting a nice deal too. The country hands them more than $2 billion a year in tax breaks. Says Walker, "Some of the sweetheart deals that were negotiated for drilling rights on public lands don't pass the straight-face test, especially given current crude oil prices." And Big Oil isn't alone. Citizens for Tax Justice estimates that corporations reap more than $123 billion a year in special tax breaks. Cut this in half and we could save about $60 billion.

    The Tab* Tax Shortfall: $290 billion (uncollected taxes) + $2.5 billion (undertaxed high rollers) + $60 billion (unwarranted tax breaks) Starting Tab: $352.5 billion

    2. Healthy Fixes.
    Medicare and Medicaid, which cover elderly and low-income patients respectively, eat up a growing portion of the federal budget. Investigations by Sen. Tom Coburn (R-OK) point to as much as $60 billion a year in fraud, waste and overpayments between the two programs. And Coburn is likely underestimating the problem.

    The U.S. spends more than $400 per person on health care administration costs and insurance -- six times more than other industrialized nations.

    That's because a 2003 Dartmouth Medical School study found that up to 30 percent of the $2 trillion spent in this country on medical care each year—including what's spent on Medicare and Medicaid—is wasted. And with the combined tab for those programs rising to some $665 billion this year, cutting costs by a conservative 15 percent could save taxpayers about $100 billion. Yet, rather than moving to trim fat, the government continues such questionable practices as paying private insurance companies that offer Medicare Advantage plans an average of 12 percent more per patient than traditional Medicare fee-for-service. Congress is trying to close this loophole, and doing so could save $15 billion per year, on average, according to the Congressional Budget Office.

    Another money-wasting bright idea was to create a giant class of middlemen: Private bureaucrats who administer the Medicare drug program are monitored by federal bureaucrats—and the public pays for both. An October report by the House Committee on Oversight and Government Reform estimated that this setup costs the government $10 billion per year in unnecessary administrative expenses and higher drug prices.

    The Tab* Wasteful Health Spending: $60 billion (fraud, waste, overpayments) + $100 billion (modest 15 percent cost reduction) + $15 billion (closing the 12 percent loophole) + $10 billion (unnecessary Medicare administrative and drug costs) Total $185 billion Running Tab: $352.5 billion +$185 billion = $537.5 billion

    3. Military Mad Money.
    You'd think it would be hard to simply lose massive amounts of money, but given the lack of transparency and accountability, it's no wonder that eight of the Department of Defense's functions, including weapons procurement, have been deemed high risk by the GAO. That means there's a high probability that money—"tens of billions," according to Walker—will go missing or be otherwise wasted.

    The DOD routinely hands out no-bid and cost-plus contracts, under which contractors get reimbursed for their costs plus a certain percentage of the contract figure. Such deals don't help hold down spending in the annual military budget of about $500 billion. That sum is roughly equal to the combined defense spending of the rest of the world's countries. It's also comparable, adjusted for inflation, with our largest Cold War-era defense budget. Maybe that's why billions of dollars are still being spent on high-cost weapons designed to counter Cold War-era threats, even though today's enemy is armed with cell phones and IEDs. (And that $500 billion doesn't include the billions to be spent this year in Iraq and Afghanistan. Those funds demand scrutiny, too, according to Sen. Amy Klobuchar, D-MN, who says, "One in six federal tax dollars sent to rebuild Iraq has been wasted.")

    Meanwhile, the Pentagon admits it simply can't account for more than $1 trillion. Little wonder, since the DOD hasn't been fully audited in years. Hoping to change that, Brian Riedl of the Heritage Foundation is pushing Congress to add audit provisions to the next defense budget.

    If wasteful spending equaling 10 percent of all spending were rooted out, that would free up some $50 billion. And if Congress cut spending on unnecessary weapons and cracked down harder on fraud, we could save tens of billions more.

    The Tab* Wasteful military spending: $100 billion (waste, fraud, unnecessary weapons) Running Tab: $537.5 billion + $100 billion = $637.5 billion

    4. Bad Seeds.
    The controversial U.S. farm subsidy program, part of which pays farmers not to grow crops, has become a giant welfare program for the rich, one that cost taxpayers nearly $20 billion last year.

    Two of the best-known offenders: Kenneth Lay, the now-deceased Enron CEO, who got $23,326 for conservation land in Missouri from 1995 to 2005, and mogul Ted Turner, who got $590,823 for farms in four states during the same period. A Cato Institute study found that in 2005, two-thirds of the subsidies went to the richest 10 percent of recipients, many of whom live in New York City. Not only do these "farmers" get money straight from the government, they also often get local tax breaks, since their property is zoned as agricultural land. The subsidies raise prices for consumers, hurt third world farmers who can't compete, and are attacked in international courts as unfair trade.

    The Tab* Wasteful farm subsidies: $20 billion Running Tab: $637.5 billion + $20 billion = $657.5 billion

    5. Capital Waste.
    While there's plenty of ongoing annual operating waste, there's also a special kind of profligacy—call it capital waste—that pops up year after year. This is shoddy spending on big-ticket items that don't pan out. While what's being bought changes from year to year, you can be sure there will always be some costly items that aren't worth what the government pays for them.

    Take this recent example: Since September 11, 2001, Congress has spent more than $4 billion to upgrade the Coast Guard's fleet. Today the service has fewer ships than it did before that money was spent, what 60 Minutes called "a fiasco that has set new standards for incompetence." Then there's the Future Imagery Architecture spy satellite program. As The New York Times recently reported, the technology flopped and the program was killed—but not before costing $4 billion. Or consider the FBI's infamous Trilogy computer upgrade: Its final stage was scrapped after a $170 million investment. Or the almost $1 billion the Federal Emergency Management Agency has wasted on unusable housing. The list goes on.

    The Tab* Wasteful Capital Spending: $30 billion Running Tab: $657.5 billion + $30 billion = $687.5 billion

    6. Fraud and Stupidity.
    Sen. Chuck Grassley (R-IA) wants the Social Security Administration to better monitor the veracity of people drawing disability payments from its $100 billion pot. By one estimate, roughly $1 billion is wasted each year in overpayments to people who work and earn more than the program's rules allow.

    The federal Food Stamp Program gets ripped off too. Studies have shown that almost 5 percent, or more than $1 billion, of the payments made to people in the $30 billion program are in excess of what they should receive.

    One person received $105,000 in excess disability payments over seven years.

    There are plenty of other examples. Senator Coburn estimates that the feds own unused properties worth $18 billion and pay out billions more annually to maintain them. Guess it's simpler for bureaucrats to keep paying for the property than to go to the trouble of selling it.

    The Tab* General Fraud and Stupidity: $2 billion (disability and food stamp overpayment) Running Tab: $687.5 billion + $2 billion = $689.5 billion

    7. Pork Sausage.
    Congress doled out $29 billion in so-called earmarks—aka funds for legislators' pet projects—in 2006, according to Citizens Against Government Waste. That's three times the amount spent in 1999. Congress loves to deride this kind of spending, but lawmakers won't hesitate to turn around and drop $500,000 on a ballpark in Billings, Montana.

    The most infamous earmark is surely the "bridge to nowhere"—a span that would have connected Ketchikan, Alaska, to nearby Gravina Island—at a cost of more than $220 million. After Hurricane Katrina struck New Orleans, Senator Coburn tried to redirect that money to repair the city's Twin Span Bridge. He failed when lawmakers on both sides of the aisle got behind the Alaska pork. (That money is now going to other projects in Alaska.) Meanwhile, this kind of spending continues at a time when our country's crumbling infrastructure—the bursting dams, exploding water pipes and collapsing bridges—could really use some investment. Cutting two-thirds of the $29 billion would be a good start.

    The Tab* Pork Barrel Spending: $20 billion Running Tab: $689.5 billion + $20 billion = $709.5 billion

    8. Welfare Kings.
    Corporate welfare is an easy thing for politicians to bark at, but it seems it's hard to bite the hand that feeds you. How else to explain why corporate welfare is on the rise? A Cato Institute report found that in 2006, corporations received $92 billion (including some in the form of those farm subsidies) to do what they do anyway—research, market and develop products. The recipients included plenty of names from the Fortune 500, among them IBM, GE, Xerox, Dow Chemical, Ford Motor Company, DuPont and Johnson & Johnson.

    The Tab* Corporate Welfare: $50 billion Running Tab: $709.5 billion + $50 billion = $759.5 billion

    9. Been There,
    Done That. The Rural Electrification Administration, created during the New Deal, was an example of government at its finest—stepping in to do something the private sector couldn't. Today, renamed the Rural Utilities Service, it's an example of a government that doesn't know how to end a program. "We established an entity to electrify rural America. Mission accomplished. But the entity's still there," says Walker. "We ought to celebrate success and get out of the business."

    In a 2007 analysis, the Heritage Foundation found that hundreds of programs overlap to accomplish just a few goals. Ending programs that have met their goals and eliminating redundant programs could comfortably save taxpayers $30 billion a year.

    The Tab* Obsolete, Redundant Programs: $30 billion Running Tab: $759.5 billion + $30 billion = $789.5 billion

    10. Living on Credit.
    Here's the capper: Years of wasteful spending have put us in such a deep hole, we must squander even more to pay the interest on that debt. In 2007, the federal government carried a debt of $9 trillion and blew $252 billion in interest. Yes, we understand the federal government needs to carry a small debt for the Federal Reserve Bank to operate. But "small" isn't how we would describe three times the nation's annual budget. We need to stop paying so much in interest (and we think cutting $194 billion is a good target). Instead we're digging ourselves deeper: Congress had to raise the federal debt limit last September from $8.965 trillion to almost $10 trillion or the country would have been at legal risk of default. If that's not a wake-up call to get spending under control, we don't know what is.

    The Tab* Interest on National Debt: $194 billion Final Tab: $789.5 billion + $194 billion = $983.5 billion

    What YOU Can Do Many believe our system is inherently broken. We think it can be fixed. As citizens and voters, we have to set a new agenda before the Presidential election. There are three things we need in order to prevent wasteful spending, according to the GAO's David Walker:

    • Incentives for people to do the right thing.

    • Transparency so we can tell if they've done the right thing.

    • Accountability if they do the wrong thing.

    Two out of three won't solve our problems.

    So how do we make it happen? Demand it of our elected officials. If they fail to listen, then we turn them out of office. With its approval rating hovering around 11 percent in some polls, Congress might just start paying attention.

    Start by writing to your Representatives. Talk to your family, friends and neighbors, and share this article. It's in everybody's interest.

    The Most Criminal Class is Writing the Laws --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers


    This is the way most fraud arises on Wall Street and it does not take even a high school education to understand how it works
    "Former RNC Finance Chair pleads guilty to $1 million bribery," by Mark Hemingway, Washington Examiner, December 4, 2009 ---
    http://www.washingtonexaminer.com/opinion/blogs/beltway-confidential/Former-RNC-Finance-Chair-pleads-guilty-to-1-million-bribery-78554297.html

    Elliott Broidy, the former Finance Chairman of the Republican National Committee, plead guilty yesterday to offering $1 million bribes to officials with New York state's pension funds. In return, Broidy got a $250 million investement in the Wall Street firm he worked for:

    Broidy, who also resigned as chairman of Markstone Capital Partners, the private equity firm, admitted that he had paid for luxury trips to hotels in Israel and Italy for pension staffers and their relatives -- including first-class flights and a helicopter tour. Broidy funneled the money through charities and submitted false receipts to the state comptroller's office to cover his tracks.

    The California financier, who was the GOP finance chairman in 2008, also paid thousands of dollars toward rent and other expenses for former "Mod Squad" star Peggy Lipton, who was dating a high-ranking New York pension official at the time.

    Broidy now faces up to four years in jail and has to return some $18 million. Since the scandal with New York's pension fund broke, it has so far led to five guilty pleas and $100 million in public funds have been returned. However, Pro-Publica -- which has been doggedly covering the story -- notes that nothing has been done to prevent future corruption:

    The system that allowed corruption to flourish in New York, where $110 billion in retirement savings are controlled by a sole trustee with no board oversight, is still in place.

    Bob Jensen's Fraud Updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm

    Are there any truly honest local, state, and Federal officials ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#Lawmakers


    The Cost Conundrum:  What a Texas town can teach us about health care

    "The Cost Conundrum:  What a Texas town can teach us about health care," by Atul Gawande, The New Yorker, June 1, 2009 --- http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?printable=true 

    It is spring in McAllen, Texas. The morning sun is warm. The streets are lined with palm trees and pickup trucks. McAllen is in Hidalgo County, which has the lowest household income in the country, but it’s a border town, and a thriving foreign-trade zone has kept the unemployment rate below ten per cent. McAllen calls itself the Square Dance Capital of the World. “Lonesome Dove” was set around here.

    McAllen has another distinction, too: it is one of the most expensive health-care markets in the country. Only Miami—which has much higher labor and living costs—spends more per person on health care. In 2006, Medicare spent fifteen thousand dollars per enrollee here, almost twice the national average. The income per capita is twelve thousand dollars. In other words, Medicare spends three thousand dollars more per person here than the average person earns.

    The explosive trend in American medical costs seems to have occurred here in an especially intense form. Our country’s health care is by far the most expensive in the world. In Washington, the aim of health-care reform is not just to extend medical coverage to everybody but also to bring costs under control. Spending on doctors, hospitals, drugs, and the like now consumes more than one of every six dollars we earn. The financial burden has damaged the global competitiveness of American businesses and bankrupted millions of families, even those with insurance. It’s also devouring our government. “The greatest threat to America’s fiscal health is not Social Security,” President Barack Obama said in a March speech at the White House. “It’s not the investments that we’ve made to rescue our economy during this crisis. By a wide margin, the biggest threat to our nation’s balance sheet is the skyrocketing cost of health care. It’s not even close.”

    The question we’re now frantically grappling with is how this came to be, and what can be done about it. McAllen, Texas, the most expensive town in the most expensive country for health care in the world, seemed a good place to look for some answers.

    From the moment I arrived, I asked almost everyone I encountered about McAllen’s health costs—a businessman I met at the five-gate McAllen-Miller International Airport, the desk clerks at the Embassy Suites Hotel, a police-academy cadet at McDonald’s. Most weren’t surprised to hear that McAllen was an outlier. “Just look around,” the cadet said. “People are not healthy here.” McAllen, with its high poverty rate, has an incidence of heavy drinking sixty per cent higher than the national average. And the Tex-Mex diet has contributed to a thirty-eight-per-cent obesity rate.

    One day, I went on rounds with Lester Dyke, a weather-beaten, ranch-owning fifty-three-year-old cardiac surgeon who grew up in Austin, did his surgical training with the Army all over the country, and settled into practice in Hidalgo County. He has not lacked for business: in the past twenty years, he has done some eight thousand heart operations, which exhausts me just thinking about it. I walked around with him as he checked in on ten or so of his patients who were recuperating at the three hospitals where he operates. It was easy to see what had landed them under his knife. They were nearly all obese or diabetic or both. Many had a family history of heart disease. Few were taking preventive measures, such as cholesterol-lowering drugs, which, studies indicate, would have obviated surgery for up to half of them.

    Yet public-health statistics show that cardiovascular-disease rates in the county are actually lower than average, probably because its smoking rates are quite low. Rates of asthma, H.I.V., infant mortality, cancer, and injury are lower, too. El Paso County, eight hundred miles up the border, has essentially the same demographics. Both counties have a population of roughly seven hundred thousand, similar public-health statistics, and similar percentages of non-English speakers, illegal immigrants, and the unemployed. Yet in 2006 Medicare expenditures (our best approximation of over-all spending patterns) in El Paso were $7,504 per enrollee—half as much as in McAllen. An unhealthy population couldn’t possibly be the reason that McAllen’s health-care costs are so high. (Or the reason that America’s are. We may be more obese than any other industrialized nation, but we have among the lowest rates of smoking and alcoholism, and we are in the middle of the range for cardiovascular disease and diabetes.)

    Was the explanation, then, that McAllen was providing unusually good health care? I took a walk through Doctors Hospital at Renaissance, in Edinburg, one of the towns in the McAllen metropolitan area, with Robert Alleyn, a Houston-trained general surgeon who had grown up here and returned home to practice. The hospital campus sprawled across two city blocks, with a series of three- and four-story stucco buildings separated by golfing-green lawns and black asphalt parking lots. He pointed out the sights—the cancer center is over here, the heart center is over there, now we’re coming to the imaging center. We went inside the surgery building. It was sleek and modern, with recessed lighting, classical music piped into the waiting areas, and nurses moving from patient to patient behind rolling black computer pods. We changed into scrubs and Alleyn took me through the sixteen operating rooms to show me the laparoscopy suite, with its flat-screen video monitors, the hybrid operating room with built-in imaging equipment, the surgical robot for minimally invasive robotic surgery.

    I was impressed. The place had virtually all the technology that you’d find at Harvard and Stanford and the Mayo Clinic, and, as I walked through that hospital on a dusty road in South Texas, this struck me as a remarkable thing. Rich towns get the new school buildings, fire trucks, and roads, not to mention the better teachers and police officers and civil engineers. Poor towns don’t. But that rule doesn’t hold for health care.

    At McAllen Medical Center, I saw an orthopedic surgeon work under an operating microscope to remove a tumor that had wrapped around the spinal cord of a fourteen-year-old. At a home-health agency, I spoke to a nurse who could provide intravenous-drug therapy for patients with congestive heart failure. At McAllen Heart Hospital, I watched Dyke and a team of six do a coronary-artery bypass using technologies that didn’t exist a few years ago. At Renaissance, I talked with a neonatologist who trained at my hospital, in Boston, and brought McAllen new skills and technologies for premature babies. “I’ve had nurses come up to me and say, ‘I never knew these babies could survive,’ ” he said.

    And yet there’s no evidence that the treatments and technologies available at McAllen are better than those found elsewhere in the country. The annual reports that hospitals file with Medicare show that those in McAllen and El Paso offer comparable technologies—neonatal intensive-care units, advanced cardiac services, PET scans, and so on. Public statistics show no difference in the supply of doctors. Hidalgo County actually has fewer specialists than the national average.

    Nor does the care given in McAllen stand out for its quality. Medicare ranks hospitals on twenty-five metrics of care. On all but two of these, McAllen’s five largest hospitals performed worse, on average, than El Paso’s. McAllen costs Medicare seven thousand dollars more per person each year than does the average city in America. But not, so far as one can tell, because it’s delivering better health care.

    One night, I went to dinner with six McAllen doctors. All were what you would call bread-and-butter physicians: busy, full-time, private-practice doctors who work from seven in the morning to seven at night and sometimes later, their waiting rooms teeming and their desks stacked with medical charts to review.

    Some were dubious when I told them that McAllen was the country’s most expensive place for health care. I gave them the spending data from Medicare. In 1992, in the McAllen market, the average cost per Medicare enrollee was $4,891, almost exactly the national average. But since then, year after year, McAllen’s health costs have grown faster than any other market in the country, ultimately soaring by more than ten thousand dollars per person.

    “Maybe the service is better here,” the cardiologist suggested. People can be seen faster and get their tests more readily, he said.

    Others were skeptical. “I don’t think that explains the costs he’s talking about,” the general surgeon said.

    “It’s malpractice,” a family physician who had practiced here for thirty-three years said.

    “McAllen is legal hell,” the cardiologist agreed. Doctors order unnecessary tests just to protect themselves, he said. Everyone thought the lawyers here were worse than elsewhere.

    That explanation puzzled me. Several years ago, Texas passed a tough malpractice law that capped pain-and-suffering awards at two hundred and fifty thousand dollars. Didn’t lawsuits go down?

    “Practically to zero,” the cardiologist admitted.

    “Come on,” the general surgeon finally said. “We all know these arguments are bullshit. There is overutilization here, pure and simple.” Doctors, he said, were racking up charges with extra tests, services, and procedures.

    The surgeon came to McAllen in the mid-nineties, and since then, he said, “the way to practice medicine has changed completely. Before, it was about how to do a good job. Now it is about ‘How much will you benefit?’ ”

    Everyone agreed that something fundamental had changed since the days when health-care costs in McAllen were the same as those in El Paso and elsewhere. Yes, they had more technology. “But young doctors don’t think anymore,” the family physician said.

    The surgeon gave me an example. General surgeons are often asked to see patients with pain from gallstones. If there aren’t any complications—and there usually aren’t—the pain goes away on its own or with pain medication. With instruction on eating a lower-fat diet, most patients experience no further difficulties. But some have recurrent episodes, and need surgery to remove their gallbladder.

    Seeing a patient who has had uncomplicated, first-time gallstone pain requires some judgment. A surgeon has to provide reassurance (people are often scared and want to go straight to surgery), some education about gallstone disease and diet, perhaps a prescription for pain; in a few weeks, the surgeon might follow up. But increasingly, I was told, McAllen surgeons simply operate. The patient wasn’t going to moderate her diet, they tell themselves. The pain was just going to come back. And by operating they happen to make an extra seven hundred dollars.

    I gave the doctors around the table a scenario. A forty-year-old woman comes in with chest pain after a fight with her husband. An EKG is normal. The chest pain goes away. She has no family history of heart disease. What did McAllen doctors do fifteen years ago?

    Send her home, they said. Maybe get a stress test to confirm that there’s no issue, but even that might be overkill.

    And today? Today, the cardiologist said, she would get a stress test, an echocardiogram, a mobile Holter monitor, and maybe even a cardiac catheterization.

    “Oh, she’s definitely getting a cath,” the internist said, laughing grimly.

    To determine whether overuse of medical care was really the problem in McAllen, I turned to Jonathan Skinner, an economist at Dartmouth’s Institute for Health Policy and Clinical Practice, which has three decades of expertise in examining regional patterns in Medicare payment data. I also turned to two private firms—D2Hawkeye, an independent company, and Ingenix, UnitedHealthcare’s data-analysis company—to analyze commercial insurance data for McAllen. The answer was yes. Compared with patients in El Paso and nationwide, patients in McAllen got more of pretty much everything—more diagnostic testing, more hospital treatment, more surgery, more home care.

    The Medicare payment data provided the most detail. Between 2001 and 2005, critically ill Medicare patients received almost fifty per cent more specialist visits in McAllen than in El Paso, and were two-thirds more likely to see ten or more specialists in a six-month period. In 2005 and 2006, patients in McAllen received twenty per cent more abdominal ultrasounds, thirty per cent more bone-density studies, sixty per cent more stress tests with echocardiography, two hundred per cent more nerve-conduction studies to diagnose carpal-tunnel syndrome, and five hundred and fifty per cent more urine-flow studies to diagnose prostate troubles. They received one-fifth to two-thirds more gallbladder operations, knee replacements, breast biopsies, and bladder scopes. They also received two to three times as many pacemakers, implantable defibrillators, cardiac-bypass operations, carotid endarterectomies, and coronary-artery stents. And Medicare paid for five times as many home-nurse visits. The primary cause of McAllen’s extreme costs was, very simply, the across-the-board overuse of medicine.

    This is a disturbing and perhaps surprising diagnosis. Americans like to believe that, with most things, more is better. But research suggests that where medicine is concerned it may actually be worse. For example, Rochester, Minnesota, where the Mayo Clinic dominates the scene, has fantastically high levels of technological capability and quality, but its Medicare spending is in the lowest fifteen per cent of the country—$6,688 per enrollee in 2006, which is eight thousand dollars less than the figure for McAllen. Two economists working at Dartmouth, Katherine Baicker and Amitabh Chandra, found that the more money Medicare spent per person in a given state the lower that state’s quality ranking tended to be. In fact, the four states with the highest levels of spending—Louisiana, Texas, California, and Florida—were near the bottom of the national rankings on the quality of patient care.

    In a 2003 study, another Dartmouth team, led by the internist Elliott Fisher, examined the treatment received by a million elderly Americans diagnosed with colon or rectal cancer, a hip fracture, or a heart attack. They found that patients in higher-spending regions received sixty per cent more care than elsewhere. They got more frequent tests and procedures, more visits with specialists, and more frequent admission to hospitals. Yet they did no better than other patients, whether this was measured in terms of survival, their ability to function, or satisfaction with the care they received. If anything, they seemed to do worse.

    That’s because nothing in medicine is without risks. Complications can arise from hospital stays, medications, procedures, and tests, and when these things are of marginal value the harm can be greater than the benefits. In recent years, we doctors have markedly increased the number of operations we do, for instance. In 2006, doctors performed at least sixty million surgical procedures, one for every five Americans. No other country does anything like as many operations on its citizens. Are we better off for it? No one knows for sure, but it seems highly unlikely. After all, some hundred thousand people die each year from complications of surgery—far more than die in car crashes.

    To make matters worse, Fisher found that patients in high-cost areas were actually less likely to receive low-cost preventive services, such as flu and pneumonia vaccines, faced longer waits at doctor and emergency-room visits, and were less likely to have a primary-care physician. They got more of the stuff that cost more, but not more of what they needed.

    In an odd way, this news is reassuring. Universal coverage won’t be feasible unless we can control costs. Policymakers have worried that doing so would require rationing, which the public would never go along with. So the idea that there’s plenty of fat in the system is proving deeply attractive. “Nearly thirty per cent of Medicare’s costs could be saved without negatively affecting health outcomes if spending in high- and medium-cost areas could be reduced to the level in low-cost areas,” Peter Orszag, the President’s budget director, has stated.

    Most Americans would be delighted to have the quality of care found in places like Rochester, Minnesota, or Seattle, Washington, or Durham, North Carolina—all of which have world-class hospitals and costs that fall below the national average. If we brought the cost curve in the expensive places down to their level, Medicare’s problems (indeed, almost all the federal government’s budget problems for the next fifty years) would be solved. The difficulty is how to go about it. Physicians in places like McAllen behave differently from others. The $2.4-trillion question is why. Unless we figure it out, health reform will fail.

    I had what I considered to be a reasonable plan for finding out what was going on in McAllen. I would call on the heads of its hospitals, in their swanky, decorator-designed, churrigueresco offices, and I’d ask them.

    The first hospital I visited, McAllen Heart Hospital, is owned by Universal Health Services, a for-profit hospital chain with headquarters in King of Prussia, Pennsylvania, and revenues of five billion dollars last year. I went to see the hospital’s chief operating officer, Gilda Romero. Truth be told, her office seemed less churrigueresco than Office Depot. She had straight brown hair, sympathetic eyes, and looked more like a young school teacher than like a corporate officer with nineteen years of experience. And when I inquired, “What is going on in this place?” she looked surprised.

    Is McAllen really that expensive? she asked.

    I described the data, including the numbers indicating that heart operations and catheter procedures and pacemakers were being performed in McAllen at double the usual rate.

    “That is interesting,” she said, by which she did not mean, “Uh-oh, you’ve caught us” but, rather, “That is actually interesting.” The problem of McAllen’s outlandish costs was new to her. She puzzled over the numbers. She was certain that her doctors performed surgery only when it was necessary. It had to be one of the other hospitals. And she had one in mind—Doctors Hospital at Renaissance, the hospital in Edinburg that I had toured.

    She wasn’t the only person to mention Renaissance. It is the newest hospital in the area. It is physician-owned. And it has a reputation (which it disclaims) for aggressively recruiting high-volume physicians to become investors and send patients there. Physicians who do so receive not only their fee for whatever service they provide but also a percentage of the hospital’s profits from the tests, surgery, or other care patients are given. (In 2007, its profits totalled thirty-four million dollars.) Romero and others argued that this gives physicians an unholy temptation to overorder.

    Such an arrangement can make physician investors rich. But it can’t be the whole explanation. The hospital gets barely a sixth of the patients in the region; its margins are no bigger than the other hospitals’—whether for profit or not for profit—and it didn’t have much of a presence until 2004 at the earliest, a full decade after the cost explosion in McAllen began.

    “Those are good points,” Romero said. She couldn’t explain what was going on.

    The following afternoon, I visited the top managers of Doctors Hospital at Renaissance. We sat in their boardroom around one end of a yacht-length table. The chairman of the board offered me a soda. The chief of staff smiled at me. The chief financial officer shook my hand as if I were an old friend. The C.E.O., however, was having a hard time pretending that he was happy to see me. Lawrence Gelman was a fifty-seven-year-old anesthesiologist with a Bill Clinton shock of white hair and a weekly local radio show tag-lined “Opinions from an Unrelenting Conservative Spirit.” He had helped found the hospital. He barely greeted me, and while the others were trying for a how-can-I-help-you-today attitude, his body language was more let’s-get-this-over-with.

    So I asked him why McAllen’s health-care costs were so high. What he gave me was a disquisition on the theory and history of American health-care financing going back to Lyndon Johnson and the creation of Medicare, the upshot of which was: (1) Government is the problem in health care. “The people in charge of the purse strings don’t know what they’re doing.” (2) If anything, government insurance programs like Medicare don’t pay enough. “I, as an anesthesiologist, know that they pay me ten per cent of what a private insurer pays.” (3) Government programs are full of waste. “Every person in this room could easily go through the expenditures of Medicare and Medicaid and see all kinds of waste.” (4) But not in McAllen. The clinicians here, at least at Doctors Hospital at Renaissance, “are providing necessary, essential health care,” Gelman said. “We don’t invent patients.”

    Then why do hospitals in McAllen order so much more surgery and scans and tests than hospitals in El Paso and elsewhere?

    In the end, the only explanation he and his colleagues could offer was this: The other doctors and hospitals in McAllen may be overspending, but, to the extent that his hospital provides costlier treatment than other places in the country, it is making people better in ways that data on quality and outcomes do not measure.

    “Do we provide better health care than El Paso?” Gelman asked. “I would bet you two to one that we do.”

    It was a depressing conversation—not because I thought the executives were being evasive but because they weren’t being evasive. The data on McAllen’s costs were clearly new to them. They were defending McAllen reflexively. But they really didn’t know the big picture of what was happening.

    And, I realized, few people in their position do. Local executives for hospitals and clinics and home-health agencies understand their growth rate and their market share; they know whether they are losing money or making money. They know that if their doctors bring in enough business—surgery, imaging, home-nursing referrals—they make money; and if they get the doctors to bring in more, they make more. But they have only the vaguest notion of whether the doctors are making their communities as healthy as they can, or whether they are more or less efficient than their counterparts elsewhere. A doctor sees a patient in clinic, and has her check into a McAllen hospital for a CT scan, an ultrasound, three rounds of blood tests, another ultrasound, and then surgery to have her gallbladder removed. How is Lawrence Gelman or Gilda Romero to know whether all that is essential, let alone the best possible treatment for the patient? It isn’t what they are responsible or accountable for.

    Health-care costs ultimately arise from the accumulation of individual decisions doctors make about which services and treatments to write an order for. The most expensive piece of medical equipment, as the saying goes, is a doctor’s pen. And, as a rule, hospital executives don’t own the pen caps. Doctors do.

    If doctors wield the pen, why do they do it so differently from one place to another? Brenda Sirovich, another Dartmouth researcher, published a study last year that provided an important clue. She and her team surveyed some eight hundred primary-care physicians from high-cost cities (such as Las Vegas and New York), low-cost cities (such as Sacramento and Boise), and others in between. The researchers asked the physicians specifically how they would handle a variety of patient cases. It turned out that differences in decision-making emerged in only some kinds of cases. In situations in which the right thing to do was well established—for example, whether to recommend a mammogram for a fifty-year-old woman (the answer is yes)—physicians in high- and low-cost cities made the same decisions. But, in cases in which the science was unclear, some physicians pursued the maximum possible amount of testing and procedures; some pursued the minimum. And which kind of doctor they were depended on where they came from.

    Sirovich asked doctors how they would treat a seventy-five-year-old woman with typical heartburn symptoms and “adequate health insurance to cover tests and medications.” Physicians in high- and low-cost cities were equally likely to prescribe antacid therapy and to check for H. pylori, an ulcer-causing bacterium—steps strongly recommended by national guidelines. But when it came to measures of less certain value—and higher cost—the differences were considerable. More than seventy per cent of physicians in high-cost cities referred the patient to a gastroenterologist, ordered an upper endoscopy, or both, while half as many in low-cost cities did. Physicians from high-cost cities typically recommended that patients with well-controlled hypertension see them in the office every one to three months, while those from low-cost cities recommended visits twice yearly. In case after uncertain case, more was not necessarily better. But physicians from the most expensive cities did the most expensive things.

    Why? Some of it could reflect differences in training. I remember when my wife brought our infant son Walker to visit his grandparents in Virginia, and he took a terrifying fall down a set of stairs. They drove him to the local community hospital in Alexandria. A CT scan showed that he had a tiny subdural hematoma—a small area of bleeding in the brain. During ten hours of observation, though, he was fine—eating, drinking, completely alert. I was a surgery resident then and had seen many cases like his. We observed each child in intensive care for at least twenty-four hours and got a repeat CT scan. That was how I’d been trained. But the doctor in Alexandria was going to send Walker home. That was how he’d been trained. Suppose things change for the worse? I asked him. It’s extremely unlikely, he said, and if anything changed Walker could always be brought back. I bullied the doctor into admitting him anyway. The next day, the scan and the patient were fine. And, looking in the textbooks, I learned that the doctor was right. Walker could have been managed safely either way.

    There was no sign, however, that McAllen’s doctors as a group were trained any differently from El Paso’s. One morning, I met with a hospital administrator who had extensive experience managing for-profit hospitals along the border. He offered a different possible explanation: the culture of money.

    “In El Paso, if you took a random doctor and looked at his tax returns eighty-five per cent of his income would come from the usual practice of medicine,” he said. But in McAllen, the administrator thought, that percentage would be a lot less.

    He knew of doctors who owned strip malls, orange groves, apartment complexes—or imaging centers, surgery centers, or another part of the hospital they directed patients to. They had “entrepreneurial spirit,” he said. They were innovative and aggressive in finding ways to increase revenues from patient care. “There’s no lack of work ethic,” he said. But he had often seen financial considerations drive the decisions doctors made for patients—the tests they ordered, the doctors and hospitals they recommended—and it bothered him. Several doctors who were unhappy about the direction medicine had taken in McAllen told me the same thing. “It’s a machine, my friend,” one surgeon explained.

    No one teaches you how to think about money in medical school or residency. Yet, from the moment you start practicing, you must think about it. You must consider what is covered for a patient and what is not. You must pay attention to insurance rejections and government-reimbursement rules. You must think about having enough money for the secretary and the nurse and the rent and the malpractice insurance.

    Beyond the basics, however, many physicians are remarkably oblivious to the financial implications of their decisions. They see their patients. They make their recommendations. They send out the bills. And, as long as the numbers come out all right at the end of each month, they put the money out of their minds.

    Others think of the money as a means of improving what they do. They think about how to use the insurance money to maybe install electronic health records with colleagues, or provide easier phone and e-mail access, or offer expanded hours. They hire an extra nurse to monitor diabetic patients more closely, and to make sure that patients don’t miss their mammograms and pap smears and colonoscopies.

    Then there are the physicians who see their practice primarily as a revenue stream. They instruct their secretary to have patients who call with follow-up questions schedule an appointment, because insurers don’t pay for phone calls, only office visits. They consider providing Botox injections for cash. They take a Doppler ultrasound course, buy a machine, and start doing their patients’ scans themselves, so that the insurance payments go to them rather than to the hospital. They figure out ways to increase their high-margin work and decrease their low-margin work. This is a business, after all.

    In every community, you’ll find a mixture of these views among physicians, but one or another tends to predominate. McAllen seems simply to be the community at one extreme.

    In a few cases, the hospital executive told me, he’d seen the behavior cross over into what seemed like outright fraud. “I’ve had doctors here come up to me and say, ‘You want me to admit patients to your hospital, you’re going to have to pay me.’ ”

    “How much?” I asked.

    “The amounts—all of them were over a hundred thousand dollars per year,” he said. The doctors were specific. The most he was asked for was five hundred thousand dollars per year.

    He didn’t pay any of them, he said: “I mean, I gotta sleep at night.” And he emphasized that these were just a handful of doctors. But he had never been asked for a kickback before coming to McAllen.

    Woody Powell is a Stanford sociologist who studies the economic culture of cities. Recently, he and his research team studied why certain regions—Boston, San Francisco, San Diego—became leaders in biotechnology while others with a similar concentration of scientific and corporate talent—Los Angeles, Philadelphia, New York—did not. The answer they found was what Powell describes as the anchor-tenant theory of economic development. Just as an anchor store will define the character of a mall, anchor tenants in biotechnology, whether it’s a company like Genentech, in South San Francisco, or a university like M.I.T., in Cambridge, define the character of an economic community. They set the norms. The anchor tenants that set norms encouraging the free flow of ideas and collaboration, even with competitors, produced enduringly successful communities, while those that mainly sought to dominate did not.

    Powell suspects that anchor tenants play a similarly powerful community role in other areas of economics, too, and health care may be no exception. I spoke to a marketing rep for a McAllen home-health agency who told me of a process uncannily similar to what Powell found in biotech. Her job is to persuade doctors to use her agency rather than others. The competition is fierce. I opened the phone book and found seventeen pages of listings for home-health agencies—two hundred and sixty in all. A patient typically brings in between twelve hundred and fifteen hundred dollars, and double that amount for specialized care. She described how, a decade or so ago, a few early agencies began rewarding doctors who ordered home visits with more than trinkets: they provided tickets to professional sporting events, jewelry, and other gifts. That set the tone. Other agencies jumped in. Some began paying doctors a supplemental salary, as “medical directors,” for steering business in their direction. Doctors came to expect a share of the revenue stream.

    Agencies that want to compete on quality struggle to remain in business, the rep said. Doctors have asked her for a medical-director salary of four or five thousand dollars a month in return for sending her business. One asked a colleague of hers for private-school tuition for his child; another wanted sex.

    “I explained the rules and regulations and the anti-kickback law, and told them no,” she said of her dealings with such doctors. “Does it hurt my business?” She paused. “I’m O.K. working only with ethical physicians,” she finally said.

    About fifteen years ago, it seems, something began to change in McAllen. A few leaders of local institutions took profit growth to be a legitimate ethic in the practice of medicine. Not all the doctors accepted this. But they failed to discourage those who did. So here, along the banks of the Rio Grande, in the Square Dance Capital of the World, a medical community came to treat patients the way subprime-mortgage lenders treated home buyers: as profit centers.

    The real puzzle of American health care, I realized on the airplane home, is not why McAllen is different from El Paso. It’s why El Paso isn’t like McAllen. Every incentive in the system is an invitation to go the way McAllen has gone. Yet, across the country, large numbers of communities have managed to control their health costs rather than ratchet them up.

    I talked to Denis Cortese, the C.E.O. of the Mayo Clinic, which is among the highest-quality, lowest-cost health-care systems in the country. A couple of years ago, I spent several days there as a visiting surgeon. Among the things that stand out from that visit was how much time the doctors spent with patients. There was no churn—no shuttling patients in and out of rooms while the doctor bounces from one to the other. I accompanied a colleague while he saw patients. Most of the patients, like those in my clinic, required about twenty minutes. But one patient had colon cancer and a number of other complex issues, including heart disease. The physician spent an hour with her, sorting things out. He phoned a cardiologist with a question.

    “I’ll be there,” the cardiologist said.

    Fifteen minutes later, he was. They mulled over everything together. The cardiologist adjusted a medication, and said that no further testing was needed. He cleared the patient for surgery, and the operating room gave her a slot the next day.

    The whole interaction was astonishing to me. Just having the cardiologist pop down to see the patient with the surgeon would be unimaginable at my hospital. The time required wouldn’t pay. The time required just to organize the system wouldn’t pay.

    The core tenet of the Mayo Clinic is “The needs of the patient come first”—not the convenience of the doctors, not their revenues. The doctors and nurses, and even the janitors, sat in meetings almost weekly, working on ideas to make the service and the care better, not to get more money out of patients. I asked Cortese how the Mayo Clinic made this possible.

    “It’s not easy,” he said. But decades ago Mayo recognized that the first thing it needed to do was eliminate the financial barriers. It pooled all the money the doctors and the hospital system received and began paying everyone a salary, so that the doctors’ goal in patient care couldn’t be increasing their income. Mayo promoted leaders who focussed first on what was best for patients, and then on how to make this financially possible.

    No one there actually intends to do fewer expensive scans and procedures than is done elsewhere in the country. The aim is to raise quality and to help doctors and other staff members work as a team. But, almost by happenstance, the result has been lower costs.

    “When doctors put their heads together in a room, when they share expertise, you get more thinking and less testing,” Cortese told me.

    Skeptics saw the Mayo model as a local phenomenon that wouldn’t carry beyond the hay fields of northern Minnesota. But in 1986 the Mayo Clinic opened a campus in Florida, one of our most expensive states for health care, and, in 1987, another one in Arizona. It was difficult to recruit staff members who would accept a salary and the Mayo’s collaborative way of practicing. Leaders were working against the dominant medical culture and incentives. The expansion sites took at least a decade to get properly established. But eventually they achieved the same high-quality, low-cost results as Rochester. Indeed, Cortese says that the Florida site has become, in some respects, the most efficient one in the system.

    The Mayo Clinic is not an aberration. One of the lowest-cost markets in the country is Grand Junction, Colorado, a community of a hundred and twenty thousand that nonetheless has achieved some of Medicare’s highest quality-of-care scores. Michael Pramenko is a family physician and a local medical leader there. Unlike doctors at the Mayo Clinic, he told me, those in Grand Junction get piecework fees from insurers. But years ago the doctors agreed among themselves to a system that paid them a similar fee whether they saw Medicare, Medicaid, or private-insurance patients, so that there would be little incentive to cherry-pick patients. They also agreed, at the behest of the main health plan in town, an H.M.O., to meet regularly on small peer-review committees to go over their patient charts together. They focussed on rooting out problems like poor prevention practices, unnecessary back operations, and unusual hospital-complication rates. Problems went down. Quality went up. Then, in 2004, the doctors’ group and the local H.M.O. jointly created a regional information network—a community-wide electronic-record system that shared office notes, test results, and hospital data for patients across the area. Again, problems went down. Quality went up. And costs ended up lower than just about anywhere else in the United States.

    Grand Junction’s medical community was not following anyone else’s recipe. But, like Mayo, it created what Elliott Fisher, of Dartmouth, calls an accountable-care organization. The leading doctors and the hospital system adopted measures to blunt harmful financial incentives, and they took collective responsibility for improving the sum total of patient care.

    This approach has been adopted in other places, too: the Geisinger Health System, in Danville, Pennsylvania; the Marshfield Clinic, in Marshfield, Wisconsin; Intermountain Healthcare, in Salt Lake City; Kaiser Permanente, in Northern California. All of them function on similar principles. All are not-for-profit institutions. And all have produced enviably higher quality and lower costs than the average American town enjoys.

    When you look across the spectrum from Grand Junction to McAllen—and the almost threefold difference in the costs of care—you come to realize that we are witnessing a battle for the soul of American medicine. Somewhere in the United States at this moment, a patient with chest pain, or a tumor, or a cough is seeing a doctor. And the damning question we have to ask is whether the doctor is set up to meet the needs of the patient, first and foremost, or to maximize revenue.

    There is no insurance system that will make the two aims match perfectly. But having a system that does so much to misalign them has proved disastrous. As economists have often pointed out, we pay doctors for quantity, not quality. As they point out less often, we also pay them as individuals, rather than as members of a team working together for their patients. Both practices have made for serious problems.

    Providing health care is like building a house. The task requires experts, expensive equipment and materials, and a huge amount of coördination. Imagine that, instead of paying a contractor to pull a team together and keep them on track, you paid an electrician for every outlet he recommends, a plumber for every faucet, and a carpenter for every cabinet. Would you be surprised if you got a house with a thousand outlets, faucets, and cabinets, at three times the cost you expected, and the whole thing fell apart a couple of years later? Getting the country’s best electrician on the job (he trained at Harvard, somebody tells you) isn’t going to solve this problem. Nor will changing the person who writes him the check.

    This last point is vital. Activists and policymakers spend an inordinate amount of time arguing about whether the solution to high medical costs is to have government or private insurance companies write the checks. Here’s how this whole debate goes. Advocates of a public option say government financing would save the most money by having leaner administrative costs and forcing doctors and hospitals to take lower payments than they get from private insurance. Opponents say doctors would skimp, quit, or game the system, and make us wait in line for our care; they maintain that private insurers are better at policing doctors. No, the skeptics say: all insurance companies do is reject applicants who need health care and stall on paying their bills. Then we have the economists who say that the people who should pay the doctors are the ones who use them. Have consumers pay with their own dollars, make sure that they have some “skin in the game,” and then they’ll get the care they deserve. These arguments miss the main issue. When it comes to making care better and cheaper, changing who pays the doctor will make no more difference than changing who pays the electrician. The lesson of the high-quality, low-cost communities is that someone has to be accountable for the totality of care. Otherwise, you get a system that has no brakes. You get McAllen.

    One afternoon in McAllen, I rode down McColl Road with Lester Dyke, the cardiac surgeon, and we passed a series of office plazas that seemed to be nothing but home-health agencies, imaging centers, and medical-equipment stores.

    “Medicine has become a pig trough here,” he muttered.

    Dyke is among the few vocal critics of what’s happened in McAllen. “We took a wrong turn when doctors stopped being doctors and became businessmen,” he said.

    We began talking about the various proposals being touted in Washington to fix the cost problem. I asked him whether expanding public-insurance programs like Medicare and shrinking the role of insurance companies would do the trick in McAllen.

    “I don’t have a problem with it,” he said. “But it won’t make a difference.” In McAllen, government payers already predominate—not many people have jobs with private insurance.

    How about doing the opposite and increasing the role of big insurance companies?

    “What good would that do?” Dyke asked.

    The third class of health-cost proposals, I explained, would push people to use medical savings accounts and hold high-deductible insurance policies: “They’d have more of their own money on the line, and that’d drive them to bargain with you and other surgeons, right?”

    He gave me a quizzical look. We tried to imagine the scenario. A cardiologist tells an elderly woman that she needs bypass surgery and has Dr. Dyke see her. They discuss the blockages in her heart, the operation, the risks. And now they’re supposed to haggle over the price as if he were selling a rug in a souk? “I’ll do three vessels for thirty thousand, but if you take four I’ll throw in an extra night in the I.C.U.”—that sort of thing? Dyke shook his head. “Who comes up with this stuff?” he asked. “Any plan that relies on the sheep to negotiate with the wolves is doomed to failure.”

    Instead, McAllen and other cities like it have to be weaned away from their untenably fragmented, quantity-driven systems of health care, step by step. And that will mean rewarding doctors and hospitals if they band together to form Grand Junction-like accountable-care organizations, in which doctors collaborate to increase prevention and the quality of care, while discouraging overtreatment, undertreatment, and sheer profiteering. Under one approach, insurers—whether public or private—would allow clinicians who formed such organizations and met quality goals to keep half the savings they generate. Government could also shift regulatory burdens, and even malpractice liability, from the doctors to the organization. Other, sterner, approaches would penalize those who don’t form these organizations.

    This will by necessity be an experiment. We will need to do in-depth research on what makes the best systems successful—the peer-review committees? recruiting more primary-care doctors and nurses? putting doctors on salary?—and disseminate what we learn. Congress has provided vital funding for research that compares the effectiveness of different treatments, and this should help reduce uncertainty about which treatments are best. But we also need to fund research that compares the effectiveness of different systems of care—to reduce our uncertainty about which systems work best for communities. These are empirical, not ideological, questions. And we would do well to form a national institute for health-care delivery, bringing together clinicians, hospitals, insurers, employers, and citizens to assess, regularly, the quality and the cost of our care, review the strategies that produce good results, and make clear recommendations for local systems.

    Dramatic improvements and savings will take at least a decade. But a choice must be made. Whom do we want in charge of managing the full complexity of medical care? We can turn to insurers (whether public or private), which have proved repeatedly that they can’t do it. Or we can turn to the local medical communities, which have proved that they can. But we have to choose someone—because, in much of the country, no one is in charge. And the result is the most wasteful and the least sustainable health-care system in the world.

    Something even more worrisome is going on as well. In the war over the culture of medicine—the war over whether our country’s anchor model will be Mayo or McAllen—the Mayo model is losing. In the sharpest economic downturn that our health system has faced in half a century, many people in medicine don’t see why they should do the hard work of organizing themselves in ways that reduce waste and improve quality if it means sacrificing revenue.

    In El Paso, the for-profit health-care executive told me, a few leading physicians recently followed McAllen’s lead and opened their own centers for surgery and imaging. When I was in Tulsa a few months ago, a fellow-surgeon explained how he had made up for lost revenue by shifting his operations for well-insured patients to a specialty hospital that he partially owned while keeping his poor and uninsured patients at a nonprofit hospital in town. Even in Grand Junction, Michael Pramenko told me, “some of the doctors are beginning to complain about ‘leaving money on the table.’ ”

    As America struggles to extend health-care coverage while curbing health-care costs, we face a decision that is more important than whether we have a public-insurance option, more important than whether we will have a single-payer system in the long run or a mixture of public and private insurance, as we do now. The decision is whether we are going to reward the leaders who are trying to build a new generation of Mayos and Grand Junctions. If we don’t, McAllen won’t be an outlier. It will be our future.

     


    LIFO Sucks Teaching Case on LIFO Layers in Years of Rising Prices

    From The Wall Street Journal Accounting Review on December 3, 2010

    Accounting Method Sucks Up Oil
    by: Dan Strumpf
    Nov 22, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Inventory Systems
    SUMMARY: "The oil market has been waiting months for...a drop in supplies along the nation's main refining corridor. Prices are poised to soar on any indication that rising demand from the recovering economy is bringing a two-year-old oil glut to an end." But drop in inventory among U.S. oil companies merely follows a typical year end pattern. "To avoid a tax charge tied to rising oil prices, refiners and other companies that store crude are scrambling to make sure they end the year with the same inventories they had at the start."
    CLASSROOM APPLICATION: The article brings to life the implications of dipping into LIFO inventory layers.
    QUESTIONS:
    1. (Introductory) What inventory method is used by most companies in the oil industry?

    2. (Advanced) What are the federal tax incentives to use LIFO inventory method?

    3. (Advanced) What Louisiana state tax requirements also influence oil companies to choose LIFO inventory accounting?

    4. (Introductory) Refer to the related article. What factors are leading to a two-week high price for oil as of December 1, 2010?

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES:
    Oil Climbs to $86.75, a 2-Week High
    by Jerry A. DiColo
    Dec 01, 2010
    Online Exclusive

    "Accounting Method Sucks Up Oil," by: Dan Strump, The Wall Street Journal, November 22, 2010 --- fhttp://online.wsj.com/article/SB10001424052748703531504575625013694074190.html?mod=djem_jiewr_AC_domainid

    An accounting practice is making the millions of barrels of excess crude that have flooded the oil market disappear—for a few weeks, anyway.

    To avoid a tax charge tied to rising oil prices, refiners and other companies that store crude are scrambling to make sure they end the year with the same inventories that they had at the start. Stockpiles on the Gulf Coast plunged nearly 7 million barrels in the week ended Nov. 12, the region's biggest drop in over two years, according to the Energy Information Administration. Another 25 million barrels need to go for this December's inventories to match last year's. But if past years are any indication, inventories are likely to rise just as quickly with the start of the new year.

    The oil market has been waiting months for just such a drop in supplies along the nation's main refining corridor. Prices are poised to soar on any indication that rising demand from the recovering economy is bringing a two-year-old oil glut to an end.

    But the recent draws aren't that sign, and it's being reflected in the price of oil. Crude prices are off 7.2% since ending at a two-year high on Nov. 11, trading late Friday at $81.51 a barrel. Futures nearly fell below $80 a barrel for the first time in a month on Wednesday—after the government inventory report—as U.S. demand looked weak.

    "It's not any huge surge in demand that's causing the drawdown," said a spokesman for a large refiner that is reducing inventories for tax reasons.

    Companies usually reduce stocks by importing less oil, then drawing on inventories to refine into fuel. Last week, oil imports hit an 11-month low, the EIA said.

    The refiner, like much of the oil industry, uses a form of accounting called "last in, first out," or LIFO, to value their inventories. The practice allows a company to claim each barrel of oil they sell was the most recent one purchased. That creates an incentive to lower end-of-year inventories when prices climb because the more expensive oil is the "first out," allowing the remaining oil to be taxed at a lower rate.

    Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation. If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.

    In addition, oil companies face taxes in Gulf Coast states based on the level of inventory they have in storage, providing another incentive to draw down year-end inventories.

    Crude stockpiles fell sharply in November and December in three of the past four years, only to quickly rebound. Inventories are down nearly 3% nationwide in the past two weeks of government data, though they remain well above the historical average.

    "Year after year, we see crude inventories in the Gulf Coast region decline in December…and it doesn't mean a darn thing in terms of whether the global oil market is tight or not," said Tim Evans, an oil analyst at Citi Futures Perspective.

    The Obama administration has periodically tried to end LIFO accounting, and earlier this month, the co-chairs of a presidential commission charged with finding ways to reduce the deficit proposed doing away with the practice.

    Companies that use LIFO, however, have opposed its repeal, saying it protects them against rising prices. The American Petroleum Institute, the main oil-industry lobbying group, has argued that repealing LIFO would result in a "significant upfront tax increase."

    Jensen Comment
    Moves are now underway to end LIFO for tax purposes and as an accounting alternative. This would make U.S. GAAP much more like IFRS international rules that never have allowed LIFO.

    "Fight for Your LIFO," by Liam Denning, The Wall Street Journal, December 2, 2010 ---
    http://online.wsj.com/article/SB10001424052748704594804575649002258068166.html?mod=djemheard_t

    Buried on page 29 of Wednesday's report was a proposal to eliminate last-in-first-out, or LIFO, accounting for inventories. Under LIFO, companies assume that the goods they sell from inventories are the last ones put in. When prices are rising, this means the cost of goods sold is higher, reducing reported profits and, thereby, the taxes paid on them. Therein lies the rationale for LIFO's potential abolition.

    The potential impact could be significant. Take Exxon Mobil, Chevron, and ConocoPhillips, the top three U.S. majors. They had an aggregate LIFO reserve of $28.3 billion at the end of 2009. In theory, abolishing LIFO would result in a tax liability of about $10 billion.

    Beyond the oil patch, a 2008 survey by the American Institute of Certified Public Accountants found 36% of U.S. firms using LIFO for at least some of their inventories.

    Dr. Charles Mulford of Georgia Tech College of Management says that while LIFO accounting is "often blamed as a tax gimmick," it also offers a more accurate picture of profits by aligning costs with revenues.

    There is another potential wrinkle. LIFO accounting is suited to periods of inflation. When prices are falling, companies using LIFO actually pay more tax, as their cost of goods sold falls and reported profit rises.

    Say LIFO is abolished and, despite Washington's best efforts, deflation takes hold. Under that scenario, the companies that benefited from LIFO accounting during the boom years would actually enjoy a tax shield on future profits from the new accounting method. In this era of unintended consequences, such a policy outcome wouldn't be wholly surprising.

    "Unintended Consequences of LIFO Repeal:  The Case of the Oil Industry," by  David A. Guenther and Richard C. Sansing, The Accounting Review, Vol. 87, No. 5, September 2012, pp. 1589-1602 (this article is not free) ---
    http://aaajournals.org/doi/full/10.2308/accr-50194

    Abstract
    This study examines the effect on firm value of repealing the last-in, first-out (LIFO) inventory method for tax purposes. Our model extends prior literature by determining quantities and prices in equilibrium, rather than specifying them exogenously. We find that LIFO repeal could increase the future after-tax cash flows of firms that had used LIFO, because the higher tax costs associated with FIFO result in lower equilibrium quantities and higher equilibrium output prices, which increase pretax cash flows. We illustrate our model by examining inventory methods used by firms in the oil industry.

    Introduction
    We examine the effects of repealing the last-in, first-out (LIFO) inventory method on firm production decisions, output prices, and firm after-tax profits. This is an important topic because repeal of LIFO, either directly or indirectly, as a consequence of adopting International Financial Reporting Standards (IFRS), is being considered by U.S. policymakers. Although our model applies to any industry, we discuss the implications of our model for the oil industry because (1) almost all firms in the industry use LIFO for their U.S. operations, and (2) demand for the oil industry's products is inelastic. Our model implies that LIFO repeal would cause the after-tax profits of firms in the oil industry to increase because (1) the higher marginal cost would reduce production and raise prices, and (2) inelastic demand implies that the higher output price would more than offset the higher tax cost associated with the first-in-first-out (FIFO) inventory method.1

    For nearly 20 years, Kang's (1993) “real value” model has influenced accounting research on the link between LIFO and firm value. The real value model implies that the value of the firm in the absence of inflation is the same as the value of the firm in the presence of inflation if the firm uses LIFO. LIFO provides a nominal tax gain, but not a real inflation-adjusted gain. This suggests that LIFO repeal would decrease the value of a firm that used LIFO. A critical assumption underlying the real value model is that neither inflation nor inventory method choice affects firms' production decisions or output prices. In this study, we relax that assumption, deriving equilibrium production decisions and prices instead of specifying them exogenously. We find that, unlike the results from the real value model, inflation and inventory choice can affect production decisions and firm value.

    Our approach applies insights from the industrial organization literature regarding the effect of cost increases on production decisions and profits under Cournot competition.2 In particular, an increase in costs, such as income taxes, that affects all firms in an industry induces all firms to reduce output, which, in turn, increases the equilibrium output price. Depending on the slope of an industry's marginal revenue curve, decreasing industry output quantity can either increase or decrease the profits and, hence, the value of the firms in the industry. If the industry marginal revenue curve is downward sloping, a cost increase causes the value of firms to decrease, because the higher selling price is not enough to offset the lost revenue from selling fewer units. In contrast, if the industry marginal revenue curve is upward sloping, a decrease in industry output results in an increase in industry total revenue, and this increase more than offsets the higher cost. Therefore, a cost increase causes the value of all firms in the industry to increase.

    Nelson (1957) and Meyer (1967) identify situations in which increases in costs can lead to increased industry profits. The idea of increasing marginal revenue at the industry level may, at first, seem unrealistic. However, as Formby et al. (1982, 303) point out, “the conditions for a positively sloping marginal revenue curve are much less stringent than is generally recognized. Simple transformations of any well-behaved convex demand function can easily result in a demand for which marginal revenue is positively sloping. For this reason, positively sloping marginal revenue functions must be considered whenever convex demand functions are analyzed.” In other words, the only restriction on increasing marginal revenue is that the demand curve must be convex.

    An excise tax on inputs, such as the tax on the sale of domestically produced coal, is one example of a cost that affects all firms in an industry. Katz and Rosen (1985) and Seade (1985) show circumstances under which an increase in a tax can increase after-tax industry profits. Our study extends this idea to the effects of a firm's inventory method used for income tax purposes. When costs are increasing due to inflation, the use of FIFO instead of LIFO by all firms in an industry is economically equivalent to an excise tax on inputs imposed on all firms. Therefore, if the industry marginal revenue curve is increasing, all firms in an industry would have greater after-tax cash flows by using FIFO instead of LIFO. However, unlike an excise tax, firms can choose an inventory cost flow assumption (LIFO) that avoids the tax increase. Every firm would prefer for other firms to use FIFO while it chooses LIFO, getting both the tax benefits of LIFO for itself while also benefiting from the reduced quantities and higher prices associated with every other firm choosing FIFO. This can occur, for example, if a non-U.S. firm that is not permitted to use LIFO under home country tax rules competes in the same market with a U.S. firm that is permitted to use LIFO. Therefore, each firm has an incentive to choose LIFO, even in a situation in which every firm would be better off if every firm were to choose FIFO.

    One way to have all firms use FIFO when doing so would increase the value of every firm is to no longer allow the use of LIFO for tax purposes in the U.S. This suggests that LIFO repeal would increase firm value if the industry's marginal revenue curve is upward sloping and all firms had adopted LIFO.

    Continued in article

    LIFO Sucks Teaching Case on LIFO Layers in Years of Rising Prices

    From The Wall Street Journal Accounting Review on December 3, 2010

    Accounting Method Sucks Up Oil
    by: Dan Strumpf
    Nov 22, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Inventory Systems
    SUMMARY: "The oil market has been waiting months for...a drop in supplies along the nation's main refining corridor. Prices are poised to soar on any indication that rising demand from the recovering economy is bringing a two-year-old oil glut to an end." But drop in inventory among U.S. oil companies merely follows a typical year end pattern. "To avoid a tax charge tied to rising oil prices, refiners and other companies that store crude are scrambling to make sure they end the year with the same inventories they had at the start."
    CLASSROOM APPLICATION: The article brings to life the implications of dipping into LIFO inventory layers.
    QUESTIONS:
    1. (Introductory) What inventory method is used by most companies in the oil industry?

    2. (Advanced) What are the federal tax incentives to use LIFO inventory method?

    3. (Advanced) What Louisiana state tax requirements also influence oil companies to choose LIFO inventory accounting?

    4. (Introductory) Refer to the related article. What factors are leading to a two-week high price for oil as of December 1, 2010?

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES:
    Oil Climbs to $86.75, a 2-Week High
    by Jerry A. DiColo
    Dec 01, 2010
    Online Exclusive

    "Accounting Method Sucks Up Oil," by: Dan Strump, The Wall Street Journal, November 22, 2010 --- fhttp://online.wsj.com/article/SB10001424052748703531504575625013694074190.html?mod=djem_jiewr_AC_domainid

    An accounting practice is making the millions of barrels of excess crude that have flooded the oil market disappear—for a few weeks, anyway.

    To avoid a tax charge tied to rising oil prices, refiners and other companies that store crude are scrambling to make sure they end the year with the same inventories that they had at the start. Stockpiles on the Gulf Coast plunged nearly 7 million barrels in the week ended Nov. 12, the region's biggest drop in over two years, according to the Energy Information Administration. Another 25 million barrels need to go for this December's inventories to match last year's. But if past years are any indication, inventories are likely to rise just as quickly with the start of the new year.

    The oil market has been waiting months for just such a drop in supplies along the nation's main refining corridor. Prices are poised to soar on any indication that rising demand from the recovering economy is bringing a two-year-old oil glut to an end.

    But the recent draws aren't that sign, and it's being reflected in the price of oil. Crude prices are off 7.2% since ending at a two-year high on Nov. 11, trading late Friday at $81.51 a barrel. Futures nearly fell below $80 a barrel for the first time in a month on Wednesday—after the government inventory report—as U.S. demand looked weak.

    "It's not any huge surge in demand that's causing the drawdown," said a spokesman for a large refiner that is reducing inventories for tax reasons.

    Companies usually reduce stocks by importing less oil, then drawing on inventories to refine into fuel. Last week, oil imports hit an 11-month low, the EIA said.

    The refiner, like much of the oil industry, uses a form of accounting called "last in, first out," or LIFO, to value their inventories. The practice allows a company to claim each barrel of oil they sell was the most recent one purchased. That creates an incentive to lower end-of-year inventories when prices climb because the more expensive oil is the "first out," allowing the remaining oil to be taxed at a lower rate.

    Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation. If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.

    In addition, oil companies face taxes in Gulf Coast states based on the level of inventory they have in storage, providing another incentive to draw down year-end inventories.

    Crude stockpiles fell sharply in November and December in three of the past four years, only to quickly rebound. Inventories are down nearly 3% nationwide in the past two weeks of government data, though they remain well above the historical average.

    "Year after year, we see crude inventories in the Gulf Coast region decline in December…and it doesn't mean a darn thing in terms of whether the global oil market is tight or not," said Tim Evans, an oil analyst at Citi Futures Perspective.

    The Obama administration has periodically tried to end LIFO accounting, and earlier this month, the co-chairs of a presidential commission charged with finding ways to reduce the deficit proposed doing away with the practice.

    Companies that use LIFO, however, have opposed its repeal, saying it protects them against rising prices. The American Petroleum Institute, the main oil-industry lobbying group, has argued that repealing LIFO would result in a "significant upfront tax increase."

    Jensen Comment
    Moves are now underway to end LIFO for tax purposes and as an accounting alternative. This would make U.S. GAAP much more like IFRS international rules that never have allowed LIFO.

    "Fight for Your LIFO," by Liam Denning, The Wall Street Journal, December 2, 2010 ---
    http://online.wsj.com/article/SB10001424052748704594804575649002258068166.html?mod=djemheard_t

    Buried on page 29 of Wednesday's report was a proposal to eliminate last-in-first-out, or LIFO, accounting for inventories. Under LIFO, companies assume that the goods they sell from inventories are the last ones put in. When prices are rising, this means the cost of goods sold is higher, reducing reported profits and, thereby, the taxes paid on them. Therein lies the rationale for LIFO's potential abolition.

    The potential impact could be significant. Take Exxon Mobil, Chevron, and ConocoPhillips, the top three U.S. majors. They had an aggregate LIFO reserve of $28.3 billion at the end of 2009. In theory, abolishing LIFO would result in a tax liability of about $10 billion.

    Beyond the oil patch, a 2008 survey by the American Institute of Certified Public Accountants found 36% of U.S. firms using LIFO for at least some of their inventories.

    Dr. Charles Mulford of Georgia Tech College of Management says that while LIFO accounting is "often blamed as a tax gimmick," it also offers a more accurate picture of profits by aligning costs with revenues.

    There is another potential wrinkle. LIFO accounting is suited to periods of inflation. When prices are falling, companies using LIFO actually pay more tax, as their cost of goods sold falls and reported profit rises.

    Say LIFO is abolished and, despite Washington's best efforts, deflation takes hold. Under that scenario, the companies that benefited from LIFO accounting during the boom years would actually enjoy a tax shield on future profits from the new accounting method. In this era of unintended consequences, such a policy outcome wouldn't be wholly surprising.

     A Very Practical Application of 'Dollar-Value Lifo
    "The IPIC Method Revisited: A Simplified Explanation and Illustration of the Inventory Price Index Computation (IPIC) Method"
    by CPA Valuation Specialist William Brighenti [william_brighenti@yahoo.com]
    http://www.cpa-connecticut.com/IPIC.html

    Bob Jensen's threads on accounting theory are at
    http://faculty.trinity.edu/rjensen/Theory01.htm

     

     

     

     



     

    Cash Flow Versus Accrual Accounting

    With a comment on principles-based standards
    "Point of view: Cash flow reporting - A call to action,"
    PwC. December 19, 2013 --- Click Here
    http://www.pwc.com/us/en/cfodirect/publications/point-of-view/cash-flow-reporting.jhtml?display=/us/en/cfodirect/publications/point-of-view&j=340449&e=rjensen@trinity.edu&l=615093_HTML&u=14804646&mid=7002454&jb=0

    The statement of cash flows is regarded by many users of the financial statements in a number of industries as the most important financial statement and is often the foundation by which users evaluate a company’s performance.  Accounting standards provide a principles-based framework for presenting sources and uses of cash. We support principles-based standards, although we recognize that their application can be complex.  This often leads to diversity in how cash flows are reported and reduces the comparability of financial reporting.  Therefore, disclosure of cash flow information is important to enhance the utility of the statement of cash flows. 

    Continued at
    http://www.pwc.com/en_US/us/cfodirect/assets/pdf/point-of-view-cash-flow-reporting.pdf

    Bob Jensen's threads on cash flows versus accruals ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#CashVsAccrualAcctg


    Cash Flow and Motive for Fraud
    RGL Forensics
    http://www.rgl.com/pubs/xprPubDetail.aspx?xpST=PubDetail&pub=1151dfb2-4570-400b-8cfa-74da7231acfd&RSS=true
    Thank you M. Raza for the heads up.

    Cash Flow and Motive for Fraud

    A company’s statement of cash flows offers an invaluable view into the sources and uses of cash in the organization’s operations. At the same time, the cash flow statement can provide important clues about the operation’s financial stability and solvency (ability to meet obligations as they are due or sufficient assets to meet ongoing liabilities). For example, poor cash flow and the likelihood of insolvency can represent a critical set of numerical red flags for uncovering the motives for committing accounting or insurance fraud.
    Moreover, investigative analysis of a company’s cash flow numbers can uncover incentives to commit fraud in two key categories--motive out of desperation (to stave off insolvency, for instance), and motive out of intentional calculation.1

     

    ESSENTIAL ACCOUNTING RULES

    Publication of the statement of cash flows is required by Generally Accepted Accounting Principles (GAAP) in the United States.2  Essentially, the cash flow statement provides for the sources and uses of cash within three categories of activities within each entity—operating, investing and financing operations.  The combined net cash provided or used for each of the three groupings of activity equals the company’s overall increase or decrease in the cash balance during the year. 

    Example: The operating activities for a cash flow statement using the indirect method:

      

    Cash Flow from Operating Activities

    Net Income                                                               $500,000

    Adjustments to Reconcile Net Income 

    to Net Cash from Operating Activities:

    Depreciation (Non-Cash Expense)                               $100,000

    (Increase) / Decrease Receivables                             ($400,000)

    (Increase) / Decrease in Inventories                          ($200,000)

    Increase / (Decrease) Payables                                 ($200,000)

    Increase / (Decrease) in Taxes Payable                     ($200,000)

    Net Cash Provided by Operating Activities          ($400,000)

    As you can see, this particular entity earned $500,000 in net profit for the year while operations actually resulted in a $400,000 decline in cash due to the ways in which cash was generated and used for operations.  The change in accounts receivable provides important insight into the difficulty the entity has had in converting sales to cash. 

    Key: If the accounts receivable balance increases during a year it means that cash receipts were less than sales for the year.  This is often symptomatic of a strain on available cash for operating activities, which in turn could be caused by other problems such as the following:

        • Financial difficulties at one or more customers. In today’s economic times, many companies are facing financial difficulty that often translates into slower payment of suppliers and vendors.  This could be a widespread problem or one that is isolated to few customers. 

    Accounts receivable aging reports will help to shed light on the specific accounts that are slow in paying. 

        • Customer service or billing difficulties. Another possible explanation for the increase in the receivables balance is that the entity is not providing quality customer service (including sub-par product quality) and customers are refusing to pay the amount owed on account or are demanding an allowance as compensation.  These problems may or may not be properly accounted for through the establishment of a reserve for doubtful accounts.  And, of course, these types of problems may be indicative of a larger more systemic customer service problem. 

    Helpful: Speaking with selected customers about the reasons for delay in payment is often very valuable in this regard.  Confirmation of receivable balances could also include an opportunity for the customer to provide feedback on the customer service received.

        • Artificial overstatement of sales and accounts receivable. The cash strain described above could also be the result of fictitious entries to the ledger. This results in artificial overstatement of sales and accounts receivable.  This is a common form of financial statement fraud designed to misrepresent the financial condition of the entity for a fraudulent purpose.  The result is to overstate assets – primarily accounts receivable-- and sales, thus artificially inflating profitability and equity balance of the operation. 

    Tracing these transactions to the underlying sales invoices and other supporting documentation as well as to specific confirmations of the receivable balance with the customer is essential to this analysis. 

    Of course, there could be other explanations for the increase in the receivables balance that may suggest that it is a normal, temporary increase.  To determine if this is the case, analyze and understand the trends and cycles of the receivables to discover whether the correlation of sales to receivables balance is seriously eroding or simply fluctuates over time.

     For illustration, in the example above, it is possible that the previous year experienced a dramatic decrease in the receivable balance, which translated to a dramatic increase in cash on hand.

    Key: The timing and history of transactions are important to the investigation and understanding of the financial situation in the context of financial motive to commit fraud.

    Bottom line: Getting to the true facts about this entity’s financial activities requires an understanding of the “why” and not simply the transactions and account balances. 

    As mentioned, an important factor is the timing of changes and their correlation —or lack thereof— to the approach to insolvency.  The question that must be asked in order to determine if there is a motive to commit fraud is whether there is a trend towards insolvency.  If there is, the pressure on management to falsify its financial reports may be great enough to push them to commit fraud. If, on the other hand, you determine that legitimate forces are behind the entities cash flow problems, you must assess the ability of the operation to survive through alternative financing or investment with a plan to turn it around.  This is the nature of structured turnarounds; rethinking the financial model and business concept with the goal of returning the operation to solvency. 

     

    CASH FLOW FROM FINANCING

    Another section of the Statement of Cash Flows that is of particular significance to the analysis of financial motive for fraud is that relating to cash flow from financing activities. 

    In this situation, the motive investigation should always include an analysis of the ability of the business entity to meet its debt obligations (and preferred stock dividends if applicable) as they come due.  And, while there is important information provided in the cash flows statement relevant to this issue, more investigation is required to unravel the real story behind the numbers. 

      

    Cash Flow from Financing Activities

    Payments of Loan Principal                                 ($500,000)

    Loan Proceeds                                                      200,000

    Net Cash Provided by Financing Activities            ($300,000)

    A quick glance of this abbreviated section of the cash flow statement tells you that payments toward the principal balance of the entity’s debt made during the year totaled $500,000 and the loan proceeds from new debt were $200,000.  The result is a further $300,000 decline in the cash balance.  While this is valuable information, it does not give us sufficient understanding of the cash flow and financing of the operation. 

    For example, while $500,000 in payments were made towards the principal on the entity’s debt, the statement does not reveal the amount of debt principal that was due and owing during the year.  It could be that the principal portion of loan payments scheduled for remittance totaled more than $1 million, but the entity lacked sufficient cash or additional financing to meet that obligation.  As such, the entity may have been forced to pursue restructuring of its debt -- by, for example, having the principal amount due in the current year pushed to the following. This would help to ease the entity’s current cash flow problem, but it  would increase the risk of being unable to meet its obligations in the subsequent period.

    The notes to the financial statements often will provide some additional insight to the loan balances, due dates, amounts due during the year, refinances, liquidations and new loans.  There may also be information on the collateral or security pledged for the loans and even compliance with loan covenants and other requirements.   These covenants and requirements are designed to assist the lending institution in managing its financial interest in the underlying security protecting its investment. 

    Where this information is not disclosed on the financial statements or notes, the analyst must seek the details in order to completely understand the nature and complexity of the entity’s debt financing.  This is critical to understanding the financial implications to negative cash flow and its relationship to the approach of insolvency. 

    And perhaps most importantly, the ability of an entity to finance its operation is critical in understanding the potential motive for fraud.  In the case of the desperate entity, for example, current debt payments due may outweigh the entity’s ability to generate cash from other sources.  Thus, among the main ways for such an organization to obtain the desperately needed cash are refinancing or borrowing additional funds.  An investigation of the cash flow from financing activities provides insight into whether management has misrepresented its financial records to facilitate such borrowing potential. 

     

    GETTING THE NEEDED INFORMATION

    Often, the most important source for this information is directly from the company’s financial institution itself. 

    Important: Whenever you request information about a specific entity from its bank, be sure to ask for complete copies of loan files, loan underwriting files, loan agreements including covenants, loan payment history, as well as collateral and security interests, procedures for loan approval and covenant violation as well as financial information files, etc. 

     

    Continued in article

    Which is More Value-Relevant: Earnings or Cash Flows?
    Go to http://faculty.trinity.edu/rjensen/theory02.htm#CashVsAccrualAcctg


    What do accruals tell us about future cash flows?
    by Barth, M. E., G. Clinch, and D. Israeli.
    Review of Accounting Studies 201621(3): 768-807.
    http://link.springer.com/article/10.1007/s11142-016-9360-4

    Our model, which is adapted from Feltham and Ohlson (Contemp Account Res 11:689–731, 1995) and Ohlson (Contemp Account Res 11:661–687, 1995) and extends Dechow and Dichev (Account Rev 77:35–59, 2002), characterizes the information about future cash flows reflected in accruals. It reveals investors can extract from accruals information about next period’s economic factor and the transitory part of one component of next period’s cash flow. The extent to which each accrual provides this information depends on whether the accrual aligns future or past cash flows and current period economics and whether it relates to the current or prior period. Thus each type of accrual has a different coefficient in valuation and forecasting cash flows or earnings. Each coefficient combines an information weight reflecting the information that accrual type provides and a multiple reflecting how that information is used in valuation and cash flow and earnings forecasting. The empirical evidence supports our main insight, namely that partitioning accruals based on their role in cash-flow alignment increases their ability to forecast future cash flows and earnings and explain firm value.

     


    Special Problems in Accounting for Law Firms

    "ABA urges federal lawmakers to NIX draft provision requiring law firms to adopt accrual accounting." by Martha Neil, ABA Journal, January 16, 2014 ---
    http://www.abajournal.com/news/article/ABA_urges_federal_lawmakers_to_nix_draft_provision_requiring_law_firms/?utm_source=maestro&utm_medium=email&utm_campaign=weekly_email

     

  • The American Bar Association is urging federal lawmakers to rethink a possible plan to require businesses to use the accrual method instead of traditional cash accounting in the discussion draft Tax Reform Act of 2013.

    Accrual accounting would be more complex and expensive, the ABA's president writes in letters to lawmakers, than the system currently used by many law firms, which recognizes income and expenses for tax purposes when money is actually received and paid out, respectively. A number of others also have objected to forcing businesses to adopt the accrual method, which could require companies and law firms to pay tax on income they not only haven't received but may never receive, according to the ABA and The Hill's On the Money blog.

    "Although we commend you for your efforts to craft legislation aimed at simplifying the tax laws—an objective that the ABA and its Section of Taxation have long supported—we are concerned that Section 212 would have the opposite effect and cause other negative unintended consequences," President James R. Silkenat wrote in Jan. 13 letters to leaders of the Senate Finance Committee (PDF) and the House Ways and Means Committee (PDF).

    "This far-reaching provision would create unnecessary complexity in the tax law by disallowing the use of the cash method; increase compliance costs and corresponding risk of manipulation; and cause substantial hardship to many law firms and other personal service businesses by requiring them to pay tax on income they have not yet received and may never receive," Silkenat continues. "Therefore, we urge you and your committee to remove this provision from the overall draft legislation."

    The potential law in its present form would apply to businesses with annual gross receipts above $10 million.

    Jensen Comment
    The FASB requires cash flow statements as supplements to accrual accounting financial statements. Accrual accounting for revenues (apart from mark-to-market accounting for financial instruments) recognizes revenues when they become legally earned irrespective of the the timing of payments. Cash flow accounting without accrual accounting as well is frowned upon because management can manipulate (manage) earnings by simply writing contracts that time collections in advance of or after legally earning revenues.

    There can also be misleading matchings expenses against cash flow revenues. For example, in one year firms can take an "earnings bath" by timing cash outflows for the purpose of next year showing an enormous jump in cash flow earnings because so many expenses were deducted the year before the revenues they helped generate are realized in cash.

    Accrual accounting is generally required for firms that sell their stocks and bonds to the public. It is also generally required for firms that borrow money from financial institutions. Law firms are generally different in that partners of a law firm can usually choose most any accounting method they want since outsiders are less impacted by "misleading" financial statements.

    Law firms have special problems with accounting. Most of the expenses are for relatively high priced labor. Many of the cases have great uncertainties as to when and if they will generate revenues. Whereas medical and accounting firms are relatively assured of collecting fees for cases, it's sometimes very hard to over many years to account for pending law firm cases that are still open on the books. Capitalized (accumulated prepaid expenses) cases are soft assets that are not as a rule traded among law firms like pending oil wells can be traded among oil firms.

    I suspect there's a history of student projects and term papers focused on accounting for law firms. If not, now is a very good time to consider such projects that demonstrate how memorized bookkeeping in textbooks can become difficult to apply in the real world.

    Bob Jensen's threads on earnings manipulation are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

  •  


     

    "How to Spot the Next Enron," by George Anders, Fast Company, December 19, 2007 ---
    http://www.fastcompany.com/magazine/58/ganders.html
    As cited by Smoleon Sense, on September 23, 2009 ---
    http://www.simoleonsense.com/investors-beware-how-to-spot-the-next-enron/

    Want to know how to avoid being fooled by the next too-good-to-be-true stock-market darling? Just remember these six tips from the cynics of Wall Street, the short sellers.

    If only we could have spotted the rascals ahead of time. That's the lament of anyone who bought Enron stock a year ago, or who worked at a now-collapsed company like Global Crossing or who trusted any corporate forecast that proved way too upbeat. How could we have let ourselves be fooled? And how do we make sure that we don't get fooled again?

    It's time to visit with some serious cynics. Some of the shrewdest advice comes from Wall Street's short sellers, who make money by betting that certain stocks will fall in price. They had a tough time in the 1990s, when it paid to be optimistic. But it has been their kind of year. Almost every day, new accounting jitters rock the stock market. And if you aren't asking about hidden partnerships and earnings manipulation -- the sort of outrages that short sellers love to expose -- you risk being blindsided by yet another business wipeout.

    Think of short sellers as being akin to veteran cops who walk the streets year after year. They pick up subtle warning signs that most of us miss. They see through alibis. And they know how to quiz accomplices and witnesses to put together the whole story, detail by detail. It's nice to live in a world where we can trust everything we're told because everyone behaves perfectly. But if the glitzy addresses of Wall Street have given way to the tough sidewalks of Mean Street these days, we might as well get smart about the neighborhood.

    The first rule of these streets, says David Rocker, a top New York money manager who has been an active short seller for more than two decades, is not to get mesmerized by a charismatic chief executive. "Most CEOs are ultimately salesmen," Rocker says. "If they showed up on your doorstep and said, 'I've got a great vacuum cleaner,' you wouldn't buy it right away. You'd want to see if it works. It's the same thing with a company."

    A legendary case in point involves John Sculley, former CEO of Apple Computer. In 1993, he briefly became chief executive of a little wireless data company called Spectrum Information Technologies and spoke glowingly of its prospects. Spectrum's stock promptly tripled. But those who had looked closely at Spectrum's technology weren't nearly as impressed.

    Just four months later, Sculley quit, saying that Spectrum's founders had misled him. The company restated its earnings, backing away from some aggressive treatment of licensing revenue that had inflated profits. The stock crashed. The only ones who came out looking smart were the short sellers who disregarded the momentary excitement of having a big-name CEO join the company. Instead, those short sellers focused on the one question that mattered: Are Spectrum's products any good?

    So in the wake of Enron, you want to know what to look for in other companies. Or, more to the point, you need to know what to look for in your own company, so you're not stuck explaining what happened to your missing 401(k) fund. Here are six basic pointers from the short-selling community.

    1. Watch cash flow, not reported net income. During Enron's heyday from 1999 to 2000, the company reported very strong net income -- aided, we now know, by dubious accounting exercises. But the actual amount of cash that Enron's businesses generated wasn't nearly as impressive. That's no coincidence.

    Companies can create all sorts of adjustments to make net income look artificially strong -- witness what we've seen so far with Enron and Global Crossing. But there's only one way to show strong cash flow from operations: Run the business well.

    2. Take a wary look at acquisition binges. Some of the most spectacular financial meltdowns of recent years have involved companies that bought too much, too fast. Cendant, for example, grew fast in the mid-1990s by snapping up the likes of Days Inn, Century 21, and Avis but overreached when it bought CUC International Inc., a direct-marketing firm. Accounting irregularities at CUC led to massive write-downs in 1997, which sent the combined company's stock plummeting.

    3. Be mindful of income-accelerating tricks. Conservative accounting says that long-term contracts should not be treated as immediate windfalls that shower all of their benefits on today's financial statements. Sell a three-year magazine subscription, and you've got predictable obligations until 2005. Those expenses will slowly flow onto your financial statements -- and it's prudent to book the income gradually as well.

    But in some industries, aggressive practitioners like to put jumbo profits on the books all at once. Left for later are worries about how to deal with the eventual costs of those long-term deals. In a recent Barron's interview, longtime short seller Jim Chanos identified such "gain on sale" accounting tricks as a sure sign that the management is being too aggressive for its own good.

    Jensen Comment
    Cash flow statements are useful, but they are no panacea replacement of accrual accounting and earnings analysis. One huge problem is that unscrupulous executives can more easily manipulate/manage cash flows --- http://faculty.trinity.edu/rjensen/theory01.htm#CashVsAccrualAcctg

     

    Question
    What do the department store chains WT Grant and Target possibly have in common?

    Answer
    WT Grant had a huge chain of departments stores across the United States. It declared bankruptcy in the sharp 1973 recession largely because of a build up of accounts receivable losses. Now in 2008 Target Corporation is in a somewhat similar bind.

    In 1980 Largay and Stickney (Financial Analysts Journal) published a great comparison of WT Grant's cash flow statements versus income statements. I used this study for years in some of my accounting courses. It's a classic for giving students an appreciation of cash flow statements! The study is discussed and cited (with exhibits) at http://www.sap-hefte.de/download/dateien/1239/070_leseprobe.pdf
    It also shows the limitations of the current ratio in financial analysis and the problem of inventory buildup when analyzing the reported bottom line net income.

    From The Wall Street Journal Accounting Weekly Review on March 14, 2008

    Is Target Corp.'s Credit Too Generous?
    by Peter Eavis
    The Wall Street Journal

    Mar 11, 2008
    Page: C1
    Click here to view the full article on WSJ.com
    http://online.wsj.com/article/SB120519491886425757.html?mod=djem_jiewr_AC
     

    TOPICS: Allowance For Doubtful Accounts, Financial Accounting, Financial Statement Analysis, Loan Loss Allowance

    SUMMARY: "'Target appears to have pursued very aggressive credit growth at the wrong time," says William Ryan, consumer-credit analyst at Portales Partners, a New York-based research firm. "Not so." says Target's chief financial officer, Douglas Scovanner, "The growth in the credit-card portfolio is absolutely not a function of a loosening of credit standards or a lowering of credit quality in our portfolio."

    CLASSROOM APPLICATION: This article covers details of financial statement ratios used to analyze Target Corp.'s credit card business. It can be used in a financial statement analysis course or while covering accounting for receivables in a financial accounting course

    QUESTIONS: 
    1. (Introductory) What types of credit cards has Target Corp. issued? Why do companies such as Target issue these cards?

    2. (Introductory) In general, what concerns analysts about Target Corp.'s portfolio of receivables on credit cards?

    3. (Introductory) How can a sufficient allowance for uncollectible accounts alleviate concerns about potential problems in a portfolio of loans or receivables? What evidence is given in the article about the status of Target's allowance for uncollectible accounts?

    4. (Advanced) "...High growth may make it [hard] to see credit deterioration that already is happening..." What calculation by analyst William Ryan is described in the article to better "see" this issue? From where does he obtain the data used in the calculation? Be specific in your answer.

    5. (Advanced) Refer again to the calculation done by the analyst Mr. Ryan. How does that calculation resemble the analysis done for an aging of accounts receivable?

    6. (Advanced) What other financial analysis ratio is used to assess the status of a credit-card loan portfolio such as Target Corp.'s?

    7. (Advanced) If analysts prove correct in their concern about Target Corp.'s credit-card receivable balance, what does that say about the profitability reported in this year? How will it impact next year's results?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     


    First Quarter (2009) net cash flow hemorrhage of General Motors
    Per Day: $113.3 million
    Per Hour: $4.72 million
    Per Minute: $78,704
    Per Second: $1,312
    Jim Mahar, Finance Professor Blog, May 7, 2009 --- http://financeprofessorblog.blogspot.com/
    Jensen Comment
    This is one of those classroom illustrations of where accrual accounting alone paints a misleading picture unless accompanied by cash flow statements. Note that net cash flow in this case includes all cash coming in, including government loans


    "Is Target Corp.'s Credit Too Generous? Retailer's Loans Rose 29% From Year Earlier As Others' Books Shrink," By Peter Eavis, The Wall Street Journal, March 11, 2008; Page C1 --- http://online.wsj.com/article/SB120519491886425757.html?mod=djem_jiewr_AC

    Ben Bernanke must love retailer Target Corp., because its credit-card business is one of the few operations in the country that has strongly increased lending in the face of the credit crunch.

    Now, though, some analysts are wondering whether the torrid expansion of the card business in the current tough environment could lead to higher-than-expected bad loans.

    At the end of Target's fiscal fourth quarter, which ended Feb. 2, the company had $8.62 billion of loans outstanding on its Visa cards, which can be used at other retailers as well as Target, and its private-label cards, which are for purchases at Target only.

    That total was up 29% from the $6.71 billion a year earlier -- and the growth rate was even greater than the 25% year-on-year rise posted in the fiscal third quarter. The card business has been responsible for a large part of the retailer's overall earnings growth.

    Other credit-card lenders' loan books have either shrunk or grown much more slowly. For instance, Discover Financial Services' U.S. credit-card business reported a 5% annual increase in loans in its fiscal fourth quarter, ended Nov. 30. Loans outstanding at Capital One Financial Corp.'s U.S. card business declined 2.8% in its fourth quarter, while Citigroup Inc.'s rose 3.6% and J.P. Morgan Chase & Co.'s was up 3%.

    Some fear that Target has lent too much at a time when a slowing economy makes it harder for borrowers to repay. And that it may be attracting struggling borrowers who can't get as much credit as they would like from other companies.

    "Target appears to have pursued very aggressive credit growth at the wrong time," says William Ryan, consumer-credit analyst at Portales Partners, a New York-based research firm.

    Not so, says Target's chief financial officer, Douglas Scovanner. The growth in the credit-card portfolio "is absolutely not a function of a loosening of credit standards or a lowering of credit quality in our portfolio," he says.

    For several years, critics have been predicting a blowup in Target's credit business. It never happened. And Mr. Scovanner notes that the company has yet to report credit losses that exceed company forecasts. He expects that to remain the case this year and predicts the company will report credit losses of about 7% of loans this year, up from 5.9% in the last fiscal year. Discover's credit losses were 3.82% of loans in its latest fiscal year, while Capital One's were 2.88%.

    Last year, Target made a choice to significantly increase its credit-card loans because it identified more borrowers that it felt comfortable lending to, Mr. Scovanner says. He adds that the loans likely won't increase at high rates in the near future from their level at the end of the latest fiscal year.

    "Target has a proven track record of managing its credit business," says Robert Botard, analyst for the AIM Diversified Dividend Fund, which holds Target shares. "Because of that track record, it's difficult to bet against them."

    But bears think this could be the point at which Target stumbles, because the high growth in its card portfolio has happened just as the economy has slowed and lenders have become tight-fisted. And if problems were to arise in the credit-card operations, they would happen at a time when the weak economy is slamming retail operations as well.

    Target's stock is up 2.5% this year, while the Standard & Poor's 500 index has slumped 13%. At a price/earnings ratio of 14.4 times expected per-share earnings for 2008, Target shares also trade above the market's multiple of 12.9 times. Yesterday, at 4 p.m. in New York Stock Exchange composite trading, Target shares fell 77 cents, or 1.5%, to $51.23.

    Investors often buy retailers to bet on an economic recovery, but Target may look less attractive to those sorts of buyers if it is grappling with problems in its credit-card operations. Target's pretax earnings rose by $128 million in the latest fiscal year. The lion's share of the increase -- $103 million -- came from the credit-card business.

    And Mr. Ryan at Portales expects Target's credit losses to be considerably higher than the company predicts. Indeed, the high growth may make it harder to see credit deterioration that already is happening, he says.

    Continued in article

     


    A Bedtime Story:  Teaching Case on Cash Flow and Cash Management

    From The Wall Street Journal Accounting Weekly Review on September 24, 2010

    Companies Like Bed Bath Need Capital Ideas
    by: Kelly Evans
    Sep 22, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Cash Flow, Cash Management

    SUMMARY: "U.S. companies are grappling with what might seem like an enviable problem: what to do with all their cash." Options for what to do with available cash are listed in the article: invest in new activities expected to grow and provide returns, pay off debt, or pay dividends. A final option is one that many have taken: U.S. companies have authorized a total of $257 billion of share repurchase programs so far in 2010.

    CLASSROOM APPLICATION: The article is useful at any level from introductory accounting and up when introducing topics related to cash and balance sheet analysis.

    QUESTIONS: 
    1. (Advanced) Why should shareholders be concerned about companies having too much cash?

    2. (Advanced) Consider the case of Bed Bath & Beyond; not only does it hold a record amount of cash but "it's expected to generate an additional $600 million to $650 million in free cash flow by the end of its fiscal year next February...." What does this statement mean? Include in your answer a definition of free cash flow.

    3. (Introductory) What options are available to companies with high cash balances?

    4. (Introductory) What have many chosen to do with their available cash? Comment on the meaning of the graphic shown in the online article.

    5. (Advanced) Compare the impact on the balance sheet equation of paying dividends to shareholders versus repurchasing one's own shares of common stock. Why would a company choose one versus the other?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Companies Like Bed Bath Need Capital Ideas," by: Kelly Evans, The Wall Street Journal, September 22, 2010 ---
    http://online.wsj.com/article/SB10001424052748703399404575506301710271266.html?mod=djem_jiewr_AC_domainid

    U.S. companies are grappling with what might seem like an enviable problem: what to do with all their cash.

    Take retailer Bed Bath & Beyond Inc., which releases fiscal second-quarter earnings Wednesday. The company had $1.64 billion in cash and short-term Treasurys as of May—a record high. And it's expected to generate an additional $600 million to $650 million in free cash flow by the end of its fiscal year next February, according to UBS Securities.

    Yet investors aren't exactly jumping for joy. A key issue Wednesday will not just be earnings and revenue growth but also whether Bed Bath is putting its cash to good use.

    It's a nationwide dilemma, particularly at tech companies. U.S. non-financial businesses had about $1.85 trillion in liquid assets as of June, according to the Federal Reserve, just shy of the first quarter's record high.

    With interest rates near zero, there is little use in so much cash lying fallow on corporate balance sheets. Some companies, like Darden Restaurants Inc., have used cash to pay off debt. Yet Bed Bath is already debt-free. Others are ramping up spending, but expected returns are low amid a sluggish outlook for revenue growth, notes Gluskin Sheff Chief Economist David Rosenberg.

    A third option is to use the cash for mergers and acquisitions, as some of the cash-heavy tech companies have been doing in recent months. Yet Bed Bath already owns several smaller chains, including Christmas Tree Shops and buybuy BABY. And deals for deals' sake is never a good idea.

    While dividends would help satisfy investors' thirst for income, such payouts are rarely used by retailers that want investors to think they are still in growth mode. Hence the trend toward buying back shares.

    Companies have authorized $257 billion of such buybacks so far this year, according to Birinyi Associates—more than double all of last year. Bed Bath repurchased about $85 million of its shares during its fiscal first quarter, ended May. Bed Bath is authorized for roughly $700 million more. The danger always exists, though, that companies will buy back at the wrong time.

    None of the options is perfect. But companies like Bed Bath need to give shareholders a clear cash strategy. They can't hunker down forever.

    Which is More Value-Relevant: Earnings or Cash Flows?
    http://faculty.trinity.edu/rjensen/theory01.htm#CashVsAccrualAcctg


    A Case About Cash Flow Versus Accrual Accounting

    From The Wall Street Journal Accounting Weekly Review on December 16, 2011

    Diamond Payments Questioned By Growers
    by: Hannah Karp
    Dec 12, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Auditing, Cash Flow, Fiscal Year, Inventory Systems, Mergers and Acquisitions

    SUMMARY: Diamond Foods, Inc., may have been attempting to reduce its 2010 costs for nut purchases and shift them into 2011 in order to maintain a sufficient stock price for use in purchasing the Pringles chips product line from Procter & Gamble. The related article indicates that Investigating the payments has led to a delay in filing the company's fiscal quarterly financial statements with the SEC.

    CLASSROOM APPLICATION: The article is useful in discussing cash versus accrual based accounting and when cash payments subsequent to a fiscal period may indicate that liabilities were in existence at a financial statement date. The discussion also can be used to discuss the impact of purchases of direct materials on the calculation of cost of goods sold.

    QUESTIONS: 
    1. (Introductory) What is the discrepancy between Diamond Foods, Inc.'s description of payments to walnut growers and what the farmers themselves say the payments are for?

    2. (Advanced) In this case, how does shifting the timing of cash payments help to shift the period in which costs are expensed by Diamond Foods, Inc.? In your answer, explain what item of cost is being paid for by Diamond.

    3. (Advanced) Does the time period for cash payouts always match the period in which expenses for the item in question are recorded? Explain your answer

    4. (Advanced) How have questions about these payments impacted Diamond Foods planned acquisition of Pringles snack chips from Procter and Gamble? In your answer, address how reducing Diamond's 2010 costs would impact the planned transaction given its structure as described in the WSJ article.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Probe Delays Diamond Foods' Report
    by Hannah Karp
    Dec 13, 2011
    Online Exclusive

    "Diamond Payments Questioned By Growers,"  by: Hannah Karp, The Wall Street Journal, December 12, 2011 ---
    http://online.wsj.com/article/SB10001424052970204336104577092701009641444.html?mod=djem_jiewr_AC_domainid

    Some walnut growers have challenged Diamond Foods Inc.'s explanation of mysterious payments to them, further tangling an accounting question that has delayed the snack maker's planned $2.35 billion acquisition of Pringles from Procter & Gamble Co.

    Diamond Foods has said a sizable payment to its walnut growers in September was an advance on their 2011 crop.

    But three growers said they told the company that they didn't intend to deliver their 2011 crops to Diamond, yet were assured by company representatives that they could cash the checks anyway. The three said they were told the checks were to top up payments for their 2010 crops.

    The company is the subject of shareholder suits that claim Diamond may have used the payments to shift costs from the fiscal year that ended July 31 into the current year, padding earnings for the previous year.

    The checks to the growers, what the company called momentum payments, are the subject of an investigation by Diamond's board and have become a sticking point in the company's deal to buy the Pringles snack brand. Diamond plans to pay in part with its stock, which has dropped 56% since late September, shortly after the company reported fiscal-year results.

    Diamond said its agreements with growers are confidential.

    Many growers, who harvested their 2011 crops last month, said they had never seen momentum payments before. Some growers also had grumbled over what they said were insufficient payments from Diamond for their 2010 crops.

    Mark Royer, who has grown walnuts for Diamond for the past 10 years, said he hadn't decide whether to deliver his 2011 crop to the company when he received his momentum check in September. He said he called his Diamond field representative to explain "what the mysterious payment represented."

    "I made the assumption it would have to be 2010 compensation, because the delivery-to-date pricing was almost 40% under market," Mr. Royer said.

    He said the representative told him Diamond executives "were not committing" about which crop the payment was for. "He simply said that he knew that certain growers were cashing their momentum-payment check with the understanding that they didn't intend to deliver in 2011."

    Mr. Royer said he then decided it was safe to deposit his check.

    He said he won't deliver this year's crop to Diamond. "I've kind of washed my hands of the matter," he says.

    A grower from Sacramento, Calif., said he was unsatisfied with his final official payment this summer for his 2010 crop. "It was grossly under what other growers had received," he said.

    He was pleased to get another check, for $90,000, several days later, he said.

    But he said he had been concerned that accepting the payment would require him to deliver his fall harvest to Diamond. He said field-service representative Eric Heidman, in Stockton, Calif., assured him that the check was the last payment for the 2010 crop.

    Mr. Heidman didn't return calls seeking comment.

    Another grower in Northern California said his field representative told him the momentum check was for 2010, and that he had told Diamond he wouldn't deliver this year's crop to the company. He said he had his lawyer send Diamond a letter, confirming that the grower wouldn't deliver this year's crop and would cash the check.

    Diamond began an investigation into its accounting practices last month after the chairman of the board's audit committee, Edward Blechschmidt, received complaints about the payments from someone outside the company.

    The investigation delayed Diamond's cash-and-stock purchase of Pringles from P&G.

    Continued in article

    Bob Jensen's threads on cash flow versus accrual accounting analysis ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#CashVsAccrualAcctg

     


    The Grumps Zigg and Zagg

    "DON’T GAG ON ZAGG," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants, May 7, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/657

    One of our loyal followers recently brought to our attention a company that just might be our first candidate for this year’s “poster child” of bad financial reporting: ZAGG.  The Company indicates that it is “Zealous About Great Gadgets,” and apparently the market likes this zealot.  ZAGG’s stock price has soared about 40 percent in the last several months, driven by both top and bottom line growth, and improving operating cash flows, all of which have been blessed by the company’s new Big 4 auditing firm, KPMG.  So, what’s the problem?  The numbers are giving off so much smoke that we think management may have blinded both the auditors and investors.

    Our review of the Company’s operating environment and 2011 10-K leads us to conclude that at the very least, the Company’s reported amounts are suspect.  At worst, management may be “cooking the books.”

     A number of performance factors exist that are creating huge pressures for managers to manipulate the financial statements.

    • The Company relies significantly on stock based compensation.  In fact, stock compensation was so significant in 2011 that it consumed almost 11 percent of income before taxes (excluding stock based compensation).
    • Additionally, ZAGG’s soaring stock price puts pressure on management to report good financial metrics (10-K, page 21), particularly given recent declines in operating performance.  Despite its growth, the Company’s gross margins continue to decline from a high of 57.5 percent in 2009 to 45.7 percent in 2011.  A DuPont Model analysis further reveals a decline in ROE from 42.7 percent in 2010 to 26.95 percent in 2011 driven primarily by slumping profit margins (13.09 percent in 2010 to 10.19 percent in 2011) and slowing asset turns (1.99 in 2010 to 1.34 in 2011).  ROE would have been even lower had it not been for an increase in leverage (1.64 in 2010 to 1.92 in 2011).
    • ZAGG’s debt agreements contain a number of financial and non-financial covenants which also create pressures for management to meet certain financial statement targets (10-K, page 10).
    • Finally, in 2011, 41 percent of the Company’s sales were made to Best Buy and Wal-Mart (10-K, page 13).  Such a concentration also puts pressure on management to report good financial results to maintain key relationships.

    A number of managerial and control issues also suggest an environment ripe for material misstatements in the accounts.

    Continued in article

    "ADDENDUM TO ZAGG," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants, May 7, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/662

    Wow! We really hit a raw nerve in the ZAGG column this morning as we are receiving a large amount of comments. Some are direct allegations and some are accusations posed as questions, but they all come as visceral reactions to a story they don’t like.

    One writes, “I hope you too are shorting ZAGG so that you two losers may personally be squeezed out at some point.” We have no position in ZAGG, neither long nor short. We would report a position if we had one.

    A second writes, “Nice timing, so you waited till Monday morning, before market opens, one day after a good earnings report by the company which put shorts on defensive position to come out with your article? Hope those hedge funds are paying you enough to justify what you guys are doing.” Nobody paid us anything for this essay.

    Another asks, “Is Pardini one of your former students you felt compelled to support?” No, he isn’t, and neither of us knows him.

    And a fourth: “What level of trust can be placed in the source and what is their relationship to ZAGG?” The blog follower who suggested the story was not a source—he gave us no information about ZAGG; he just said it was an interesting firm to look at. We looked at it and provided our own observations. As to his holdings or those of his investment firm, we have no idea. We didn’t ask and we don’t care what his holdings are. His holdings didn’t affect our work. And neither of us knows the fellow personally.

    Sometimes blog followers point us in a particular direction. We take our own peek and do our own research. Sometimes we drop the idea; sometimes we decide to write it up. In all cases, we do our own analysis. You might not like the analysis, and you may disagree with the conclusions. That’s fine, but in this case we stand by our analysis: any firm that hides the fact that operating cash flow and free cash flow are negative by adding some receivables to cash is engaging in accounting shenanigans.

    "CLARIFICATION of ZAGG’S CASH FLOWS," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants Blog, May 9, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/674

    Except for one observation that we mention later, none of the dozens of comments by ZAGG investors, supporters, and management staff changed our opinion expressed Monday, but they did cause us to re-assess the study. We re-read the 10-K, re-ran several metrics, rethought what they meant, and checked FASB documents.

    Contrary to what we have been accused of, we desire to conduct independent research and publish our findings, wherever they might take us. And we make clarifications if necessary.

    You will recall in Monday’s piece that we adjusted cash from operations as part of our financial analyses, and said it was negative. Several commentators claimed that we misinterpreted footnote 10 by reading the fair value number as the value of cash and backed out the credit card receivables. After yet another reading, we still find the footnote ambiguous, and wish that the company had said it was the fair value of the credit card receivables.

    If these footnote 10 numbers are indeed credit card receivables as some parties suggest, we shall adjust our computations of two cash flow metrics. The result: operating cash flow adjustments are not as large as reported in our previous analysis, and operating cash flows are no longer negative.

    Continued in article

     

    Bob Jensen's threads on corporate governance are at
    http://faculty.trinity.edu/rjensen/Fraud001.htm#Governance 

     


    It is very difficult to find academic research in accounting that benefits practice professionals
    Here's an exception from Professors Chuck Mulford and Gene Comiskey from Georgia Tech

    "Cash Flow: a Better Way to Know Your Bank? A study of commercial banks comes up with ways accounting for operating cash flow could be improved," by Sarah Johnson, CFO.com, July 9, 2009 ---
    http://www.cfo.com/article.cfm/13981499/c_2984368/?f=archives 

    If banks more consistently accounted for their operating cash flow, companies could gain a better grasp of their commercial banks' financial health, two professors suggest in a report to be released later this week.

    The results would be astoundingly different than what financial institutions' statements of cash flows tell us today. In the course of an attempt to make the firms' cash-flow reports more comparable - which entailed several adjustments to how banks classified their investments, accounted for non-cash transfers of their loans, and recorded cash flow from acquisitions last year - the researchers saw huge swings, both downward (Bank of America) and upward (KeyCorp).

    As it stands now, banks can't be reliably compared to each other by their recorded cash flow from operations, the researchers contend. Their observations stem from their study of the cash-flow reports of 15 of the largest independent and publicly traded U.S. commercial banks in terms of total assets as of December 31, 2008. "Right now, operating cash flow for a bank is basically meaningless," says Charles Mulford, director of the Georgia Tech Financial Analysis Lab, who co-wrote the study with fellow accounting professor Eugene Comiskey.

    In BofA's case, the bank reported operating cash flow for 2008 of $4 billion. But under the researchers' method, the firm would have had an operating cash flow of negative $6.9 billion. Other financial institutions that saw a decline under the researchers' calculations: J.P. Morgan Chase and Wells Fargo.

    Some firms went the other way. These included Citigroup, Fifth Third Bancorp, PNC Financial, and SunTrust Banks. KeyCorp, which had reported $220 million in negative operating cash flow last year, could have had a positive $3 billion result if it hadn't moved some loans out of the held-for-sale classification to the held-for-investment category.

    To be sure, the banks that would have had better results may have been more concerned with the end product of other financial metrics and made changes to its investment portfolio for the benefit of its earnings results, rather than worrying about its operating cash flow, according to Mulford. After all, he noted, operating cash flow a figure largely ignored by analysts when it comes to banks.

    Moreover, the researchers aren't accusing the banks of doing anything wrong, since current accounting rules allow them to freely make non-cash transfers between investment classifications, a move which can have varying effects on how loans and securities are accounted for in cash-flow statements. Most likely, Mulford says, the firms that make these reclassifications are doing so for the good of their overall investment portfolio, which in turn could help their earnings in the near term.

    Banks' cash-flow reports differ among each other in other ways as well. They vary in how they designate their various cash flows as being from operating, investing, or financing activities. Perhaps, the researchers imply, those concerned with banks' financial stability should demand that more attention is paid to the cash-flow statement to get the banks to be more consistent - and to give their investors incentive to give their cash reports as much credence as they would those of non-financial firms.

    "For companies in general, cash flow is their lifeblood," Mulford says. "Are they creating cash or consuming it? If they're consuming it, then they have to find it somewhere, and may have to rely on the capital markets, which aren't at a very friendly time right now."

    However, with banks, the cash-flow metric is overlooked, Mulford contends. The researchers don't offer a solution or take a stance, but rather ask that their research be used by standard-setters and analysts to push for change. "Obviously something is wrong with [the structure of] cash-flow statements when nobody uses it for a particular group," Mulford says, calling his report an "open invitation" to the Financial Accounting Standards Board.

    "We wrote the study in the interest of building dialogue and possibly improving upon the usefulness of cash flow for commercial banks," Mulford says.

    The researchers question the usefulness of the current characterization of increases and decreases in deposits as financing cash flow. Instead, they believe customer-driven deposits should be accounted for under operating cash flow since "the very health of a bank's operations depend on its deposit base and its ability to attract a growing stream of deposits." The researchers admit their report's final calculations are not fully accurate, partly because they didn't have enough information to distinguish between brokered and consumer-driven deposits.

    Stressing that they're mainly trying to stir up public discussion about the problems in the financial reporting of banks' operating cash flow, the researchers acknowledge that reports' conclusions are far from perfect. After all, the researchers' adjusted numbers give troubled Citigroup a relatively rosy picture of $159.4 billion in adjusted operating cash flow - compared, for example, to a negative $94.3 billion for J.P. Morgan.


    Question
    For investors, how informative is accrual accounting vis-a-vis cash flow reporting?
    Hint:  It all depends!

    From the Unknown Professor's Financial Rounds Blog on November 24, 2007 --- http://financialrounds.blogspot.com/

    More on The Accrual Anomaly and Abnormal Returns

    Here's another paper on "tradable" patterns in stock returns. The CXO Advisory Group recently put up a summary of the study titled "Repairing the Accruals Anomaly" by Hafzalla, Lunholm and Van Winkle. The paper examines the pattern that stock market performance of firms with low accruals (i.e. the difference between the firm's earnings and cash flows) is significantly greater than the performance of their higher accrual counterparts. It does a pretty good job of examining Sloan's "Accrual Anomaly" with a few tweaks:

    It corrects for the extent to which the firm is financially healthy, using Piotrowski's "financial health" indicator. It measures accruals in relation to earnings rather than to assets

    Their findings are that the accrual anomaly does a better job of sorting out investment performance for financially healthy firms. Their results are pretty strong (note- the following is CXO's summary):

    A hedge strategy that is long (short) firms of high (low) financial health (ignoring accruals) generates an average size-adjusted annual return of 9.36% across the entire sample. After excluding firms with the lowest financial health scores, a hedge strategy that is long (short) the 10% of firms with the lowest (highest) traditional accruals generates an average size-adjusted annual return of 13.64%, with 7.98% coming from the long side Using the total sample, a hedge strategy that is long (short) low-accrual, high financial health (high-accrual, low financial health) firms produces an average size-adjusted annual return of 22.93%, with a 14.92% from the long side.

    Here's a pretty good grapic of size adjusted abnormal returns on the various portfolios --- http://financialrounds.blogspot.com/

    "Repairing the Accruals Anomaly," by Russell J. Jundholm,  Nader Hafzalla,  and Edmund Matthew Van Winkle,

    Abstract:
    We document how the effectiveness of an accruals-based trading strategy changes systematically with the financial health of the sample firms or with the benchmark used to identify an extreme accrual. Our refinements significantly improve the strategy's annual hedge return, and do so mostly because they improve the return earned on the long position in low accrual stocks. These results are important because recent evidence has shown that, absent these “repairs,” the accrual strategy does not yield a significantly positive return in the long portion of the hedge portfolio. We also find that our new measure of accruals is not dependent on the presence or absence of special items and it identifies misvalued stocks just as well for loss firms as for gain firms, in contrast to the traditional accruals measure. Finally, we show that our repairs succeed where the traditional measure of accruals fails because they more effectively select firms where the difference between sophisticated and naïve forecasts are the most extreme. As such, our results are consistent with Sloan's earnings fixation hypothesis and are inconsistent with some alternative explanations for the accrual anomaly.

    Jensen Comment
    Current findings on these relationships may be more difficult to extrapolate as fair value accounting becomes more prevalent --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    It's elementary Watson! Of course the statement of cash flow matters.

    "Why the Statement of Cash Flows Matters," by Scott Rothbortm, TheStreet, September 21, 2007 --- Click Here
    Jensen Comment
    This really is elementary, but it does have some rather nice current examples.

    Perhaps a better topic would be "why accrual accounting still matters."

    "Which is More Value-Relevant: Earnings or Cash Flows?" by Ervin L. Black, Sr., SSRN, May 1998 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=118089 
     

    Statements in the financial press and recent research suggest that controversy exists as to which accounting measure is more value-relevant: earnings or cash flows. This study examines the relative value-relevance of earnings and cash flow measures in the context of the firm life-cycle. Earnings are predicted to be more value-relevant in mature stages. Cash flows are expected to be more value relevant in stages characterized by growth and/or uncertainty. In general the hypotheses are supported using Wald chi-square tests (Biddle, Seow, and Siegel 1995) of the Edwards, Bell, Ohlson (1995) model. Evidence supports the hypothesis that earnings are more value-relevant than operating, investing, or financing cash flows in mature life-cycle stages. However, in the start-up stage investing cash flows are more value relevant than earnings. In growth and decline stages, operating cash flows are more value relevant than earnings.

    Jensen Comment
    The above paper by Professor Black is an illustration of a working paper that for quite a long time was available free from BYU. Now that it's on SSRN it's no longer free. SSRN did not necessarily contribute to the open sharing of research papers.

    By the way, even if cash flow statements were hypothetically more relevant in all instances, accrual accounting statements would still be vital. My DAH reason is that, if accountants only reported cash flows, it would be quite simple for managers to distort period-to-period performance by simply altering the contractual timings of cash in and cash out. This is much more simple to do for cash payments than for accrual transactions. There would also be the pesky problem of capital maintenance if depreciation and amortization gets overlooked. In theory capital maintenance is not overlooked in fair value accounting since values decline with asset deterioration. However, fair value accounting is quite another matter entirely --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

     


    The Controversy Over Fair Value (Mark-to-Market) Financial Reporting

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Before I begin, I would like to mention an old theory case that I taught years ago that for students concisely explains the difference between financial statements prepared under historical costs, price-level adjustments, replacement costs, and exit values ---
    www.cs.trinity.edu/~rjensen/temp/wtdcase2a.xls
    This was almost always considered one of the best take aways from my theory course even though students worked on it the first day of the course.

    EY 2020 Comment Letter:  SEC’s proposal on funds’ good faith determinations of fair value ---
    https://www.ey.com/en_us/assurance/accountinglink/comment-letter---sec-s-proposal-on-funds--good-faith-determinati


    A very concise summary of the positions of various accounting theory experts in history since 1909 and authoritative bodies over the years since 1936:
    "Asset valuation: An historical perspective"
    Authors: Racliffe, Thomas A. (Thomas Arthur) and Munter, Paul
    Accounting Historians Journal
    1980
    http://umiss.lib.olemiss.edu:82/record=b1000230
    Jensen Comment:  I really liked this summary of the valuation literature prior to 1980.
    For example, what was the main difference between exit value advocates Chambers versus Sterling?


    Usefulness of fair values for predicting banks’ future earnings: evidence from other comprehensive income and its components
    by Brian Bratten, Monika Causholli, and Urooj Khan
    Review of Accounting Studies , Volume 21, Issue 1, pp 280–315
    http://link.springer.com/article/10.1007/s11142-015-9346-7

    This paper examines whether fair value adjustments included in other comprehensive income (OCI) predict future bank performance. It also examines whether the reliability of these estimates affects their predictive value. Using a sample of bank holding companies, we find that fair value adjustments included in OCI can predict earnings both 1 and 2 years ahead. However, not all fair value-related unrealized gains and losses included in OCI have similar implications. While net unrealized gains and losses on available-for-sale securities are positively associated with future earnings, net unrealized gains and losses on derivative contracts classified as cash flow hedges are negatively associated with future earnings. We also find that reliable measurement of fair values enhances predictive value. Finally, we show that fair value adjustments recorded in OCI during the 2007–2009 financial crisis predicted future profitability, contradicting criticism that fair value accounting forced banks to record excessive downward adjustments.


    Color Book Accounting
    It's sad that neither the FASB nor the IASB can conceptualize "true cost" and "real value." But then most important things in life cannot be operationally conceptualized.  We saving those tasks for smart robots.

    Short-term value changers can be very misleading about long-term value
    We have a 6'7" grandson who was photographed and reported up in a local (California) newspaper nearly every month for his outstanding performances in both high school football and basketball. He was recruited by major universities (e.g., Cal and Oregon) for both sports but had to drop out due to a heart valve weakness. His younger brother was even taller in every grade. We all predicted his "value" in athletics would exceed that of his brother. We all drooled over the possible full-ride scholarships. Now he is a 6"8" freshman in high school. He's into the academics and could care less about sports. So much for predicting long-term "value" based upon short term value changers like growth spurts in childhood. So much for using transitory short-term price fluctuations to predict long-term value.

    “What the SEC requires isn’t thorough enough to get to the numbers investors really want,” said Mike Kelly, an analyst with Global Hunter Securities in Houston. “What is the true cost of producing a barrel of oil? And what is the real value of the assets?”
    "The Price of Oil Is About to Blow a Hole in Corporate Accounting," by Asjylyn Loder, Bloomberg, March 4, 2015 ---
    http://www.bloomberg.com/news/articles/2015-03-04/oil-at-95-a-barrel-discovered-in-sec-rules-on-reserves?cmpid=BBD030415&alcmpid=

    The U.S. Securities and Exchange Commission requires drillers to calculate the value of their oil reserves every year using average prices from the first trading days in each of the previous 12 months. Because oil didn’t start its freefall to about $45 till after the OPEC meeting in late November, companies in their latest regulatory filings used $95 a barrel to figure out how much oil they could profitably produce and what it’s worth. Of the 12 days that went into the fourth-quarter average, crude was above $90 a barrel on 10 of them.

    So Continental Resources Inc., led by billionaire Harold Hamm, reported last month that the present value of its oil and gas operations increased 13 percent last year to $22.8 billion. For Devon Energy Corp., a pioneer of hydraulic fracturing, it jumped 31 percent to $27.9 billion.

    This year tells a different story. The average price on the first trading days of January, February and March was $51.28 a barrel. That means a lot of pain -- and writedowns -- are in store when drillers’ first-quarter numbers are announced in April and May.

    “It has postponed the reckoning,” said Julie Hilt Hannink, head of energy research at New York-based CFRA, an accounting adviser.

    Cash Flow

    Companies use the first-trading-day-of-every-month calculation to estimate future cash flow and to tally how much crude can be profitably pumped out of the ground. The SEC introduced the formula in 2009 as part of wider changes in how the regulator required drillers to report reserves. Prior to the shift, the value of the reserves was measured based on the oil price on the last day of the year, which also caused distortions.

    There are no current plans to revisit or modify SEC reporting rules, Erin Stattel, an SEC spokeswoman, said in an e-mail. She declined to comment further.

    Most shale drillers are reporting increases in what’s known as proved reserves. The SEC requires oil producers to submit an annual tally, along with an estimate of the present value of the future cash flow from those properties. The estimates are limited to what the firm is reasonably certain it can extract from existing wells and prospects scheduled to be drilled within five years. The reports are based on factors such as geology, engineering, historical production -- and price. To count as proved, the resources must be economic to develop given existing market conditions.

    “What the SEC requires isn’t thorough enough to get to the numbers investors really want,” said Mike Kelly, an analyst with Global Hunter Securities in Houston. “What is the true cost of producing a barrel of oil? And what is the real value of the assets?”

    A similar pricing formula helps determine whether some companies need to write off their oil and gas properties.

    Market Value

    West Texas Intermediate for April delivery fell 31 cents to $50.21 a barrel on the New York Mercantile Exchange at 12:30 p.m. local time. Brent dropped 52 cents to $60.50.

    Continental provides one example of how much the price move matters. The company’s Feb. 3 press release announcing the $22.8 billion figure included a disclaimer saying the estimate didn’t represent market value.

    Three weeks later, Continental published more detail in its annual financial report to the SEC. Using current prices instead of the SEC-prescribed $95 a barrel would erase $13.8 billion, or 61 percent, from the value of Continental’s oil and natural gas properties. It would also mean that 10 percent of the company’s reserves, the equivalent of 135 million barrels, would be too expensive to pump with prices where they are, the company said in the filing.

    SEC Rules

    “Continental just follows the rules like everyone else that are mandated by the SEC” and provided additional details to investors in its filing, John Kilgallon, the company’s vice president of investor relations, said in an interview.

    Continental shares have risen almost 14 percent this year. Devon’s stock is little changed. That compares with the Bloomberg Intelligence North America Independent Exploration & Production Index, which has risen more than 2 percent since the beginning of 2015.

    The drillers in the index will lose an estimated 89 cents per share in the first quarter of 2015, according to data compiled by Bloomberg Intelligence. The companies gained $1.13 in the first quarter of 2014 and 26 cents in the three months ended Dec. 31, the data show.

    Devon follows SEC regulations and provides updates “in the course of regular disclosures under SEC rules,” Tim Hartley, a company spokesman, said in an e-mail.

    The company’s Feb. 17 press release said that its proved oil reserves rose “to the highest level in company history.” Three days later, in its SEC filing, the Oklahoma City-based driller said it expects to take writedowns “beginning with the first quarter of 2015.” The company didn’t offer details except to say that it doesn’t expect the amounts to have an impact on cash flow or liquidity. However, they will be material to its net earnings.

    Net earnings and EBITDA cannot be defined since the FASB and IASB elected to give the balance sheet priority over the income statement in financial reporting ---
    "The Asset-Liability Approach: Primacy does not mean Priority," by Robert Bloomfield, FASRI Financial Accounting Standards Research Initiative, October 6, 2009 ---
    http://www.fasri.net/index.php/2009/10/the-asset-liability-approach-primacy-does-not-mean-priority/

    "Whither the Concept of Income?" by Shizuki Saito University of Tokyo and Yoshitaka Fukui Aoyama Gakuin University, SSRN, May 17, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607234

    Abstract:
    Since the 1970s, the decision-usefulness has taken center stage and our attention has been concentrated on valuation of assets and liabilities instead of income measurement. The concept of income, once considered the gravitational center of accounting has lost its primacy and become a byproduct of the balance sheet derived from the measurement of assets and liabilities.

    However, we have not been equipped with robust conceptual foundation supporting theoretically reasoned accounting measurement. It is not only theoretically but also practically important to renew our seemingly waned interest in the concept of income because ongoing reforms of accounting standards cannot be successfully implemented without a sound understanding of the concept of income.


    Accounting rule Warren Buffett loathes boosts Berkshire's bottom line to $81B ---
    https://www.foxbusiness.com/money/accounting-rule-warren-buffett-loathes-boosts-berkshires-bottom-line-to-81b

    Jensen Comment
    The accounting rule is controversial in that net earnings and portfolio values are subject to short-term transitory variations in security prices that may have little to do with long-term earnings and value. For example, Tesla share prices are subject to huge day-by-day volatility caused news events that usually do not reflect changes future cash flows of the company.

    Reporting of a portfolio's value becomes highly dependent upon what day the reporting takes place.

    Also there's a difference in value based upon such factors as control. For example, if Buffett's firm only owns a few shares of Company X the price of $100 per share means something different than if his firm owns 51% of the voting shares. That $100 per share represents the liquidity value of one share of stock. It does not reflect the possibly enormous value of having control of the management of the company.

    The same rule could be a stock market and real estate disaster for any tax (think a wealth or income tax)  that forces investors to liquidate portfolios to pay the tax. At the moment tax accounting rules do not generally require liquidation for value appreciation alone.

    It's a little like reporting the number of birds to be served for dinner while they are still in the bush and can fly away before dinner time.

    Bob Jensen's threads on value accounting theory ---
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValueFails

    Also see
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting


    March 2019:  Three Times You Should Consider Business Valuation (usually infrequent events) ---
    https://www.accountingweb.com/practice/clients/3-times-you-should-consider-business-valuation

    Jensen Comment
    The three major problems with business valuation is that:

    1.  Respectable valuations are costly (not usually cost effective on an annual basis)

    2. Business valuations are highly subjective (due largely varying assumptions) and differ between teams of valuators --- which is the reason mergers and acquisitions often take place when "buyers" are more optimistic than "sellers."  Exhibit A is the widely varying valuation between the Michael Jackson Estate between his family versus the IRS. Exhibit B is the valuation of Tesla based on stock price fluctuations where prices fluctuate greatly both due to news releases about Tesla and ups and downs of the stock market apart from news about Tesla.

    3. Business valuations are unstable and change with not only economic conditions but with such things as scandals.  Exhibit A is the expected 2019 crash in the value of the the Michael Jackson estate as media outlets are now banning the playing of his music and videos following the current release of the HBO documentary leaving the audiences more convinced that he was a serial pedophile who bought off witnesses before court trials. Whether or not he's guilty as implied is not so much an issue as the impact of media outlets to new publicity that he's guilty. Exhibit C is the real estate value in Queens between the Amazon announcement of HQ 2 in Queens and the subsequent crash in valuations following the Amazon announcement that it was reneging on Queens. Value can be fickle indeed.

    Exhibit D is the Non-GAAP Earnings Management at Kraft Heinz Co.
    From the CFO Journal's Morning Ledger on March 6, 2019

     The problems Kraft Heinz Co. disclosed last month are shining a light on a growing concern: the company’s tailored financial metrics that help make its results look better.

    You say tomato, I say $6 billion. Since the 2015 merger that created Kraft Heinz, the packaged-food company has reported adjusted operating earnings totaling more than $24 billion. But reported cash flow from operations under standard accounting rules for that same period was only about $6 billion.

    Mind the GAAP. The gap in cash flow tallies underscores the need for investors to be cautious when relying on nonstandard metrics, rather than those that governed by U.S. Generally Accepted Accounting Principles. The relatively low operating cash flow might have been a tipoff to investors that Kraft Heinz was faltering. Last month it announced a big write-down and a decline in the value of several key brands.

    Caveat emptor. Companies are allowed to report tailored financial metrics, but they must provide detailed disclosures and can’t feature them more prominently than official measures. In recent years, the U.S. Securities and Exchange Commission has criticized many companies over the way they feature adjusted measures. 

    Bob Jensen's threads on pro forma and other non-GAAP reporting ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

     


    From the CPA Newsletter on December 1, 2014

    PCAOB receives wide range of feedback on fair value proposal
    http://www.complianceweek.com/blogs/accounting-auditing-update/ideas-for-guidance-on-auditing-estimates-draws-mixed-reviews#.VHyI_MlS7rx
    The Public Company Accounting Oversight Board is receiving varying levels of support during the comment period for its ideas on changing guidance on auditing fair value measurements and accounting estimates. Some commenters said the standard didn't need to be changed while other suggestions ranged from a single comprehensive new standard to involving the Securities and Exchange Commission so there is a response broader than just an auditing standard. Compliance Week/Accounting & Auditing Update blog (11/26)

    Jensen Comment
    Problems of appraisal professionalism include the following:

    1. Assets and liabilities are so specialized in terms of valuation estimation. Appraisals of debentures is quite unlike appraisals of commodities. Appraisals of options is quite unlike appraisals of interest rate swaps. Appraisals of housing development real estate is quite unlike appraisals cattle or even land having oil and mineral reserves.
       

    2. There is notorious subjectivity in most appraisal tasks, especially subjectivity built upon widely varying assumptions.
       

    3. Assets and liabilities are often very unique even within a given classification. For example, the estimating value of development property ofExit 132 of an interstate highway may be totally unlike estimating the value of development property off Exits 131 .133, and 167. Estimation of a McDonald's debenture may be quite unlike estimating an Intel debenture.
       

    4. The appraisal professions vary widely as to fraud history and barriers to entry (e.g., certification examinations), experience requirements, and notorious histories of fraud. For example, most real estate bubbles and recoveries bring out the worst in terms of real estate appraisals of loan values of homes and businesses. The bottom line is that the appraisal professions are not as respected as the professions of accounting, law, and medicine. Yeah even law!
       

    5. The same appraisal firm gave me widely varying estimates of my home based upon the purpose of the appraisal. The appraisal when I wanted to take out a mortgage was much higher than the subsequent appraisal when I wanted to lower my property taxes. The appraisal firm aimed to please me. Go figure!


    Teaching Case
    Cost Accounting and Inventory Valuation
    by Bob Jensen: 
    Differences Between Mark-to-Market Accounting for Derivative Contracts Versus Commodity Inventories
    ---
    http://faculty.trinity.edu/rjensen/Mark-to-MarketCorn.htm


    Does Fair Value Accounting Provide More Useful Financial Statements than Current GAAP for Banks?

     The Accounting Review
    Article Volume 93, Issue 6 (November 2018)
    https://aaajournals.org/doi/full/10.2308/accr-52007

    John M. McInnis

    Yong Yu
    The University of Texas at Austin

    Christopher G. Yust
    Texas A&M University


     

    ABSTRACT

    Standard setters contend that fair value accounting yields the most relevant measurement for financial instruments. We examine this claim by comparing the value relevance of banks' financial statements under fair value accounting with that under current GAAP, which is largely based on historical costs. We find that the combined value relevance of book value of equity and income under fair value is less than that under GAAP. We also find that fair value income is less value-relevant than GAAP income because of the inclusion of transitory unrealized gains and losses in fair value income. More surprisingly, we find that book value of equity under fair value is not more value-relevant than under GAAP, due both to divergence between exit value and value-in-use and to measurement error in fair value estimates. Overall, our results suggest that financial statements under fair value accounting provide less relevant information for bank valuation than financial statements under current GAAP.

    Keywords: fair value, historical cost, financial instrument, bank, value relevance


    ASU 2016-01 kicks in at the end of 2017

    NYT:  A Little-Known Accounting Change Could Have a Big Impact ---
    https://www.nytimes.com/2017/05/12/business/dealbook/a-little-known-accounting-change-could-have-a-big-impact.html?_r=0

    . . .

    But Update 2016-01 could significantly affect — and distort — the way companies like Alphabet, Intel, IBM and Salesforce.com, which make a lot of small investments in other companies, report their earnings. It could also curtail such investments from being made in the first place, because some businesses say the costs of complying with the rule are too high.

    Here’s how things would change with the new rule: Now, when a company buys a stake of less than 20 percent in another company, it usually accounts for the investment on its balance sheet at cost — the price it paid for it. Over time, under the old rules, if the value of the investment goes down, the rules required a corresponding write-down of the value, both through the company’s income statement and on its balance sheet. But if the value increases over time, the investment can still be kept at cost.

    While investors were fully informed when an investment lost value, there was less transparency for them when an investment increased in value. What investors lost in transparency on the upside, it has been argued, was gained in not requiring corporate executives to place a number on these often difficult-to-value investments every quarter.

    That’s what is going to change after Dec. 15. From then on, each minority investment a public company makes will have to be valued quarterly, whether that value has increased or decreased. That potential volatility will soon be required to flow through a company’s income statement, with the possibility of causing fluctuations to earnings per share from something that is not even a core business.

    Corporate executives will have two choices on how to go about valuing these investments.

    They can either spend the time valuing these investments themselves (or hire an accounting firm or a valuation firm like Duff & Phelps), or they can choose to wait until there is a market-driven valuation event and then mark up the value of the investment accordingly. How a company chooses to value these investments — whether every quarter or when there is a market event — has to be selected soon, and then cannot be changed. This, too, has added to the corporate executives’ concerns.

    Take, for example, investments that have been made over the years in Uber, which now has a valuation of around $70 billion. In 2013, Google Ventures, now part of Alphabet Inc., Google’s parent company, invested $258 million in Uber at a post-money valuation of $3.76 billion. Four years later, that investment is now worth around $4.8 billion.

     Continued in article

    What Are the Main Provisions? ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    The amendments in this Update make targeted improvements to generally accepted accounting principles (GAAP) as follows:

    1. Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

    2. Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value.

    3. Eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities.

    4. Eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.

    5. Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.

    6. Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.

    Jensen Insert
    Banks’ Discretion Over the Debt Valuation Adjustment for Own Credit Risk ---
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2920617

    Banks that recognize financial liabilities at fair value currently must record unrealized gains (losses) on these liabilities attributable to increases (decreases) in the banks’ own credit risk, referred to as the debt (or debit) valuation adjustment (DVA), in earnings each period. For a sample of publicly traded European banks during 2008-2013, we investigate the economic and discretionary determinants of DVA. We find that DVA exhibits the expected associations with economic factors, being positively associated with the change in banks’ bond yield spread and negatively associated with the changes in banks’ unsecured debt and average remaining bond maturity. We also provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis and its immediate aftermath. To remove non-discretionary smoothing of earnings, we decompose DVA into nondiscretionary (normal) and discretionary (abnormal) components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP and that have histories of using LLP to smooth earnings use DVA less to smooth earnings, consistent with LLP and DVA being substitutable ways to smooth earnings. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA. They may support the FASB’s recent decision in ASU 2016-1 to require firms to record DVA in other comprehensive income.

    7. Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements.

    8. Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.

     

    Note how ASU 2016-01 relates to IFRS 9 ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    "The Effect of Fair Value versus Historical Cost Reporting Model on Analyst Forecast Accuracy," by Lihong Liang and Edward J. Riedl,  The Accounting Review,: May 2014, Vol. 89, No. 3, pp. 1151-1177 ---
    http://aaajournals.org/doi/full/10.2308/accr-50687  (Not Free)

    ABSTRACT:

    This paper examines how the reporting model for a firm's operating assets affects analyst forecast accuracy. We contrast U.K. and U.S. investment property firms having real estate as their primary operating asset, exploiting that U.K. (U.S.) firms report these assets at fair value (historical cost). We assess the accuracy of a balance-sheet-based forecast (net asset value, or NAV) and an income-statement-based forecast (earnings per share, or EPS). We predict and find higher NAV forecast accuracy for U.K. relative to U.S. firms, consistent with the fair value reporting model revealing private information that is incorporated into analysts' balance sheet forecasts. We find this difference is attenuated when the fair value and historical cost models are more likely to converge: during recessionary periods.

    Finally, we predict and find lower EPS forecast accuracy for U.K. firms when reporting under the full fair value model of IFRS, in which unrealized fair value gains and losses are included in net income. This is consistent with the full fair value model increasing the difficulty of forecasting net income through the inclusion of non-serially correlated elements such as these gains/losses. Information content analyses provide further support for these inferences. Overall, the results indicate that the fair value reporting model enhances analysts' ability to forecast the balance sheet, but the full fair value model reduces their ability to forecast net income.

    Keywords:  fair value, historical cost, analyst forecast accuracy, net asset value, real estate

    Received: September 2011; Accepted: December 2013 ;Published Online: December 2013

     

    I. INTRODUCTION

    This paper examines the effect of the reporting model on the accuracy of analyst outputs. Specifically, we investigate whether the model—fair value or historical cost—used to report firms' primary operating assets of real estate differentially affects the accuracy of two analyst forecasts: a balance-sheet-based forecast (net asset value, or “NAV”), and an income-statement-based forecast (earnings-per-share, or “EPS”).1 Accordingly, this paper combines the literatures on fair value reporting for nonfinancial assets (e.g., Easton, Eddey, and Harris 1993) and analyst forecast accuracy (e.g., Lang and Lundholm 1996) to examine how the reporting model affects the precision of different types of analyst outputs.

    We choose as our setting publicly traded investment property firms domiciled either in the U.K. or U.S. during the period 2002–2010. Investment property firms invest in real estate assets for rental income and/or capital appreciation. The choice of this setting is advantageous for several reasons. First, this industry is among the few in which fair value reporting can be observed for the firm's primary operating assets. Although other industries, such as banking and insurance, have significant exposure to fair value reporting, these settings are more complex as the within-firm accounting treatment across their operating assets varies significantly, and they are subject to substantial regulation.2 Second, our focus on the U.K. and U.S. exploits the primary reporting difference for this industry across these two countries. Specifically, U.K. investment property firms recognize property assets at fair value on the balance sheet under both U.K. domestic accounting standards as well as more recently adopted International Financial Reporting Standards (IFRS). Unrealized fair value changes are reported in a revaluation reserve under U.K. standards, but reported in net income under IFRS. In contrast, U.S. investment property firms report property assets at historical cost as mandated under U.S. standards; further, industry practice is that these firms rarely voluntarily disclose property fair values. Third, despite the latter reporting difference, the real estate industry in both countries is highly developed, with both having a substantial number of publicly traded real estate firms, relatively liquid property markets, and a large number of analysts following these firms.

    To assess analyst forecast accuracy, we choose two forecast types, a balance-sheet-based forecast (NAV) and an income-statement-based forecast (EPS). NAV forecasts are commonly applied in the investment property industry, and are primary inputs into analyst's target price estimates. They are calculated by taking the estimated fair value of the firm's assets, which are primarily the real estate properties, and subtracting the estimated fair value of the firm's liabilities, primarily debt. As such, NAV provides an estimate of the value of the firm's net assets in place. Second, we examine the accuracy of EPS forecasts, which represent analysts' estimates of the firm's ability to generate income. We note that this industry is among the few for which both balance sheet and income statement forecasts are commonly observable.

    We hypothesize three primary effects. First, we predict higher accuracy of NAV forecasts for firms providing investment property fair values. That is, we expect that the reporting of these fair values, as done by U.K. firms, reveals private information regarding the underlying asset values. Analysts incorporate this information into their forecasts, leading to greater forecast accuracy. Second, we predict that this relatively greater NAV accuracy for firms providing fair values will be attenuated during circumstances in which the fair value and historical cost reporting models are likely to converge. To proxy for such a setting, we use the financial crisis, during which real estate assets in both the U.K. and U.S. declined substantially. Third, we predict that full fair value reporting required under IFRS will reduce the accuracy of analysts' EPS forecasts, owing to increased difficulty of forecasting net income when it includes non-serially correlated items such as unrealized fair value gains and losses.

    Empirical results confirm all three predictions. We find that NAV forecasts for U.K. firms are more accurate relative to those for U.S. firms. Further, we find that this greater accuracy is attenuated during the financial crisis of 2007–2008, consistent with convergence of the fair value and historical cost reporting models during this period. Finally, we document greater EPS forecast accuracy for U.S. firms relative to U.K. firms when the latter report under IFRS. To mitigate concerns that our analyses may reflect differences across the U.K. and U.S. settings that are unrelated to our predicted financial reporting effects, our primary analyses use a difference-in-differences design. Our findings also are robust to estimating a fully interacted model to control for different effects across the U.K. and U.S. samples; using alternative measures of the dependent variables to assess the use of market value to benchmark NAV forecast accuracy due to the latter's lack of reported actual amounts; and conducting subsample analysis. Finally, corroborating evidence reveals greater information content for U.K. relative to U.S. NAV forecasts, with this difference reduced during the financial crisis. Despite the higher EPS forecast error, however, U.K. EPS forecasts have greater information content under IFRS.

    These findings make three contributions. First, we link the fair value literature, which provides evidence of the decision relevance of reported fair values (e.g., Barth 1994), to that on analyst forecast accuracy (e.g., Clement 1999) by documenting that fair values of key operating assets can enhance the accuracy of analysts' balance-sheet-based forecasts. However, our evidence further suggests that the benefits to fair value reporting may primarily occur during expansionary economic periods, where the fair value and historical cost reporting models are most likely to diverge. In addition, our evidence suggests that full fair value reporting in which unrealized gains and losses are incorporated into income can impede income statement forecast accuracy. Second, our analyses of NAV forecasts are new because analysts' balance sheet forecasting activities are rarely studied in the prior literature. Finally, our evidence is likely of interest to U.S. and international standard-setters in their ongoing deliberations regarding the extent in which to incorporate fair value into reporting standards.

    Section II provides the background, prior literature, and hypothesis development. Section III presents the research design. Section IV reviews the sample and primary empirical results. Section V presents sensitivity analyses, and Section VI concludes.

    II. BACKGROUND, PRIOR LITERATURE, AND HYPOTHESIS DEVELOPMENT

    Background \
    This paper analyzes U.K. and U.S. publicly traded investment property firms over 2002–2010, which have as their primary operating structure tangible assets consisting of real estate investments. These firms invest in real estate to obtain rental income and/or for capital appreciation. We exploit a key difference across the two groups of firms: U.K. firms report these real estate assets at fair value, while U.S. firms report them at historical cost.

    The reporting of investment properties for U.K.-domiciled firms within our sample period falls under two regimes: U.K. domestic standards from 2002–2004; and International Financial Reporting Standards (IFRS) from 2005–2010. Both require that U.K. firms report investment properties on the balance sheet at fair value. The relevant U.K. domestic standard, Accounting for Investment Properties, Statement of Standard Accounting Practice No. 19 (SSAP 19; Accounting Standards Committee [ASC] 1994), requires investment property to be reported on the balance sheet at “open market value” at fiscal year-end. This is very similar to “fair value” as defined by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB).3 Unrealized fair value gains/losses are reported in a revaluation reserve, and thus do not pass through net income.

    Continued in article


    "How Do Auditors Use Valuation Specialists When Auditing Fair Values?" by Emily E. Griffith, SSRN, May 30, 2014 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2460970 

    Abstract:
    Auditors frequently rely on valuation specialists in audits of fair values to help them improve audit quality in this challenging area. However, auditing standards provide inadequate guidance in this setting, and problems related to specialists’ involvement suggest specialists do not always improve audit quality. This study examines how auditors use valuation specialists in auditing fair values and how specialists’ involvement affects audit quality. I interviewed 28 audit partners and managers with extensive experience using valuation specialists and analyzed the interviews from the perspective of Giddens’ (1990, 1991) theory of trust in expert systems. I find that while valuation specialists perform many of the most difficult and important elements of auditing fair values, auditors retain the final responsibility for making overall conclusions about fair values. This situation causes tension for auditors who bear responsibility for the final conclusions about fair values, yet who must rely on the expertise of valuation specialists to make their final judgments. Consistent with this tension, auditors tend to make specialists’ work conform to the audit team’s prevailing view. This puts audit quality at risk. Additional threats to audit quality arise from the division of labor between auditors and valuation specialists because auditors, though ultimately responsible for audit judgments, must rely on work done by valuation specialists that they cannot understand or review in the depth that they review other audit work papers. This study informs future research addressing problems related to auditors’ use of valuation specialists, an area in which problems have already been identified by the PCAOB and prior research
    .

    Jensen Comment 1
    One of the problems is that some types of valuation may rely upon the same defective databases no matter whether they are used by employees of audit firms or outsourced valuation specialists hired by audit firms.Exhibit A is that virtually all valuation experts of interest rate swaps and forward contracts using the LIBOR underlying were relying upon LIBOR yeild curves in the Bloomberg or Reuters database terminals that were using LIBOR rates manipulated fraudulently by the large banks like Barclays ---
    http://en.wikipedia.org/wiki/Libor

    On 28 February 2012, it was revealed that the U.S. Department of Justice was conducting a criminal investigation into Libor abuse.[49] Among the abuses being investigated were the possibility that traders were in direct communication with bankers before the rates were set, thus allowing them an advantage in predicting that day's fixing. Libor underpins approximately $350 trillion in derivatives. One trader's messages indicated that for each basis point (0.01%) that Libor was moved, those involved could net "about a couple of million dollars".[50]

    On 27 June 2012, Barclays Bank was fined $200m by the Commodity Futures Trading Commission,[7] $160m by the United States Department of Justice[8] and £59.5m by the Financial Services Authority[9] for attempted manipulation of the Libor and Euribor rates.[51] The United States Department of Justice and Barclays officially agreed that "the manipulation of the submissions affected the fixed rates on some occasions".[52][53] On 2 July 2012, Marcus Agius, chairman of Barclays, resigned from the position following the interest rate rigging scandal.[54] Bob Diamond, the chief executive officer of Barclays, resigned on 3 July 2012. Marcus Agius will fill his post until a replacement is found.[55][56] Jerry del Missier, Chief Operating Officer of Barclays, also resigned, as a casualty of the scandal. Del Missier subsequently admitted that he had instructed his subordinates to submit falsified LIBORs to the British Bankers Association.[57]

    By 4 July 2012 the breadth of the scandal was evident and became the topic of analysis on news and financial programs that attempted to explain the importance of the scandal.[58] On 6 July, it was announced that the U.K. Serious Fraud Office had also opened a criminal investigation into the attempted manipulation of interest rates.[59]

    On 4 October 2012, Republican U.S. Senators Chuck Grassley and Mark Kirk announced that they were investigating Treasury Secretary Tim Geithner for complicity with the rate manipulation scandal. They accused Geithner of knowledge of the rate-fixing, and inaction which contributed to litigation that "threatens to clog our courts with multi-billion dollar class action lawsuits" alleging that the manipulated rates harmed state, municipal and local governments. The senators said that an American-based interest rate index is a better alternative which they would take steps towards creating.[60] Aftermath

    Early estimates are that the rate manipulation scandal cost U.S. states, counties, and local governments at least $6 billion in fraudulent interest payments, above $4 billion that state and local governments have already had to spend to unwind their positions exposed to rate manipulation.[61] An increasingly smaller set of banks are participating in setting the LIBOR, calling into question its future as a benchmark standard, but without any viable alternative to replace

    Jensen Comment 2
    FAS 133 and IAS 39 ushered in national and international requirements to book derivative contracts at fair values and adjust those values to "market" at least every 90 days. However, those "markets" are replete with market manipulation scandals that corrupt the databases used by valuation experts---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

     

     


    From the CFO Journal's Morning Ledger on January 9, 2013

    Companies switching to “mark-to-market” pension accounting could reap benefits this earnings season
    AT&T
    , Verizon Communications and about 30 other companies have migrated to mark-to-market,
    the WSJ’s Michael Rapoport notes. In 2011 and 2012, that change weighed on earnings, largely because interest rates were falling. But 2013 is different, thanks to surging interest rates and strong stock-market performance. “It’s going to account for a huge rise in operating earnings” at the affected companies, said Dan Mahoney, director of research at accounting-research firm CFRA.

    Some mark-to-market companies with fiscal years ended in September have already reported pension gains. Chemical maker Ashland had a $498 million pretax mark-to-market pension gain in its Q4, versus a $493 million pension loss in its fiscal 2012 fourth quarter. That made up about 40% of the company’s $1.24 billion in operating income for fiscal 2013.

    Most companies don’t use mark-to-market pension accounting. Instead, they filter pension gains and losses into earnings gradually, and compute pension performance using an estimated rate of return, not the actual return, Rapoport says. That system is still acceptable under GAAP, but it has been widely criticized as confusing, and accounting rule-makers recently indicated they may consider revisions.

    Jensen Comment

    What I don't like about mark-to-market valuation of pensions is that the deals new retirees negotiate might vary significantly (certainly not always) whether they retire in May versus June. For example, a professor might have a lower CREF savings balance in June relative to May if something very good or very bad happens in the stock market between May and June.

    I have mixed feelings about mark-to-market of unrealized value changes in market\ values subject to frequent short-term transitory impacts that are often washed out over longer periods such that the ups and downs of short term values are more fiction than fact. For example, computer generated bid and ask trading tends to over-react to media jolts like when the President proposes legislation that has not even begun to to run the gauntlet through both legislative branches where legislation proposals can and usually do become greatly modified if the President's proposals even pass at all.

    For example the Dow went down purportedly when President Obama proposed legislation in 2014 for restoring long-term unemployment benefits. The ultimate impact of such legislation on stock prices depends upon whether this proposal ultimately passes both the House and Senate and how the spending is financed. If the Democrats agree to budget cuts in other areas, the impact on stock prices will be greatly affected by what cuts are used to fund the added  unemployment compensation.

    While the President's proposal is tied up in the legislative process the short-term pension fund mark-to-market values will move up and down in values changes that are never realized until the proposed legislation either passes or is rejected.

    What is more worrisome are those events that really spike stock prices temporarily such as reports of severe droughts or floods that greatly impact crop production in one summer but have very little impact on over multiple years.

    I also hate the way unrealized value changes are mixed with recognized earned revenue in the calculation of business net earnings. Some of the changes in earnings thereby are fictional.

    Bob Jensen's threads on pension accounting and post-retirement benefits ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Pensions

     


    PwC's Appeal to Upgrade the Shameful Valuation Profession Smitten With Non-independence and Unreliability

    Jensen Comment
    Tom Selling repeatedly assumes there is a valuation profession of men and women in white robes and gold halos who can be called upon to reliably and independently valuate such things as troubled loan investments having no deep markets. Bob Jensen argues that the valuation profession is one of the least-independent and least-reliable professions in the world, especially in the USA as evidenced in part by the shameful valuations of mortgage collateral on tens of millions of properties, thereby enabling subprime mortgages that never should have been granted in the first place. Furthermore credit rating agencies that value securities participated wildly in overvaluing poisoned CDO bonds that brought down some of the big investment banks of Wall Street like Bear Sterns, Merrill Lynch, and Lehman Bros.

    In the article below, PwC calls the valuation profession shameful and calls for major upgrades that, while falling short of issuing white robes with gold halos, would go a long way toward improving a rotten profession.

    "PwC Calls for New Approach to Valuations," by Tammy Whitehouse, Compliance Week, November 26, 2013 ---
    http://www.complianceweek.com/pwc-calls-for-new-approach-to-valuations/article/322671/

    The largely unregulated valuation profession could use a shake-up, in the view of some who rely on valuations to achieve regulatory compliance.

    PwC recently published two white papers calling on the valuation profession to up their game in terms of unifying themselves under a single professional framework and improving their standards. The financial reporting world needs greater quality and consistency, the Big 4 firms says, as financial reporting grows increasingly reliant on valuations to help prepare and audit financial statements steeped in fair value measurements. One paper focuses on the need for the valuation profession to unify itself under a single professional infrastructure, while the other addresses the need for better valuation standards.

    The message is consistent with one delivered earlier by Paul Beswick, now chief accountant at the Securities and Exchange Commission. “The fragmented nature of the profession creates an environment where expectation gaps can exist between valuators, management, and auditors, as well as standard setters and regulators,” he said at a 2011 accounting conference. The SEC and the Public Company Accounting Oversight Board both have called on preparers and auditors to pay closer attention to the valuations they are relying on and not simply accept them at face value.

    “Historically, the valuation profession hasn't been front and center in capital markets,” says John Glynn, U.S. valuation services leader for PwC. “The accounting model didn't have as many pieces measured at fair value as we have today. Some of the questions about the professional infrastructure that didn't matter previously have become more apparent.”

    The valuation profession is governed by a number of different professional organizations, PwC says, each with different credentialing and membership requirements and none of them specific to the needs of capital markets. “To maintain its professional standing in an increasingly rigorous environment and promote greater confidence in its work, the valuation profession needs to address questions about the quality, consistency, and reliability of its valuations, particularly those performed for financial reporting purposes,” PwC writes. “A key element to successfully addressing such questions is having a leading global standard setter that issues technical valuation standards governing the performance of valuations for financial reporting purposes.”

    The answer is not necessarily a new regulatory channel, says Glynn. “We need to give the valuation profession a way to build a self-regulatory mechanism,” he says. “One or or more of the professional organizations need to agree to build something that is focused on building a high-quality infrastructure to support the valuation professionals that are working in public capital markets, particularly around financial reporting.” That should include education requirements, accreditations, certifications, as well as professional standards and performance standards developed under a robust system of due process, he says. The International Valuations Standards Council is showing potential to become a leader in driving the profession to a unified, global valuation approach, Glynn says.


    From the CFO Journal's Morning Ledger on April 11, 2014

    Mark-to-market (fair value) accounting and testing of corporate internal controls challenge auditors
    A review of audit inspections by 30 regulators around the world found key trouble spots for auditors,
    CFOJ’s Emily Chasan reports. Auditors of public firms were most likely to be cited for improperly auditing fair-value measurement, troubles in testing internal controls and evaluating the adequacy of financial statements and disclosures, according to the International Forum of Independent Audit Regulators. Audit deficiencies also rose last year to 1,260, an 18% increase from 2012.

     Bob Jensen's threads on audit firm professionalism ---
    http://faculty.trinity.edu/rjensen/Fraud001c.htm


    "The Effect of Fair Value versus Historical Cost Reporting Model on Analyst Forecast Accuracy," by Lihong Liang and Edward J. Riedl,  The Accounting Review,: May 2014, Vol. 89, No. 3, pp. 1151-1177 ---
    http://aaajournals.org/doi/full/10.2308/accr-50687  (Not Free)

    ABSTRACT:

    This paper examines how the reporting model for a firm's operating assets affects analyst forecast accuracy. We contrast U.K. and U.S. investment property firms having real estate as their primary operating asset, exploiting that U.K. (U.S.) firms report these assets at fair value (historical cost). We assess the accuracy of a balance-sheet-based forecast (net asset value, or NAV) and an income-statement-based forecast (earnings per share, or EPS). We predict and find higher NAV forecast accuracy for U.K. relative to U.S. firms, consistent with the fair value reporting model revealing private information that is incorporated into analysts' balance sheet forecasts. We find this difference is attenuated when the fair value and historical cost models are more likely to converge: during recessionary periods.

    Finally, we predict and find lower EPS forecast accuracy for U.K. firms when reporting under the full fair value model of IFRS, in which unrealized fair value gains and losses are included in net income. This is consistent with the full fair value model increasing the difficulty of forecasting net income through the inclusion of non-serially correlated elements such as these gains/losses. Information content analyses provide further support for these inferences. Overall, the results indicate that the fair value reporting model enhances analysts' ability to forecast the balance sheet, but the full fair value model reduces their ability to forecast net income.

    Keywords:  fair value, historical cost, analyst forecast accuracy, net asset value, real estate

    Received: September 2011; Accepted: December 2013 ;Published Online: December 2013

     

    I. INTRODUCTION

    This paper examines the effect of the reporting model on the accuracy of analyst outputs. Specifically, we investigate whether the model—fair value or historical cost—used to report firms' primary operating assets of real estate differentially affects the accuracy of two analyst forecasts: a balance-sheet-based forecast (net asset value, or “NAV”), and an income-statement-based forecast (earnings-per-share, or “EPS”).1 Accordingly, this paper combines the literatures on fair value reporting for nonfinancial assets (e.g., Easton, Eddey, and Harris 1993) and analyst forecast accuracy (e.g., Lang and Lundholm 1996) to examine how the reporting model affects the precision of different types of analyst outputs.

    We choose as our setting publicly traded investment property firms domiciled either in the U.K. or U.S. during the period 2002–2010. Investment property firms invest in real estate assets for rental income and/or capital appreciation. The choice of this setting is advantageous for several reasons. First, this industry is among the few in which fair value reporting can be observed for the firm's primary operating assets. Although other industries, such as banking and insurance, have significant exposure to fair value reporting, these settings are more complex as the within-firm accounting treatment across their operating assets varies significantly, and they are subject to substantial regulation.2 Second, our focus on the U.K. and U.S. exploits the primary reporting difference for this industry across these two countries. Specifically, U.K. investment property firms recognize property assets at fair value on the balance sheet under both U.K. domestic accounting standards as well as more recently adopted International Financial Reporting Standards (IFRS). Unrealized fair value changes are reported in a revaluation reserve under U.K. standards, but reported in net income under IFRS. In contrast, U.S. investment property firms report property assets at historical cost as mandated under U.S. standards; further, industry practice is that these firms rarely voluntarily disclose property fair values. Third, despite the latter reporting difference, the real estate industry in both countries is highly developed, with both having a substantial number of publicly traded real estate firms, relatively liquid property markets, and a large number of analysts following these firms.

    To assess analyst forecast accuracy, we choose two forecast types, a balance-sheet-based forecast (NAV) and an income-statement-based forecast (EPS). NAV forecasts are commonly applied in the investment property industry, and are primary inputs into analyst's target price estimates. They are calculated by taking the estimated fair value of the firm's assets, which are primarily the real estate properties, and subtracting the estimated fair value of the firm's liabilities, primarily debt. As such, NAV provides an estimate of the value of the firm's net assets in place. Second, we examine the accuracy of EPS forecasts, which represent analysts' estimates of the firm's ability to generate income. We note that this industry is among the few for which both balance sheet and income statement forecasts are commonly observable.

    We hypothesize three primary effects. First, we predict higher accuracy of NAV forecasts for firms providing investment property fair values. That is, we expect that the reporting of these fair values, as done by U.K. firms, reveals private information regarding the underlying asset values. Analysts incorporate this information into their forecasts, leading to greater forecast accuracy. Second, we predict that this relatively greater NAV accuracy for firms providing fair values will be attenuated during circumstances in which the fair value and historical cost reporting models are likely to converge. To proxy for such a setting, we use the financial crisis, during which real estate assets in both the U.K. and U.S. declined substantially. Third, we predict that full fair value reporting required under IFRS will reduce the accuracy of analysts' EPS forecasts, owing to increased difficulty of forecasting net income when it includes non-serially correlated items such as unrealized fair value gains and losses.

    Empirical results confirm all three predictions. We find that NAV forecasts for U.K. firms are more accurate relative to those for U.S. firms. Further, we find that this greater accuracy is attenuated during the financial crisis of 2007–2008, consistent with convergence of the fair value and historical cost reporting models during this period. Finally, we document greater EPS forecast accuracy for U.S. firms relative to U.K. firms when the latter report under IFRS. To mitigate concerns that our analyses may reflect differences across the U.K. and U.S. settings that are unrelated to our predicted financial reporting effects, our primary analyses use a difference-in-differences design. Our findings also are robust to estimating a fully interacted model to control for different effects across the U.K. and U.S. samples; using alternative measures of the dependent variables to assess the use of market value to benchmark NAV forecast accuracy due to the latter's lack of reported actual amounts; and conducting subsample analysis. Finally, corroborating evidence reveals greater information content for U.K. relative to U.S. NAV forecasts, with this difference reduced during the financial crisis. Despite the higher EPS forecast error, however, U.K. EPS forecasts have greater information content under IFRS.

    These findings make three contributions. First, we link the fair value literature, which provides evidence of the decision relevance of reported fair values (e.g., Barth 1994), to that on analyst forecast accuracy (e.g., Clement 1999) by documenting that fair values of key operating assets can enhance the accuracy of analysts' balance-sheet-based forecasts. However, our evidence further suggests that the benefits to fair value reporting may primarily occur during expansionary economic periods, where the fair value and historical cost reporting models are most likely to diverge. In addition, our evidence suggests that full fair value reporting in which unrealized gains and losses are incorporated into income can impede income statement forecast accuracy. Second, our analyses of NAV forecasts are new because analysts' balance sheet forecasting activities are rarely studied in the prior literature. Finally, our evidence is likely of interest to U.S. and international standard-setters in their ongoing deliberations regarding the extent in which to incorporate fair value into reporting standards.

    Section II provides the background, prior literature, and hypothesis development. Section III presents the research design. Section IV reviews the sample and primary empirical results. Section V presents sensitivity analyses, and Section VI concludes.

    II. BACKGROUND, PRIOR LITERATURE, AND HYPOTHESIS DEVELOPMENT

    Background \
    This paper analyzes U.K. and U.S. publicly traded investment property firms over 2002–2010, which have as their primary operating structure tangible assets consisting of real estate investments. These firms invest in real estate to obtain rental income and/or for capital appreciation. We exploit a key difference across the two groups of firms: U.K. firms report these real estate assets at fair value, while U.S. firms report them at historical cost.

    The reporting of investment properties for U.K.-domiciled firms within our sample period falls under two regimes: U.K. domestic standards from 2002–2004; and International Financial Reporting Standards (IFRS) from 2005–2010. Both require that U.K. firms report investment properties on the balance sheet at fair value. The relevant U.K. domestic standard, Accounting for Investment Properties, Statement of Standard Accounting Practice No. 19 (SSAP 19; Accounting Standards Committee [ASC] 1994), requires investment property to be reported on the balance sheet at “open market value” at fiscal year-end. This is very similar to “fair value” as defined by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB).3 Unrealized fair value gains/losses are reported in a revaluation reserve, and thus do not pass through net income.

    Continued in article


    Hi Pat,

    Tom Selling writes that:


    It has been my position throughout that the FASB has come to realize that their own individual interests, as opposed to the public interest, requires that any changes they make to GAAP must be acceptable to Wall Street and the bankers.

    . . .

    At this point, the object of the exercise should be painfully obvious.  Compared to current values, even the best possible version of amortized cost accounting that bankers could use to save their hides (a la Mr. Shabudin), or feather their nests (a la the bankers who remain at large) is nothing more than a straw man.

    More at
    http://accountingonion.com/2013/09/hank-paulson-says-another-financial-crisis-is-inevitable-the-fasb-is-working-to-prove-him-right.html

    What Tom does not point out the inconsistency of the above argument in light of the fact that the bankers are lobbying against the amortized cost accounting change in the three-bucket fair value standard for loan losses, the fair value standard that's served them so well in managing their earnings since fair value of unique troubled loans often have no value in the market or a fire-sale value that's inappropriate.

    It's not surprising industry is lobbying against the proposed credit loss and loan loss (bad debts) accounting model proposed by the FASB that will beef up bad debt reserves ---
    http://www.elfaonline.org/issues/accounting/pdfs/ELFACreditLossesCommentLtr.pdf

    I would contend that he should be taking on the IASB more than the FASB. The IASB has proven that when it comes to recognizing losses on debt like Greek Bonds, the IASB is allowing European bankers and EU lawmakers to dictate accounting standards for loan impairments.


    ASU 2016-01 kicks in at the end of 2017

    NYT:  A Little-Known Accounting Change Could Have a Big Impact ---
    https://www.nytimes.com/2017/05/12/business/dealbook/a-little-known-accounting-change-could-have-a-big-impact.html?_r=0

    . . .

    But Update 2016-01 could significantly affect — and distort — the way companies like Alphabet, Intel, IBM and Salesforce.com, which make a lot of small investments in other companies, report their earnings. It could also curtail such investments from being made in the first place, because some businesses say the costs of complying with the rule are too high.

    Here’s how things would change with the new rule: Now, when a company buys a stake of less than 20 percent in another company, it usually accounts for the investment on its balance sheet at cost — the price it paid for it. Over time, under the old rules, if the value of the investment goes down, the rules required a corresponding write-down of the value, both through the company’s income statement and on its balance sheet. But if the value increases over time, the investment can still be kept at cost.

    While investors were fully informed when an investment lost value, there was less transparency for them when an investment increased in value. What investors lost in transparency on the upside, it has been argued, was gained in not requiring corporate executives to place a number on these often difficult-to-value investments every quarter.

    That’s what is going to change after Dec. 15. From then on, each minority investment a public company makes will have to be valued quarterly, whether that value has increased or decreased. That potential volatility will soon be required to flow through a company’s income statement, with the possibility of causing fluctuations to earnings per share from something that is not even a core business.

    Corporate executives will have two choices on how to go about valuing these investments.

    They can either spend the time valuing these investments themselves (or hire an accounting firm or a valuation firm like Duff & Phelps), or they can choose to wait until there is a market-driven valuation event and then mark up the value of the investment accordingly. How a company chooses to value these investments — whether every quarter or when there is a market event — has to be selected soon, and then cannot be changed. This, too, has added to the corporate executives’ concerns.

    Take, for example, investments that have been made over the years in Uber, which now has a valuation of around $70 billion. In 2013, Google Ventures, now part of Alphabet Inc., Google’s parent company, invested $258 million in Uber at a post-money valuation of $3.76 billion. Four years later, that investment is now worth around $4.8 billion.

     Continued in article

    What Are the Main Provisions? ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    The amendments in this Update make targeted improvements to generally accepted accounting principles (GAAP) as follows:

    1. Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

    2. Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value.

    3. Eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities.

    4. Eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.

    5. Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.

    6. Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.

    Jensen Insert
    Banks’ Discretion Over the Debt Valuation Adjustment for Own Credit Risk ---
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2920617

    Banks that recognize financial liabilities at fair value currently must record unrealized gains (losses) on these liabilities attributable to increases (decreases) in the banks’ own credit risk, referred to as the debt (or debit) valuation adjustment (DVA), in earnings each period. For a sample of publicly traded European banks during 2008-2013, we investigate the economic and discretionary determinants of DVA. We find that DVA exhibits the expected associations with economic factors, being positively associated with the change in banks’ bond yield spread and negatively associated with the changes in banks’ unsecured debt and average remaining bond maturity. We also provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis and its immediate aftermath. To remove non-discretionary smoothing of earnings, we decompose DVA into nondiscretionary (normal) and discretionary (abnormal) components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP and that have histories of using LLP to smooth earnings use DVA less to smooth earnings, consistent with LLP and DVA being substitutable ways to smooth earnings. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA. They may support the FASB’s recent decision in ASU 2016-1 to require firms to record DVA in other comprehensive income.

    7. Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements.

    8. Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.

     

    Note how ASU 2016-01 relates to IFRS 9 ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    "The Effect of Fair Value versus Historical Cost Reporting Model on Analyst Forecast Accuracy," by Lihong Liang and Edward J. Riedl,  The Accounting Review,: May 2014, Vol. 89, No. 3, pp. 1151-1177 ---
    http://aaajournals.org/doi/full/10.2308/accr-50687  (Not Free)

    ABSTRACT:

    This paper examines how the reporting model for a firm's operating assets affects analyst forecast accuracy. We contrast U.K. and U.S. investment property firms having real estate as their primary operating asset, exploiting that U.K. (U.S.) firms report these assets at fair value (historical cost). We assess the accuracy of a balance-sheet-based forecast (net asset value, or NAV) and an income-statement-based forecast (earnings per share, or EPS). We predict and find higher NAV forecast accuracy for U.K. relative to U.S. firms, consistent with the fair value reporting model revealing private information that is incorporated into analysts' balance sheet forecasts. We find this difference is attenuated when the fair value and historical cost models are more likely to converge: during recessionary periods.

    Finally, we predict and find lower EPS forecast accuracy for U.K. firms when reporting under the full fair value model of IFRS, in which unrealized fair value gains and losses are included in net income. This is consistent with the full fair value model increasing the difficulty of forecasting net income through the inclusion of non-serially correlated elements such as these gains/losses. Information content analyses provide further support for these inferences. Overall, the results indicate that the fair value reporting model enhances analysts' ability to forecast the balance sheet, but the full fair value model reduces their ability to forecast net income.

    Keywords:  fair value, historical cost, analyst forecast accuracy, net asset value, real estate

    Received: September 2011; Accepted: December 2013 ;Published Online: December 2013

     

    I. INTRODUCTION

    This paper examines the effect of the reporting model on the accuracy of analyst outputs. Specifically, we investigate whether the model—fair value or historical cost—used to report firms' primary operating assets of real estate differentially affects the accuracy of two analyst forecasts: a balance-sheet-based forecast (net asset value, or “NAV”), and an income-statement-based forecast (earnings-per-share, or “EPS”).1 Accordingly, this paper combines the literatures on fair value reporting for nonfinancial assets (e.g., Easton, Eddey, and Harris 1993) and analyst forecast accuracy (e.g., Lang and Lundholm 1996) to examine how the reporting model affects the precision of different types of analyst outputs.

    We choose as our setting publicly traded investment property firms domiciled either in the U.K. or U.S. during the period 2002–2010. Investment property firms invest in real estate assets for rental income and/or capital appreciation. The choice of this setting is advantageous for several reasons. First, this industry is among the few in which fair value reporting can be observed for the firm's primary operating assets. Although other industries, such as banking and insurance, have significant exposure to fair value reporting, these settings are more complex as the within-firm accounting treatment across their operating assets varies significantly, and they are subject to substantial regulation.2 Second, our focus on the U.K. and U.S. exploits the primary reporting difference for this industry across these two countries. Specifically, U.K. investment property firms recognize property assets at fair value on the balance sheet under both U.K. domestic accounting standards as well as more recently adopted International Financial Reporting Standards (IFRS). Unrealized fair value changes are reported in a revaluation reserve under U.K. standards, but reported in net income under IFRS. In contrast, U.S. investment property firms report property assets at historical cost as mandated under U.S. standards; further, industry practice is that these firms rarely voluntarily disclose property fair values. Third, despite the latter reporting difference, the real estate industry in both countries is highly developed, with both having a substantial number of publicly traded real estate firms, relatively liquid property markets, and a large number of analysts following these firms.

    To assess analyst forecast accuracy, we choose two forecast types, a balance-sheet-based forecast (NAV) and an income-statement-based forecast (EPS). NAV forecasts are commonly applied in the investment property industry, and are primary inputs into analyst's target price estimates. They are calculated by taking the estimated fair value of the firm's assets, which are primarily the real estate properties, and subtracting the estimated fair value of the firm's liabilities, primarily debt. As such, NAV provides an estimate of the value of the firm's net assets in place. Second, we examine the accuracy of EPS forecasts, which represent analysts' estimates of the firm's ability to generate income. We note that this industry is among the few for which both balance sheet and income statement forecasts are commonly observable.

    We hypothesize three primary effects. First, we predict higher accuracy of NAV forecasts for firms providing investment property fair values. That is, we expect that the reporting of these fair values, as done by U.K. firms, reveals private information regarding the underlying asset values. Analysts incorporate this information into their forecasts, leading to greater forecast accuracy. Second, we predict that this relatively greater NAV accuracy for firms providing fair values will be attenuated during circumstances in which the fair value and historical cost reporting models are likely to converge. To proxy for such a setting, we use the financial crisis, during which real estate assets in both the U.K. and U.S. declined substantially. Third, we predict that full fair value reporting required under IFRS will reduce the accuracy of analysts' EPS forecasts, owing to increased difficulty of forecasting net income when it includes non-serially correlated items such as unrealized fair value gains and losses.

    Empirical results confirm all three predictions. We find that NAV forecasts for U.K. firms are more accurate relative to those for U.S. firms. Further, we find that this greater accuracy is attenuated during the financial crisis of 2007–2008, consistent with convergence of the fair value and historical cost reporting models during this period. Finally, we document greater EPS forecast accuracy for U.S. firms relative to U.K. firms when the latter report under IFRS. To mitigate concerns that our analyses may reflect differences across the U.K. and U.S. settings that are unrelated to our predicted financial reporting effects, our primary analyses use a difference-in-differences design. Our findings also are robust to estimating a fully interacted model to control for different effects across the U.K. and U.S. samples; using alternative measures of the dependent variables to assess the use of market value to benchmark NAV forecast accuracy due to the latter's lack of reported actual amounts; and conducting subsample analysis. Finally, corroborating evidence reveals greater information content for U.K. relative to U.S. NAV forecasts, with this difference reduced during the financial crisis. Despite the higher EPS forecast error, however, U.K. EPS forecasts have greater information content under IFRS.

    These findings make three contributions. First, we link the fair value literature, which provides evidence of the decision relevance of reported fair values (e.g., Barth 1994), to that on analyst forecast accuracy (e.g., Clement 1999) by documenting that fair values of key operating assets can enhance the accuracy of analysts' balance-sheet-based forecasts. However, our evidence further suggests that the benefits to fair value reporting may primarily occur during expansionary economic periods, where the fair value and historical cost reporting models are most likely to diverge. In addition, our evidence suggests that full fair value reporting in which unrealized gains and losses are incorporated into income can impede income statement forecast accuracy. Second, our analyses of NAV forecasts are new because analysts' balance sheet forecasting activities are rarely studied in the prior literature. Finally, our evidence is likely of interest to U.S. and international standard-setters in their ongoing deliberations regarding the extent in which to incorporate fair value into reporting standards.

    Section II provides the background, prior literature, and hypothesis development. Section III presents the research design. Section IV reviews the sample and primary empirical results. Section V presents sensitivity analyses, and Section VI concludes.

    II. BACKGROUND, PRIOR LITERATURE, AND HYPOTHESIS DEVELOPMENT

    Background \
    This paper analyzes U.K. and U.S. publicly traded investment property firms over 2002–2010, which have as their primary operating structure tangible assets consisting of real estate investments. These firms invest in real estate to obtain rental income and/or for capital appreciation. We exploit a key difference across the two groups of firms: U.K. firms report these real estate assets at fair value, while U.S. firms report them at historical cost.

    The reporting of investment properties for U.K.-domiciled firms within our sample period falls under two regimes: U.K. domestic standards from 2002–2004; and International Financial Reporting Standards (IFRS) from 2005–2010. Both require that U.K. firms report investment properties on the balance sheet at fair value. The relevant U.K. domestic standard, Accounting for Investment Properties, Statement of Standard Accounting Practice No. 19 (SSAP 19; Accounting Standards Committee [ASC] 1994), requires investment property to be reported on the balance sheet at “open market value” at fiscal year-end. This is very similar to “fair value” as defined by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB).3 Unrealized fair value gains/losses are reported in a revaluation reserve, and thus do not pass through net income.

    Continued in article

     

    What Are the Main Provisions? ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    The amendments in this Update make targeted improvements to generally accepted accounting principles (GAAP) as follows:

    1. Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

    2. Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value.

    3. Eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities.

    4. Eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.

    5. Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.

    6. Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.

    Jensen Insert
    Banks’ Discretion Over the Debt Valuation Adjustment for Own Credit Risk ---
    https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2920617

    Banks that recognize financial liabilities at fair value currently must record unrealized gains (losses) on these liabilities attributable to increases (decreases) in the banks’ own credit risk, referred to as the debt (or debit) valuation adjustment (DVA), in earnings each period. For a sample of publicly traded European banks during 2008-2013, we investigate the economic and discretionary determinants of DVA. We find that DVA exhibits the expected associations with economic factors, being positively associated with the change in banks’ bond yield spread and negatively associated with the changes in banks’ unsecured debt and average remaining bond maturity. We also provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis and its immediate aftermath. To remove non-discretionary smoothing of earnings, we decompose DVA into nondiscretionary (normal) and discretionary (abnormal) components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP and that have histories of using LLP to smooth earnings use DVA less to smooth earnings, consistent with LLP and DVA being substitutable ways to smooth earnings. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA. They may support the FASB’s recent decision in ASU 2016-1 to require firms to record DVA in other comprehensive income.

    7. Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements.

    8. Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.

     

    Note how ASU 2016-01 relates to IFRS 9 ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs

    "The Effect of Fair Value versus Historical Cost Reporting Model on Analyst Forecast Accuracy," by Lihong Liang and Edward J. Riedl,  The Accounting Review,: May 2014, Vol. 89, No. 3, pp. 1151-1177 ---
    http://aaajournals.org/doi/full/10.2308/accr-50687  (Not Free)

    ABSTRACT:

    This paper examines how the reporting model for a firm's operating assets affects analyst forecast accuracy. We contrast U.K. and U.S. investment property firms having real estate as their primary operating asset, exploiting that U.K. (U.S.) firms report these assets at fair value (historical cost). We assess the accuracy of a balance-sheet-based forecast (net asset value, or NAV) and an income-statement-based forecast (earnings per share, or EPS). We predict and find higher NAV forecast accuracy for U.K. relative to U.S. firms, consistent with the fair value reporting model revealing private information that is incorporated into analysts' balance sheet forecasts. We find this difference is attenuated when the fair value and historical cost models are more likely to converge: during recessionary periods.

    Finally, we predict and find lower EPS forecast accuracy for U.K. firms when reporting under the full fair value model of IFRS, in which unrealized fair value gains and losses are included in net income. This is consistent with the full fair value model increasing the difficulty of forecasting net income through the inclusion of non-serially correlated elements such as these gains/losses. Information content analyses provide further support for these inferences. Overall, the results indicate that the fair value reporting model enhances analysts' ability to forecast the balance sheet, but the full fair value model reduces their ability to forecast net income.

    Keywords:  fair value, historical cost, analyst forecast accuracy, net asset value, real estate

    Received: September 2011; Accepted: December 2013 ;Published Online: December 2013

     

    I. INTRODUCTION

    This paper examines the effect of the reporting model on the accuracy of analyst outputs. Specifically, we investigate whether the model—fair value or historical cost—used to report firms' primary operating assets of real estate differentially affects the accuracy of two analyst forecasts: a balance-sheet-based forecast (net asset value, or “NAV”), and an income-statement-based forecast (earnings-per-share, or “EPS”).1 Accordingly, this paper combines the literatures on fair value reporting for nonfinancial assets (e.g., Easton, Eddey, and Harris 1993) and analyst forecast accuracy (e.g., Lang and Lundholm 1996) to examine how the reporting model affects the precision of different types of analyst outputs.

    We choose as our setting publicly traded investment property firms domiciled either in the U.K. or U.S. during the period 2002–2010. Investment property firms invest in real estate assets for rental income and/or capital appreciation. The choice of this setting is advantageous for several reasons. First, this industry is among the few in which fair value reporting can be observed for the firm's primary operating assets. Although other industries, such as banking and insurance, have significant exposure to fair value reporting, these settings are more complex as the within-firm accounting treatment across their operating assets varies significantly, and they are subject to substantial regulation.2 Second, our focus on the U.K. and U.S. exploits the primary reporting difference for this industry across these two countries. Specifically, U.K. investment property firms recognize property assets at fair value on the balance sheet under both U.K. domestic accounting standards as well as more recently adopted International Financial Reporting Standards (IFRS). Unrealized fair value changes are reported in a revaluation reserve under U.K. standards, but reported in net income under IFRS. In contrast, U.S. investment property firms report property assets at historical cost as mandated under U.S. standards; further, industry practice is that these firms rarely voluntarily disclose property fair values. Third, despite the latter reporting difference, the real estate industry in both countries is highly developed, with both having a substantial number of publicly traded real estate firms, relatively liquid property markets, and a large number of analysts following these firms.

    To assess analyst forecast accuracy, we choose two forecast types, a balance-sheet-based forecast (NAV) and an income-statement-based forecast (EPS). NAV forecasts are commonly applied in the investment property industry, and are primary inputs into analyst's target price estimates. They are calculated by taking the estimated fair value of the firm's assets, which are primarily the real estate properties, and subtracting the estimated fair value of the firm's liabilities, primarily debt. As such, NAV provides an estimate of the value of the firm's net assets in place. Second, we examine the accuracy of EPS forecasts, which represent analysts' estimates of the firm's ability to generate income. We note that this industry is among the few for which both balance sheet and income statement forecasts are commonly observable.

    We hypothesize three primary effects. First, we predict higher accuracy of NAV forecasts for firms providing investment property fair values. That is, we expect that the reporting of these fair values, as done by U.K. firms, reveals private information regarding the underlying asset values. Analysts incorporate this information into their forecasts, leading to greater forecast accuracy. Second, we predict that this relatively greater NAV accuracy for firms providing fair values will be attenuated during circumstances in which the fair value and historical cost reporting models are likely to converge. To proxy for such a setting, we use the financial crisis, during which real estate assets in both the U.K. and U.S. declined substantially. Third, we predict that full fair value reporting required under IFRS will reduce the accuracy of analysts' EPS forecasts, owing to increased difficulty of forecasting net income when it includes non-serially correlated items such as unrealized fair value gains and losses.

    Empirical results confirm all three predictions. We find that NAV forecasts for U.K. firms are more accurate relative to those for U.S. firms. Further, we find that this greater accuracy is attenuated during the financial crisis of 2007–2008, consistent with convergence of the fair value and historical cost reporting models during this period. Finally, we document greater EPS forecast accuracy for U.S. firms relative to U.K. firms when the latter report under IFRS. To mitigate concerns that our analyses may reflect differences across the U.K. and U.S. settings that are unrelated to our predicted financial reporting effects, our primary analyses use a difference-in-differences design. Our findings also are robust to estimating a fully interacted model to control for different effects across the U.K. and U.S. samples; using alternative measures of the dependent variables to assess the use of market value to benchmark NAV forecast accuracy due to the latter's lack of reported actual amounts; and conducting subsample analysis. Finally, corroborating evidence reveals greater information content for U.K. relative to U.S. NAV forecasts, with this difference reduced during the financial crisis. Despite the higher EPS forecast error, however, U.K. EPS forecasts have greater information content under IFRS.

    These findings make three contributions. First, we link the fair value literature, which provides evidence of the decision relevance of reported fair values (e.g., Barth 1994), to that on analyst forecast accuracy (e.g., Clement 1999) by documenting that fair values of key operating assets can enhance the accuracy of analysts' balance-sheet-based forecasts. However, our evidence further suggests that the benefits to fair value reporting may primarily occur during expansionary economic periods, where the fair value and historical cost reporting models are most likely to diverge. In addition, our evidence suggests that full fair value reporting in which unrealized gains and losses are incorporated into income can impede income statement forecast accuracy. Second, our analyses of NAV forecasts are new because analysts' balance sheet forecasting activities are rarely studied in the prior literature. Finally, our evidence is likely of interest to U.S. and international standard-setters in their ongoing deliberations regarding the extent in which to incorporate fair value into reporting standards.

    Section II provides the background, prior literature, and hypothesis development. Section III presents the research design. Section IV reviews the sample and primary empirical results. Section V presents sensitivity analyses, and Section VI concludes.

    II. BACKGROUND, PRIOR LITERATURE, AND HYPOTHESIS DEVELOPMENT

    Background \
    This paper analyzes U.K. and U.S. publicly traded investment property firms over 2002–2010, which have as their primary operating structure tangible assets consisting of real estate investments. These firms invest in real estate to obtain rental income and/or for capital appreciation. We exploit a key difference across the two groups of firms: U.K. firms report these real estate assets at fair value, while U.S. firms report them at historical cost.

    The reporting of investment properties for U.K.-domiciled firms within our sample period falls under two regimes: U.K. domestic standards from 2002–2004; and International Financial Reporting Standards (IFRS) from 2005–2010. Both require that U.K. firms report investment properties on the balance sheet at fair value. The relevant U.K. domestic standard, Accounting for Investment Properties, Statement of Standard Accounting Practice No. 19 (SSAP 19; Accounting Standards Committee [ASC] 1994), requires investment property to be reported on the balance sheet at “open market value” at fiscal year-end. This is very similar to “fair value” as defined by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB).3 Unrealized fair value gains/losses are reported in a revaluation reserve, and thus do not pass through net income.

    Continued in article

    Note how ASU 2016-01 relates to IFRS 9 ---
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175832457331&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1070379&blobheadervalue1=filename%3DASU_2016-01.pdf&blobcol=urldata&blobtable=MungoBlobs


    Fair Value Accounting for Financial Instruments:
    Does It Improve the Association between Bank Leverage and Credit Risk?

    I preface this tidbit that I've been pretty negative (especially to Tom Selling's posts in The Accounting Onion Blog) of fair value accounting when unrealized fair values are comingled with legally recognized revenues. This balance sheet priority over the income statement has pretty much destroyed FASB and IASB ability to even define net income.

    I support fair value reporting under a multi-column reporting format where legally recognized revenues are segregated from unrealized fair value changes in the derivation of net earnings. Hence I am not really critical of fair value accounting if dual earnings measures are provided in the process.

    On the AECM Tom Selling and Patricia Walters (and I suspect many others) cling to a preference even when unrealized fair value changes are comingled with legally recognized revenues in the calculations of net earning and its derivatives like eps and P/E ratios in single-column reporting.

    In the interest of academic integrity, however, I respect these opinions of my AECM friends and am willing to point out empirical evidence that support their positions and the positions of the IASB and FASB regarding fair value accounting for financial instruments.

    One such important piece of empirical evidence is provided in the following citation:
    Title:  "Fair Value Accounting for Financial Instruments: Does It Improve the Association between Bank Leverage and Credit Risk?"
    Authors:  Elizabeth Blankespoor, Thomas J. Linsmeier, Kathy R. Petroni and Catherine Shakespeare
    Source:  The Accounting Review, July 2013, pp. 1143-1178
    http://aaajournals.org/doi/full/10.2308/accr-50419

    Abstract
    Many have argued that financial statements created under an accounting model that measures financial instruments at fair value would not fairly represent a bank's business model. In this study we examine whether financial statements using fair values for financial instruments better describe banks' credit risk than less fair-value-based financial statements. Specifically, we assess the extent to which various leverage ratios, which are calculated using financial instruments measured along a fair value continuum, are associated with various measures of credit risk. Our leverage ratios include financial instruments measured at (1) fair value; (2) U.S. GAAP mixed-attribute values; and (3) Tier 1 regulatory capital values. The credit risk measures we consider are bond yield spreads and future bank failure. We find that leverage measured using the fair values of financial instruments explains significantly more variation in bond yield spreads and bank failure than the other less fair-value-based leverage ratios in both univariate and multivariate analyses. We also find that the fair value of loans and deposits appear to be the primary sources of incremental explanatory power.

    Jensen Caution
    As is common in nearly all accountics science studies the analysis is limited to only association and not causation which, in this particular paper, is dutifully pointed out by these veteran accoutics scientists.

    The authors also dutifully point out arguments for and against fair value accounting in credit risk analysis

    Several parties currently support fair value accounting. In a 2008 joint letter to the Securities and Exchange Commission, the Chartered Financial Analyst Institute Centre for Financial Market Integrity (CFA Institute), the Center for Audit Quality, the Consumer Federation of America, and the Council of Institutional Investors support fair value accounting because they believe it provides more accurate, timely, and comparable information to investors than amounts that would be reported under other alternative accounting approaches (CFA 2008a). In a survey of CFA Institute members worldwide more than 75 percent of the 2,006 respondents indicate that they believe that fair value requirements improve transparency and contribute to investor understanding of financial institutions' risk and that full fair value accounting for financial instruments will improve market integrity (CFA 2008b). Presumably if fair values better describe bank risk, then fair value accounting may mitigate rather than exacerbate financial crises (Financial Crisis Advisory Group 2009; Bleck and Liu 2007). In a Financial Times editorial, Lloyd Blankfein, chairman and chief executive officer of Goldman Sachs, argues that “an institution's assets must be valued at fair market value—the price at which buyers and sellers transact—not at the (frequently irrelevant) historic value” (Blankfein 2009).

    There are five basic arguments against fair value accounting as discussed in more detail in ABA (2006, 2009). First, fair value accounting for assets that are instruments held for collection does not faithfully represent a bank's financial condition. As discussed above, changes in fair value of these instruments may be transitory. Consistent with this view, Sheila Bair, then chairman of the Federal Deposit Insurance Corporation, has argued that there is no relevance in using fair value accounting for loans that are held to maturity (N'Diaye 2009).

    Second, fair value accounting for liabilities that are instruments held for payment is not appropriate for two reasons. First, there are few opportunities for firms to settle liabilities before maturity at other than the principal amount. Debt markets are frequently very illiquid and contractual restrictions often preclude the transfer of financial liabilities. These limited opportunities to transfer liabilities before payment suggest that fair values of financial liabilities are less relevant for decision making than fair values of financial assets because the fair values of liabilities are less likely to be realized.6 Second, many argue that it is counterintuitive that under fair value accounting for fixed-rate debt, an increase in credit risk results in a write-down of the value of the debt and an associated gain in net income.7

    The third argument against fair value is that the financing of a bank's operations links loans issued with the deposits received and, therefore, in order to best capture the economics of the banking model, loans and deposits need to be similarly measured. From this perspective, because it is difficult to estimate the fair values of deposits, especially non-term deposits, both loans and deposits should be recognized at amortized cost. The difference between fair values and historical cost of non-term deposits, such as demand and savings deposits that bear low rates of interest, arises because a significant proportion of these funds can be expected to remain on deposit for long periods of time, allowing the bank to invest the deposits in higher yielding and longer duration loans. As shown by Flannery and James (1984), because these non-term deposits are fairly insensitive to interest rate changes, they serve as a type of hedge against the effect that changes in interest rates have on loans. Specifically, if interest rates rise, then the fair value of fixed-rate loans held by the bank will fall, but this loss will be offset by a rise in the fair value of the deposits associated with the increasing benefits of low- or no-cost financing in an increasing interest rate environment. If the stable source of funding provided by depositors is not recognized while the fair value of loans is recognized, then the bank will appear more volatile than it truly is.8

    The fourth opposing argument is that when fair values must be estimated, the valuation process can be significantly complex and the resulting numbers sufficiently unreliable to cause the benefits not to outweigh the costs. The fifth argument is that because fair value accounting contributes to the procyclicality of the financial system, it is one of the root causes of the recent financial crisis, creating significant harm to the economy.

    Our examination of the ability of fair values versus more historical-cost-based measures (GAAP and Tier 1 capital) to reflect a bank's credit risk directly addresses the first three opposing arguments. Our paper, however, does not contribute to understanding the costs, complexity, and reliability of fair value accounting or whether fair values contribute to procyclicality. We believe procyclicality is an interesting issue and acknowledge that the role of fair values in the recent financial crisis is still not fully understood.

    And the authors dutifully conclude the following on the last page of the article:

    The results of our study should not be used in isolation to suggest that all financial instruments should be recognized and measured at fair value. Our study only speaks to the ability of fair values to reflect credit risks of banks. There are other costs and benefits associated with a movement to fair values that we do not consider. Most notably, our study does not address the potential implications that fair value accounting has on procyclicality or contracting. In addition, we do not demonstrate that decision makers are using the fair values to determine credit risk; rather, we only demonstrate that fair values are most highly associated with the credit risk determinations. Last, it is worthwhile to note that we measure fair values based on the fair values currently being recognized or disclosed by banks. The FASB and the IASB have recently issued standards that define fair values more precisely (see footnote 5 for details) and, to the extent that this new definition affects the ultimate fair values recognized or disclosed under future expected revisions to the classification and measurement guidance for financial instruments, our results may not generalize.

    Added Jensen Comment
    This paper does not provide any information on how the IASB is currently butting heads with the EU Parliament (at the behest of the powerful EU banking lobby) regarding different stances on fair value accounting by EU banks.


    From the CFO Journal's Morning Ledger on June 26, 2013

    Non-GAAP metrics are playing a bigger role in financial reporting. Since regulators relaxed their stance on the use of nontraditional financial reporting measures in 2010, companies have been embracing metrics like customer churn rates and average revenue per user, CFOJ’s Emily Chasan writes.

    Driving the trend is a desire on the parts of both investors and corporate managers to focus on measures that have less noise and are clear indicators of the direction of the business. “There’s a disconnect between what finance departments want to report and financial-statement users want to receive,” Prof. Paul Bahnson of Boise State University said an Institute of Management Accountants conference in New Orleans this week. Corporate managers may prefer to report smoother results with less volatility based on historical information, but investors want to make sure they’re seeing more current information and capturing natural volatility.

    Meanwhile, Prof. Paul Miller of the University of Colorado at Colorado Springs argues that historical cost information is losing its relevance. He says accountants should think about historical costs as “unverifiable” and “unreliable” since they are statistically based on a sample size of a single transaction and can’t capture the full market value of an asset.

    Jensen Comment
    Paul Miller is extremely misleading about historical cost bookings in the ledgers. To my knowledge no historical cost advocate from AC Littleton to Yuji Ijiri has ever claimed that historical cost financial statements even pretend to "capture the full market value of an asset" or any part  or combination thereof except in the case of conservatism overrides when historical cost book values significantly overstate current values. For example, if inventory carrying values (at historical cost) are seriously in excess of disposal value due to damage or obsolescence the Conservatism Principle dictates a departure from historical cost.

    To my knowledge AC Littleton historically is the strongest advocate of historical cost accounting as modified by the Conservatism Principle. He repeatedly asserted that historical cost measurements make no pretenses of being surrogates for entry values or exit values or values-in-use under fair value accounting. Whereas the focus of fair value accounting is on balance sheet items, the main focus of historical cost accounting is on the income statement under the Matching Principle ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue
    Fair value advocates inappropriately wrote off the Matching Principle years ago. To their embarrassment the Matching Principle is still with us in FASB and IASB standards in spirit if not in name.

    Paul Miller's statement that "historical costs as 'unverifiable' and iunreliable' since they are statistically based on a sample size of a single (original) transaction" implicitly assumes that the only purpose of historical cost book value is to be a surrogate for some type of current market value. Since entry value accounting  requires arbitrary depreciation formulas and exit value accounting reports assets in their worst possible uses (yard sale junk items) what Paul Miller must mean is "value-in-use."

    But to my knowledge no economist or accountant has ever figured out how to value any nonfinancial booked asset in Exxon at its "value-in-use."

    The most important statistic, in my opinion, that is tracked by investors and financial analyst is current earnings in some form whether as Earnings-Per-Share  or Price/Earnings ratios. Like it or not historical cost is still a primary driver of current earnings under FASB or IASB accounting standards. Paul Miller's assertion that "historical cost information is losing its relevance" is totally incorrect as long as earnings measure are driven primarily by historical cost rules still drive earnings measurement under FASB and IASB rules. This will be true until the FASB and IASB eliminate historical cost depreciation and amortization and all the other historical cost accruals completely from the accounting standards. I may be ice skating and skiing in Hell before that happens.

    Having said this, I've no objection to entry value or exit value columns alongside GAAP columns prepared under FASB or IASB standards. I just do not want all unrealized temporal changes in market values to impact on current earnings. I vote for OCI in that department for items like marketable securities now carried at exit values under FASB and IASB standards.


    Mark-to-Make-Believe Accounting

    Lehman’s accounting was especially opaque, even relative to other investment banks (and that’s really saying something). Their Level 3 assets were described as “mark-to-make-believe.” The firm was especially evasive when asked for hard numbers for its liabilities. After the collapse of Bear Stearns they were the next obvious bank to collapse. They were smaller, more heavily leveraged and with greater exposure to the mortgage market. Even a cursory review of Lehman’s books revealed lots of red flags.
    "10 Things You May Not Have Known About Lehman Brothers," by Barry Ritholtz, Ritholtz Blog, September 18, 2013 ---
    http://www.ritholtz.com/blog/2013/09/10-things-you-may-not-have-known-about-lehman-brothers/

    Short list:

    1. At the Ira Sohn Investment Research Conference in May 2008, hedge fund manager David Einhorn explained why he believed Lehman Brothers was insolvent. At the time, Lehman was already significantly off its highs but still trading above $40.

    2. Lehman’s accounting was especially opaque, even relative to other investment banks (and that’s really saying something). Their Level 3 assets were described as “mark-to-make-believe.” The firm was especially evasive when asked for hard numbers for its liabilities. After the collapse of Bear Stearns they were the next obvious bank to collapse. They were smaller, more heavily leveraged and with greater exposure to the mortgage market. Even a cursory review of Lehman’s books revealed lots of red flags.

    3. The WSJ pointed out the complicity of Lehman’s accountants in their collapse. Management 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. In May 2008, a Lehman Sr VP alerted management about accounting irregularities, a warning ignored by Lehman auditors Ernst & Young.

    4. The infamous REPO 105 — a fraudulent accounting gimmick that temporarily removed over $50 billion in securities inventory from its balance sheet — existed for the sole purpose of hiding liabilities from shareholders. By creating a materially misleading picture of the firm’s financial condition in late 2007 and 2008, Lehman’s management and its accountants were engaging in fraud. This also suggests that LEH was much more leveraged and at far greater risk for insolvency than was realized at the time (So, no, short-sellers did not kill Lehman).

    5.  Warren Buffett made an offer to Lehman, one that turned out to be more generous than the offer later accepted by Goldman Sachs. (One may surmise that Fuld’s rejection of Buffett’s bid was the last straw as far as the Fed and Treasury were concerned. If they were unwilling to help themselves, why should the taxpayer write another $30 billion check?)

    6. Many potential suitors kicked the tires at Lehman – but none could get past their massive liabilities or their opaque accounting. Too many toxic assets on books that were untrustworthy led to no serious buyer appearing.

    7. Once Lehman filed for bankruptcy, Barclays scooped up most of the U.S. and U.K. operations—without any of that toxic junk paper to worry about. Nomura Securities took over Lehman’s Asian operations.

    8. Neuberger Berman had been bought by Lehman Brothers in the 1990s. Its management purchased the wealth management unit post bankruptcy. They essentially bought themselves back at a huge discount.

    9. Lehman Brothers CEO Dick Fuld was wildly over-compensated. A Harvard study calculated that Fuld earned $522.7 million from 2000 to 2007. He garnered $461.2 million of that from selling 12.4 million shares of Lehman. (BusinessWeek)

    10.  Lehman Brothers was dissolved 158 years after its founding.

    Did I miss any of the lesser known factoids about Lehman Brothers?


    Underlying Bases of Balance Sheet Valuation
    Go to http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting

     


    New Tool for Fair Value Accounting

    Bond Valuation App ---
    http://people.stern.nyu.edu/adamodar/New_Home_Page/uValue.html


    Estates Are Particularly Difficult to Value

    From the CPA Newsletter on July 30, 2013

    Minnesota Twins heirs fight IRS over team valuation ---
    http://www.accountingweb.com/article/minnesota-twins-heirs-go-bat-against-irs-tax-court/222153
    Minnesota Twins owner Carl Pohlad's heirs -- sons Robert, James and William -- are battling the Internal Revenue Service in U.S. Tax Court over estate taxes. The argument centers on the valuation of the major league baseball team. The IRS says the stake was grossly undervalued and is adding a $48 million penalty on the taxes it says the heirs still owe.

    Jensen Comment
    This is an example of where a balance sheet prepared in accordance with GAAP is useless for valuation. The bulk of the value resides in unbooked intangibles, especially human resources and reputation for future television deals.

    Some Thoughts on Fair Value Accounting

    Our recent AECM regarding why accounting standard setters require mark-to-market (fair value) adjustments of marketable securities (except for HTM securities) and do not generally allow mark-to-market adjustments to inventories (except for precious metals and LCM downward adjustments for permanent impairments).

    Fungible --- http://en.wikipedia.org/wiki/Fungible
    I think this "inconsistency" in the accounting standards hinges on the concept of fungible. Marketable securities are generally fungible. A General Motors share of stock NYC is identical to other GM shares in Bavaria versus Hong Kong versus Sugar Hill, New Hampshire. One advantage of fair value accounting for marketable securities is that these securities are fungible until they become unique such as when companies go bankrupt.

    The classic example for fungible inventories that I always used in class is the difference between new cars in a dealer's lot and used cars in that same lot is that new cars are fungible (there are thousands or tens of thousands in the world exactly like that new car) and used cars are not fungible. There is no other car in the world exactly like any of the used cars in a dealer's parking lot. We have Blue Book pricing of used cars of every make and model, but these are only suggested prices before serious negotiations between buyers and a seller of used models with varying mileage, accident histories, flooding histories such as being trapped while being parked in flood waters, new parts installed such as a new engine or new transmission, etc.

    My point here is that it's almost impossible to accurately value a used car until a buyer and seller have negotiated a purchase price. And the variation from Blue Book suggested prices can be quite material in amount. Thus we can value General Motors common shares before we have a buyer, but we can't value any used car before we have a buyer.

    I used to naively claim that this was not the case of new cars because they were fungible like General Motors common shares. But on second thought I was wrong. New cars are not fungible items. Consider the case of a particular BMW selling for $48,963 in Munich. The same car will sell for varying prices in NYC versus Hong Kong versus Sugar Hill, NH. This variation is due largely to delivery cost differentials.

    Now consider the Car A and Car B BMW models that are exactly alike (including color) in a Chicago dealership lot. After three months, a buyer and the dealer agree on a $67.585 price for Car A. Car B sits in the lot for over 11 months before a buyer and the dealer agree on a price of $58,276. This discount is prompted mostly by the fact that the new models are out making Car B seem like its a year old even though it odometer has less than two miles.

    My point here is that until a dealer finds a buyer for either a new car or a used car, we really don't know what the inventory fair value is for those non-fungible items. Similarly the same grade and quality of corn in Minneapolis has a different price than identical corn in Chicago. Corn and other commodities like oil are not really fungible for inventory valuation purposes.

    There are numerous examples of where inventory product values really can't be known until a sales transaction takes place. We can fairly accurately estimate the replacement costs of some of the new items for sale although FAS 33 found that the cost of generally doing so accurately for inventory valuation purposes probably exceeds the value of such replacement cost adjustments at each financial reporting date.

    There's great moral hazards in allowing owners of non-fungible inventories to estimate fair values before sales transactions actually take place. Creative accounting would be increasingly serious if accounting standards allowed fair value accounting for non-fungible items that vary in value depending upon the buyer and the time and place of sales negotiations.

    Thus we can explain to our students that the reason we report marketable securities at fair value and inventories at transaction or production historical costs is that marketable securities are fungibles and most inventories are not fungible. The main reason is that estimating the value of truly fungible marketable securities is feasible before we have a sales transaction whereas the value of so many non-fungible (unique) items is not known until we have a sales transaction at a unique time and place.

    Bob Jensen's valuation threads are at
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue

    Bpb Jensen's threads on contingencies and intangibles ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on July 17, 2015

    Microsoft Write-Down Stokes Valuation Concerns
    by: Kimberly S. Johnson
    Jul 09, 2015
    Click here to view the full article on WSJ.com
     

    TOPICS: Acquisitions, Goodwill, Write-Down

    SUMMARY: Finance chiefs may need to tread more carefully when pricing acquisitions, to avoid hefty write downs at a later date. Microsoft Corp.'s $7.6 billion write-down of its 2014 acquisition of Nokia's handset business is the latest, and among the largest in the tech industry in recent years. Hewlett-Packard Co. wrote down $8.8 billion in 2012 on its acquisition of U.K. software maker Autonomy. A year prior, the company wrote down $885 million based on its 2010 Palm acquisition.

    CLASSROOM APPLICATION: This article is appropriate for financial accounting, especially coverage of goodwill and write-downs.

    QUESTIONS: 
    1. (Introductory) What is goodwill? How is it related to acquisitions? Why do they occur?

    2. (Advanced) What is a write-down? What are the details of Microsoft's write-down? Why did the company have to do a write-down?

    3. (Advanced) Are write-downs problematic in all situations? How can write-downs be avoided? What should management be doing to manage these situations?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "Microsoft Write-Down Stokes Valuation Concerns," by Kimberly S. Johnson, The Wall Street Journal, July 9, 2015 ---
    http://blogs.wsj.com/cfo/2015/07/09/microsoft-write-down-stokes-valuation-concerns/?mod=djem_jiewr_AC_domainid

    Finance chiefs may need to tread more carefully when pricing acquisitions, to avoid hefty write downs at a later date.

    Microsoft Corp.’s $7.6 billion write-down of its 2014 acquisition of Nokia ’s handset business is the latest, and among the largest in the tech industry in recent years. Hewlett-Packard Co. wrote down $8.8 billion in 2012 on its acquisition of U.K. software maker Autonomy. A year prior, the company wrote down $885 million based on its 2010 Palm acquisition.

    Sale premiums are typically higher on technology assets, because they’re “priced on growth, rather than near-term profitability,” said Glen Kernick, technology industry leader at Duff & Phelps Corp., a valuation and corporate finance advisory firm.

    “Tech companies are carrying a higher proportion of goodwill…with allocations of greater than 50%,” he said. “Deals and valuations are premised on risker synergies and future technologies.”

    Five information technology companies in the S&P 500 recorded goodwill impairment charges or write-downs during their 2014 fiscal year, according to S&P Capital IQ. Communications equipment maker Juniper Networks Inc. recorded the largest goodwill impairment in 2014, $850 million, for its security reporting unit.

    Yahoo Inc. took an $88.4 million impairment hit in 2014 based on the value of its units in the Middle East, India and Southeast Asia, according to a regulatory filing.

    In 2013, Earthlink Holdings Corp. and Applied Materials Inc. reported the largest tech write-downs, according to Duff &Phelps, at $256.7 million and $224 million, respectively. The companies did not return requests for comment.

    Mr. Kernick said he expects to see more tech company impairment charges as valuations in certain parts of the sector are getting “a little frothy.” Pricing for cloud-computing and mobile payment companies are worth watching, he said.

    Continued in article


    The Professional's Guide to Fair Value: The Future of Financial Reporting
    by James P. Catty
    Wiley 2012 Edition
    ISBN: 978-1-1180-0438-8

    From the CFO.com Morning Ledger on May 13, 2013

    Shift to valuations, estimates challenges auditors
    Corporate auditors must increasingly adjust their approach to handle corporate financial statements that are now dominated by estimates and valuations of assets, PCAOB member Jay Hanson said. In a speech posted to the PCAOB website, Mr. Hanson said estimates and measurements are one of the most frequently identified trouble spots by the U.S. auditor watchdog, as managers and accountants have to spend more time focusing on the fair value of financial instruments, goodwill impairments and intangible assets in the new economy,
    Emily Chasan notes. “Thirty years ago, financial statements were dominated by tangible assets and historical cost accounting,” Mr. Hanson said. “Today, after rapid advances in technology, the development of innovative business models and the mind-numbing complexity of many investments, the balance sheets of an increasing number of companies are dominated by valuation estimates.”


    Hi Patricia,

    Some years back I wrote the following on the AECM ---
    http://faculty.trinity.edu/rjensen/Theory02.htm

    To my knowledge the first accountant to assert that fair value accounting was "truth" to my knowledge was Kenneth MacNeal. I've really enjoyed these intense friendly debates about single-column versus multiple column financial statements with Tom Selling and Patricia Walters on the AECM. But I do not want to leave anybody with the impression that I'm an advocate of historical costing balance sheets. I'm opposed to such balance sheets for reasons never envisioned by current value reporting scholars like Kenneth MacNeal, John Canning, Ray Chambers, Bob Sterling, Edgar Edwards, Phillip Bell, and others. I merely advocate a historical cost column in the balance sheet because I believe there is value added in reporting net earnings based upon only legally realized revenues and profits under the matching principle. I do think the historical cost balance accounts are residuals of the realized revenue matching concept that have enormous limitations in terms of evaluating financial opportunities and risks.

    The first scholar to ever associate exit value accounting to "Truth in Accounting" to my knowledge was Kenneth MacNeal in the context of going concern accounting (as opposed to personal financial statements and business liquidation accounting). His 1939 book Truth in Accounting made a strong case for exit value accounting.

    Scholars Book reprinted MacNeal's classic 1939 Book (ISBN 0914348043 )
    http://books.google.com/books/about/Truth_in_Accounting.html?id=zokDYAAACAAJ 

    Tom Selling on January 23, 2012 wrote the following ---
    http://accountingonion.typepad.com/theaccountingonion/2012/01/

    For nearly 100 years leading academics have advocated some type of current cost or value replacement of the historical cost basis of accounting. Historical cost never pretended, as repeatedly noted by AC Littleton, to be valuation accounting. In 1929, John Canning started the ball rolling for current (replacement) cost accounting, which is sometimes called "entry value" accounting. In 1939, Kenneth MacNeal commenced the ball rolling for exit value accounting where buildings, vehicles, and factory machinery are valued at what they can sell for, rather than amortized historical costs.

    From an academic standpoint the literature on value accounting has probably been more focused upon the bad features (e.g., goodwill accounting) of historical cost accounting rather than on convincing research that some type of "value" accounting justifies the costs of preparation. The sermons on the evils of historical cost accounting became less convincing as research emerged in the 1990s showing that historical cost accounting really did have value for both earnings and stock price forecasting.

    John Canning's current (replacement) cost baton has now been passed to Tom Selling. Like John Canning, Tom advocates that business firms spend tens of billions of dollars annually shifting from traditional historical cost reporting of operating assets to replacement costs. The problem is that replacement cost advocates can point to zero research convincing us that the benefits of such drastic changes in financial statements justify the costs.

    Entry (replacement) cost adjustments of historical costs advocated early on in John Canning's famous doctoral dissertation  really is not in the realm of "fair value"  accounting since it is really is only cost-adjusted accounting complete with all the arbitrary accruals that exit value theorists hate such as depreciation and amortization.

    So let's return to exit value accounting and "Truth""
    "Truth in Accounting:  The Ordeal of Kenneth MacNeal," by S.A. Zeff, The Accounting Review, July 1982.

     MacNeal's book was controversial to say the least and was generally not well received at first, although various scholars picked up the exit valuation ball and ran with it in accounting theory. Highly notable were Accounting Hall of Famers Ray Chambers, Bob Sterling, Edgar Edwards, and Phillip Bell ---
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/
    Some of MacNeal's deciples were thus inducted into the Hall of Fame whereas he himself has been overlooked.

    Shortly thereafter in 1939 Hall of Famers Bill Paton and A.C. Littleton countered MacNeal in their 1940 defense of historical cost accounting on the grounds that it was never intended to be valuation accounting. Rather it focused more on the income statement and the Matching Principle were as a result of double entry accounting the balance sheet was a secondary accumulation of residuals. In fair value accounting the balance sheet is primary and the income statement is an accumulation of residuals that comingle realized transactions with unrealized changes in value.
    http://faculty.trinity.edu/rjensen/theory01.htm#Paton

    Whereas some fair value advocates claim that exit value accounting is the only "truth" in accounting, other accounting theorists are more cautious about throwing about the word "truth" --- especially in our Academy where words like "truth" and "proof" are generally avoided outside the context of explicit underlying assumptions that are almost always open to debate.

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    I will close this tidbit with several articles that I think dispel the notion that fair value accounting is "truth" outside certain concepts and assumptions.

    Article One (when financial statements became less predictive)

    Although I could never find good economic reasons why traditional financial statements like those of the 1970s and 1980s were predictive of future performance, there are tons of empirical studies that show that traditional accounting earnings are predictive of future performance. Practically every TAR and JAR paper had one or more articles pointing to predictive values of traditional accounting studies.

    More recent studies in the past decade indicate that fair value financial statements are less predictive.

    "Ball and Brown and the Usefulness of EPS." by Robert Lipe, FASRI, August 9, 2012 ---
    http://www.fasri.net/index.php/2012/08/ball-and-brown-and-the-usefulness-of-eps/

    At the AAA meeting in DC, I attended a presidential address by Ray Ball and Phil Brown regarding their seminal research paper (JAR 1968). They described the motivation for their study as a test of existing scholarly research that painted a dim picture of reported earnings. The earlier writers noted that earnings were based on old information (historical cost) or, worse yet, a mix of old and new information (mixed attributes). The early articles concluded that earnings could not be informative, and therefore major changes to accounting practice where necessary to correct the problem.

    Ball and Brown viewed this literature as providing a testable hypothesis – market participants should not be able to use earnings in a profitable manner. Stated another way, knowing the amount of earnings that would be reported at the end of the year with certainty could not be used to profitably trade common stocks at the beginning of the year. Evidence to the contrary would suggest the null that earnings are non-informative does not hold.

    While the methods part of the paper is probably difficult for recent accounting archivalists to follow, Ball and Brown produce perhaps the single most famous graph in the accounting literature. It shows stock returns trending up over the year for companies that ultimately report increases in earnings and trending down for companies that report decreases in earnings. Thus they show that accounting numbers can be informative even if the aggregate number is not computed using a single unified measurement approach across transactions/events. Subsequent research would show that numbers from the income statement have predictive ability for future earnings and cash flows.

    As I sat listening to these two research icons, I could not help but think about some comments I have heard recently from a few standard setters and practitioners. Those individuals express contempt for EPS in a mixed attribute world. They appear to wish they could jump in a time machine and eliminate per share computations related to income. I readily admit that EPS does not explain much of the variance in returns over periods of one year or less ( e.g., Lev, JAR 1989). However the link is clearly significant, and over longer periods, the R2’s are quite high (Easton, Harris, and Ohlson, JAE 1992). Can the standard setters make incremental improvements to increase usefulness of EPS? I sure hope so, and maybe the recent paper posted by Alex Milburn will help. But dismissing a reported number because it is not derived from a single consistent measurement attribute – be it fair value or historical cost – seems to revert back to pre-Ball and Brown views that are rejected by years of research.

    Jensen Comment
    Given the balance sheet focus of the FASB and the IASB at the expense of the income statement I don't see how net income or eps could be anything but misleading to investors and financial analysts. The biggest hit, in my opinion, is the way the FASB and IASB create earnings volatility not only unrealized fair value changes but the utter fiction created by posting fair value changes that will never ever be realized for held-to-maturity investments and debt. This was not the case at the time of the seminal Ball and Brown article. Those were olden days before accounting standards injected huge doses of fair value fiction in eps numbers so beloved by investors and analysts.

     

    Article Two (when "truth" is not in fair value earnings

    Largely because fair value theorists cannot define net income on anything other than cherry-picked Hicksian theory, the FASB and IASB standard setters instead focus on the balance sheet where think they are on more solid footing conceptualizing  assets and liabilities. This, however, is not without its troubles.
    See
    "The Asset and Liability View: What It Is and What It Is Not—Implications for International Accounting Standard Setting from a Theoretical Point of View"
    Jens Wüstemann, University of Mannheim; Sonja Wüstemann, Goethe University Frankfurt am Main
    American Accounting Association Annual Meetings, August 4, 2010
    http://aaahq.org/AM2010/display.cfm?Filename=SubID_2022.pdf&MIMEType=application%2Fpdf

    I would like you to especially note the reference to the "stewardship function" below in the context of historical cost accounting.

    ABSTRACT
    In their current standard setting projects the FASB and the IASB seek to enhance consistency in the application of accounting standards and comparability of financial statements by fully implementing the asset and liability view. However, neither in standard setting nor in the accounting literature is there agreement on what the asset and liability view constitutes. In this paper, we show that the asset and liability view is compatible with different, sometimes even opposing concepts, such as historical cost accounting and fair value accounting, and thus cannot ensure internal consistency on its own. By means of the example of revenue recognition we point out the difficulty to determine the changes in assets and liabilities that shall give rise to revenue. We argue that the increase in assets that leads to revenue is the obtainment of the right to consideration and thus should be focused on by the

    Boards.

    1. Introduction

    A major aim of the FASB and the IASB in their current standard setting projects is to achieve internal consistency of the accounting regimes U.S. GAAP and IFRS (IASB 2008c, BC2.46; IASB 2008a, S3; IASB 2008d, par. 5; IASB 2009, p. 5). One of the reasons for inconsistencies in present U.S. GAAP and IFRS is that recognition and measurement principles and rules are developed on the basis of two competing concepts − the asset and liability view and the revenue and expense view (Wüstemann and Wüstemann 2010).

    Until the 1970s the so called revenue and expense view had been prevailing in international accounting standard setting. In the U.S. this view was introduced by Paton and Littleton in the American Accounting Association Monograph No. 3 in 1940 (Paton and Littleton 1940: 1956) and soon became the state of the art in U.S. accounting theory and practice. Similar developments took place in other countries, e.g. Germany, where Schmalenbach (1919) was the main driver for the establishment of the comparable ’dynamic accounting theory’

    (Dynamische Bilanztheorie)
    According to the revenue and expense view the principal purpose of accounting is to determine periodic net income as a measure of an entity’s effectiveness in using inputs to obtain and sell output (
    stewardship function) by recognising revenue when it is earned or realised and by matching the related costs with those revenues (FASB 1976, par. 38−42; Paton and Littleton 1940: 1956, p. 10 et sqq.; see for the tradition of the stewardship function Edwards, Dean and Clarke 2009). Some proponents of the revenue and expense view see net income as an indicator of an entity’s ‘usual, normal, or extended performance’ (‘earning power’) (FASB 1976, par. 62) that may help users not only to assess management’s performance but also to estimate the value of the firm (Black 1980, p. 20; Breidleman 1973, p. 654). This requires irregular and random events that distort net periodic profit, such as the receipt of grants and losses from bad debt, to be smoothed out (Beidleman 1973, p. 653 et sqq.; Bevis 1965: 1986, p. 104−107; FASB 1976, par. 59; Schmalenbach 1919, p. 32−36). Under the revenue and expense view the function of the balance sheet is to ‘store’ residuals resulting from the matching and allocation process; the deferred debits and credits depicted in the balance sheet do not necessarily represent resources and obligations (Paton and Littleton 1940: 1956, p. 72−74; Schmalenbach 1919, p. 26; Sprouse 1978, p. 68).

    In the 1970s the FASB realised that the key concepts under the revenue and expense view − revenues and expenses − are not precisely definable making earnings ‘unduly subject to the effects of personal opinion about what earnings of an enterprise for a period should be’ (FASB 1976, par. 60). In order to limit arbitrary judgements and to achieve a more consistent income determination the FASB decided to shift the focus to the more robust concepts of assets and liabilities and thus to the asset and liability view as evidenced by the issuance of SFAC 3 Elements of Financial Statements (now SFAC 6) in 1980 (Storey 2003, p. 35 et sqq.; Miller 1990, p. 26 et seq.; see for a similar development in Germany around the same time Moxter 1993). The so called asset and liability view in the U.S. has its origins in the Sprouse and Moonitz monograph that was published in 1962 as part of the AICPA’s Accounting Research Studies.

    Under this view all financial statement elements are derived from the definitions of assets and liabilities. Income resulting from changes in assets and liabilities measures an entity’s increase in net assets (FASB 1976, par. 34; Johnson 2004, p. 1; Ronen 2008, p. 184; Sprouse and Moonitz 1962, par. 11, 46, 49). The asset and liability view can serve the purpose to objectify income measurement by restricting recognition in the balance sheet to those items that embody resources and obligations (Sprouse 1978, p. 70). Alternatively, the asset and liability view can be adopted in order to inform users about future cash flows that are expected to flow from an entity’s assets and liabilities, which are supposed to help them in estimating firm value (Scott 1997, p. 159−162; Hitz 2007, p. 333 and 336−338).

    Despite the declared shift from the revenue and expense view to the asset and liability view in the 1970s, certain U.S. standards and also the ‘older’ IFRS, for example those on revenue recognition, still follow the revenue and expense view (Ernst & Young 2009, p. 1558; Wüstemann and Kierzek 2005, p. 82 et seq.). In the beginning of the 21st century the FASB and the IASB have begun several projects, above all the Conceptual Framework Project, that shall lead to an all-embracing implementation of the asset and liability view (Wüstemann and Wüstemann 2010).

    We observe that both in the accounting literature and the standard setting processes, there is confusion about the meaning and implications of the asset and liability view, especially as regards the role of the realisation principle and the matching principle as well as fair value measurement (see literature review below). A second problem is that the asset and liability view does not provide clear guidance on how assets and liabilities shall be defined and which changes in assets and liabilities shall give rise to income. The FASB and the IASB have − up to now − been struggling with the problem of bringing current revenue recognition guidance in conformity with the asset and liability view for seven years. In December 2008, they finally published a Discussion Paper ‘Preliminary Views on Revenue Recognition in Contracts with Customers’, but the issuance of the new standard is not yet foreseeable.

    The aim of this paper is to shed light on the conceptual underpinnings of the asset and liability view, to clarify misunderstandings in the accounting literature and standard setting about its meaning and to discuss implications for international accounting standard setting. The remainder is organised as follows: In the first part of the paper we depict the different opinions that exist with regard to the asset and liability view and then clarify the concept by defining recognition and measurement principles as well as purposes of financial statements that are compatible with this view. Subsequently, we analyse in how far the asset and liability view is implemented in present U.S. GAAP and IFRS and in which areas accounting principles still exist that oppose the asset and liability view. In the final part we point out the difficulty to define assets and liabilities taking the current FASB’s and IASB’s joint project on revenue recognition as an example and make suggestions for improvement.

    Continued in article
     http://aaahq.org/AM2010/display.cfm?Filename=SubID_2022.pdf&MIMEType=application%2Fpdf

    Conclusion
    And after all these years of trying the standard setters have not yet come up with standards that are very good for evaluating financial performance of business firms, something that they are well aware of in Australia ---
    "GAAP Based Financial Reporting:  Measurement and Business Performance" --- Click Here
    http://www.charteredaccountants.com.au/Industry-Topics/Reporting/Resources-and-toolkits/~/media/Files/Industry topics/Reporting/Resources and toolkits/Reports/GAAPbased_financial_reporting.ashx

     I think the major problem, aside from the cost of generating more relevant and reliable information, is that standards setters never look beyond single-column financial statements that inevitably lead them to horrid mixed model measurements that destroy aggregations into summary measures like "Total Assets" and "Net Income." Bob Herz recommends doing away with aggregating net income metrics. I recommend having multiple columns and multiple net income aggregations.
    See http://faculty.trinity.edu/rjensen/theory02.htm#ChangesOnTheWay

     

    Article Three (when "truth" is not in fair value earnings)

    Spinning Debt Into Earnings With the Wave of a Fair Value Accounting Wand
    "Euro banks' £169bn in accounting alchemy," by: Lindsey White, Financial Times Advisor, January 19, 2009 --- Click Here

    European banks conjured more than £169bn of debt into profit on their balance sheets in the third quarter of 2008, a leaked report shows.

    Money Managementhas gained exclusive access to a report from JP Morgan, surveying 43 western European banks.

    It shows an exact breakdown of which banks increased their asset values simply by reclassifying their holdings.

    Germany is Europe's largest economy, and was the first European nation to announce that it was in recession in 2008. Based on an exchange rate of 1 Euro to £0.89, its two largest banks, Deutsche Bank and Commerzbank, reclassified £22.2bn and £39bn respectively.

    At the same exchange rate, several major UK banks also made the switch. RBS reclassified £27.1bn of assets, HBOS reclassified £13.7bn, HSBC reclassified £7.6bn and Lloyds TSB changed £3.2bn. A number of Nordic and Italian banks also switched debts to become profits.

    Banks are allowed to rearrange these staggering debts thanks to an October 2008 amendment to an International Accounting Standards law, IAS 39. Speaking to MM, IAS board member Philippe Danjou said that the amendment was passed in "record time".

    The board received special permission to bypass traditional due process, ushering through the amendment in a matter of days, in order to allow banks to apply the changes to their third quarter reports.

    However, it is unclear how much choice the board actually had in the matter.

    IASB chairman Sir David Tweedie was outspoken in his opposition to the change, publicly admitting that he nearly resigned as a result of pressure from European politicians to change the rules.

    Danjou also admitted that he had mixed views on the change, telling MM, "This is not the best way to proceed. We had to do it. It's a one off event. I'd prefer to go back to normal due process."

    While he was reluctant to point fingers at specific politicians, Danjou admitted that Europe's "largest economies" were the most insistent on passing the change.

    As at December 2008, no major French, Portuguese, Spanish, Swiss or Irish banks had used the amendment.

    BNP Paribas, Credit Agricole, Danske Bank, Natixis and Societe Generale were expected to reclassify their assets in the fourth quarter of 2008.

    The amendment was passed to shore up bank balance sheets and restore confidence in the midst of the current credit crunch. But it remains to be seen whether reclassifying major debts is an effective tactic.

    "Because the market situation was unique, events from the outside world forced us to react quickly," said Danjou. "We do not wish to do it too often. It's risky, and things can get missed."


    Article Four (when amortized cost seems to more of the "truth")

    The Downside of Fair Value Accounting for Money Funds

    From the CFO.com Morning Ledger on April 30, 2013

    Treasurers Hunt for Money Fund Alternatives

    Corporate treasurers are hunting for alternatives to money-market funds as the SEC eyes reforms. The biggest concern is that money funds would have to report daily changes in the value of their underlying assets, which would make their share prices fluctuate, writes Vipal Monga in today’s Marketplace section. That could complicate accounting and leave companies facing potential tax liabilities.

    Proponents of floating share prices say the shift would boost transparency. And any fluctuations in asset values aren’t expected to be dramatic. But treasurers worry that even a little bit of volatility would force them to track the value of the funds more closely, which could require more staff and upgrades in software and accounting systems. “The investor would need to keep track of the cost basis of each investment, and would have a tax liability to pay on any gain,” said Tom Deas, treasurer of chemical company FMC and chairman of the National Association of Corporate Treasurers.

    Among the alternatives, some corporate treasurers are looking at separately managed accounts, which are custom-made investment vehicles run by money managers. “If money funds are forced to go to a floating NAV, we will see a lot of companies shift a larger portion of their balances to separately managed portfolios,” said Jerry Klein, managing director at investment adviser Treasury Partners. Even so, companies have found that it’s not easy to recreate the advantages of money funds—especially in terms of easy access to their cash.

    "Amortized Cost Accounting is “Fair” for Money Market Funds," by Dennis R. Beresford, U.S. Chamber of Commerce Center for Capital Markets Competitiveness, Fall 2012
    http://www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/Money-Market-Funds_FINAL.layout.pdf

    Summary

    Recent events have caused the U.S. Securities and Exchange Commission (SEC) to rethink the long-standing use of amortized cost by money market mutual funds in valuing their investments in securities. This practice supports the use of the stable net asset value (a “buck” a share) in trading shares in such funds. Some critics have challenged this accounting practice, arguing that it somehow misleads investors by obfuscating changes in value or implicitly guaranteeing a stable share price.

    This paper shows that the use of amortized cost by money market mutual funds is supported by more than 30 years of regulatory and accounting standard-setting consideration. In addition, its use has been significantly constrained through recent SEC actions that further ensure its appropriate use. Accounting standard setters have accepted this treatment as being in compliance with generally accepted accounting principles (GAAP). Finally, available data indicate that amortized cost does not differ materially from market value for investments industry wide. In short, amortized cost is “fair” for money market funds.

    Background

    Money market mutual funds have been in the news a great deal recently as the SEC first scheduled and then postponed a much-anticipated late August vote to consider further tightening regulations on the industry.1 Earlier, Chairman Mary Schapiro had testified to Congress about her intention to strengthen the SEC regulation of such funds, in light of issues arising during the financial crisis of 2008 when one prominent fund “broke the buck,” resulting in modest losses to its investors. Sponsors of some other funds have sometimes provided financial support to maintain stable net asset values. And certain funds recently experienced heavy redemptions due to the downgrade of the U.S. Treasury’s credit rating and the European banking crisis.

    Money market funds historically have priced their shares at $1, a practice that facilitates their widespread use by corporate treasurers, municipalities, individuals, and many others who seek the convenience of low-risk, highly liquid investments. This $1 per share pricing convention also conforms to the funds’ accounting for their investments in short-term debt securities using amortized cost. This method means that, in the absence of an event jeopardizing the fund’s repayment expectation with respect to any investment, the value at which these funds carry their investments is the amount paid (cost) for the investments, which may include a discount or premium to the face amount of the security. Any discount or premium is recorded (amortized) as an adjustment of yield over the life of the security, such that amortized cost equals the principal value at maturity.

    Some commentators have criticized the use of this amortized cost methodology and argued for its elimination. In a telling example of the passionate but inaccurate attention being devoted to this issue, an editorial in the June 10, 2012, Wall Street Journal described this longstanding financial practice in a heavily regulated industry as an “accounting fiction” and an “accounting gimmick.”

    . . .

    Reasoning for Use of Amortized Cost

    The FASB has been considering various aspects of the accounting for financial instruments for approximately 25 years. During that time it has issued standards on topics such as accounting for marketable securities, accounting for derivative instruments and hedging, impairment, disclosure, and others. Also, the FASB has issued standards or endorsed standards issued by the AICPA of a specialized nature applying to certain industry groups such as investment companies, insurance companies, broker/dealers, and banks. Further, the FASB is presently involved in a major project that has encompassed approximately the past 10 years, whereby it is endeavoring to conform its standards on financial instruments to the related standards issued by the International Accounting Standards Board. Aspects of that project have stalled recently, and the two boards have reached different conclusions on certain key issues. Other aspects of that project are moving forward.

    Over this 25-year period, probably the most controversial aspect of the financial instruments project has been to what extent those instruments should be carried at market or fair value in financial statements rather than historical cost. On several occasions the FASB has indicated a strong preference for fair value as a general objective. But there has been a great deal of opposition from many quarters, and the FASB has tended to determine the appropriate measurement attribute for particular instruments (fair value, amortized cost, etc.) in different projects based on the facts and circumstances in each case.

    . . . (very long passages from this 21-page article are not quoted here)

    Conclusion

    Accounting for investment securities by money market mutual funds appropriately remains based on amortized cost. The amortized cost method of accounting is supported by the very short-term duration, high quality, and hold-to-maturity nature of most of the investments held. The SEC’s 2010 rule changes have considerably strengthened the conditions under which these policies are being applied. As a result of the 2010 SEC rule changes, funds now report the market value of each investment in a monthly schedule submitted to the SEC that is then made publicly available after 60 days. That provides additional information for investors. And the FASB’s current thinking articulates this accounting treatment as GAAP.

     

    Jensen Comment
    My main objection to booking fair values of HTM investments is that the interim adjustments for fair values that will never be realized destroys the income statement. Of course, the FASB and IASB have systematically destroyed the concept of net earnings in many other standards to a point where these standard setters can no longer even define net earnings.

    The good news is that the FASB has a proposal to offset fair value adjustments of assets and liabilities to Other Comprehensive Income (OCI) instead of current earnings. Let's hope this becomes the rule of the land.

    Research Studies from the Chamber's Center for Capital Markets ---
    http://www.centerforcapitalmarkets.com/resources/publications/

     


    Article Five (a video)

    Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an exercise in writing fiction with fair values:
    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!

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them. “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said
    "Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New York Times, April 20, 2009 ---
    http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

    This is starting to feel like amateur hour for aspiring magicians.

    Another day, another attempt by a Wall Street bank to pull a bunny out of the hat, showing off an earnings report that it hopes will elicit oohs and aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of America all tried to wow their audiences with what appeared to be — presto! — better-than-expected numbers.

    But in each case, investors spotted the attempts at sleight of hand, and didn’t buy it for a second.

    With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

    Bank of America sold its shares in China Construction Bank to book a big one-time profit, but Ken Lewis heralded the results as “a testament to the value and breadth of the franchise.”

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

    “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

    Investors reacted by throwing tomatoes. Bank of America’s stock plunged 24 percent, as did other bank stocks. They’ve had enough.

    Why can’t anybody read the room here? After all the financial wizardry that got the country — actually, the world — into trouble, why don’t these bankers give their audience what it seems to crave? Perhaps a bit of simple math that could fit on the back of an envelope, with no asterisks and no fine print, might win cheers instead of jeers from the market.

    What’s particularly puzzling is why the banks don’t just try to make some money the old-fashioned way. After all, earning it, if you could call it that, has never been easier with a business model sponsored by the federal government. That’s the one in which Uncle Sam and we taxpayers are offering the banks dirt-cheap money, which they can turn around and lend at much higher rates.

    “If the federal government let me borrow money at zero percent interest, and then lend it out at 4 to 12 percent interest, even I could make a profit,” said Professor Finkelstein of the Tuck School. “And if a college professor can make money in banking in 2009, what should we expect from the highly paid C.E.O.’s that populate corner offices?”

    But maybe now the banks are simply following the lead of Washington, which keeps trotting out the latest idea for shoring up the financial system.

    The latest big idea is the so-called stress test that is being applied to the banks, with results expected at the end of this month.

    This is playing to a tough crowd that long ago decided to stop suspending disbelief. If the stress test is done honestly, it is impossible to believe that some banks won’t fail. If no bank fails, then what’s the value of the stress test? To tell us everything is fine, when people know it’s not?

    “I can’t think of a single, positive thing to say about the stress test concept — the process by which it will be carried out, or outcome it will produce, no matter what the outcome is,” Thomas K. Brown, an analyst at Bankstocks.com, wrote. “Nothing good can come of this and, under certain, non-far-fetched scenarios, it might end up making the banking system’s problems worse.”

    The results of the stress test could lead to calls for capital for some of the banks. Citi is mentioned most often as a candidate for more help, but there could be others.

    The expectation, before Monday at least, was that the government would pump new money into the banks that needed it most.

    But that was before the government reached into its bag of tricks again. Now Treasury, instead of putting up new money, is considering swapping its preferred shares in these banks for common shares.

    The benefit to the bank is that it will have more capital to meet its ratio requirements, and therefore won’t have to pay a 5 percent dividend to the government. In the case of Citi, that would save the bank hundreds of millions of dollars a year.

    And — ta da! — it will miraculously stretch taxpayer dollars without spending a penny more.


    March 4, 2013 message from Roger Collins

    From

    http://www.bbc.co.uk/news/business-21653131 

    Some quotes

    "HSBC paid out $4.2bn (£2.8bn) last year to cover the cost of past wrongdoing. As well as $1.9bn in fines for money laundering, the bank also set aside another $2.3bn for mis-selling financial products in the UK. The figures came as HSBC reported rising underlying profitability and revenue in 2012, and an overall profit before tax of $20.6bn

    Chief executive Stuart Gulliver's total remuneration for 2012 was some $7m, compared with $6.7m the year before. And after taking account of the deferral of pay this year and in more highly-remunerated years previously, Mr Gulliver actually received $14.1m in 2012, up from $10.6m in 2011.

    The company's 16 top executives received an average of $4.9m each."

    "During a conference call to present the results, Mr Gulliver told investors that the bank was not reconsidering whether to relocate its headquarters from London back to Hong Kong, in order to avoid a recently agreed worldwide cap on bonuses of all employees of banks based in the EU."

    "HSBC's underlying profits - which ignore one-time accounting effects as well as the impact of changes in the bank's creditworthiness - rose 18%."

    "The bank's results were heavily affected by a negative "fair value adjustment" to its own debt of $5.2bn in 2012, compared with a positive adjustment of $3.9bn the year before. The adjustment is an accounting requirement that takes account of the price at which HSBC could buy back its own debts from the markets. It has the perverse effect of flattering a bank's profits at a time when markets are more worried about its ability to repay its debts, and vice versa."

    More in article.

    Regards,

    Roger

    Roger Collins
    Associate Professor
    OM1275 TRU School of Business & Economics

     

    Bob Jensen's threads on the controversies of fair value accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue

     


    Hi Tom,

    I really do appreciate that you are trying to be constructive. However, even the pejorative title of your blog post, like that of Francine's post, seems to suggest that auditors are getting away with something they should not get away with in the courts.
    Your title is:  "Why Nothing Sticks to Auditors when Loans Go Bad"
    Her title is: "Big Four Auditors and Jury Trials: Not In The U.S.

    In your blog posting you then goes on to state:

    If the auditors don't settle, then (follow me on this one) the SEC will have to convince the ALJ that the auditors acted "unreasonably" by not concluding that the numbers fed to them by management were themselves "unreasonable."
     

    I tried to point out that both auditors and management relied upon "unreasonable" mortgage value estimates thousands of thousands  of mortgage valuation experts at the time of the KPMG audit in question. Over 99.999% of those valuation experts were greatly overvaluing those poisoned mortgages in Countrywide Financial, IndyMac Bank, Ameriquest, Wells Fargo, Washington Mutual, etc. The exception was Peter Schiff, but nobody was listening to him.

    Sleazy real estate appraisers were greatly overvaluing properties serving as collateral.

    Security valuation experts were greatly overvaluing the mortgages. and CDO portfolios comprised of those mortgage investments. Many relied upon the flawed Gaussian copula function.

    Your proposals for improved auditing almost always entail suggesting that auditors rely on "independent valuation experts."

    My point is that in these particular instance of auditors at Countrywide, IndyMac, Washington Mutual, and the others virtually all "independent valuation experts" were going to agree to unreliable valuations by experts for reasons given in Professor Galbaith's Senate Testimony:
    "Why the ‘Experts’ Failed to See How Financial Fraud Collapsed the Economy," by "James K. Galbraith, Big Picture, June 2, 2010 ---
    http://www.ritholtz.com/blog/2010/06/james-k-galbraith-why-the-experts-failed-to-see-how-financial-fraud-collapsed-the-economy/

    My point is that fair value accounting and KPMG's auditing relying on "independent valuation experts" of the mortgages in Countrywide would not have helped to predict that Countrywide was no longer a going concern. The valuation experts across the U.S.A. did not foresee the collapse of the mortgage lending companies and Wall Street investment banks until after the bubble burst.

    Where did the auditors fail?
    The CPA auditors like KPMG and the other Big Four firms failed because they did not go granular on a sampling of mortgages held by Countrywide Financial, IndyMac Bank, Ameriquest, Wells Fargo, Washington Mutual, Bear Stearns, Lehman Bros., Merrill Lynch, and over 1,000 other failed banks. The failing was to rely upon valuation experts rather than to themselves sample the mortgage investments during audits to investigate the likelihood of mortgages failing.

    The auditors should have detected that there was not a snow ball chance in Hell that Mervene on welfare and food stamps was going to pay off a $103,000 mortgage on her shack.

    For a picture of Mervene's shack in Phoenix go to
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
    After foreclosure on this shack, her neighbors bought it for less than $10,000 and tore the eyesore down.

    Diligent auditors should've detected themselves that something was wrong if a woman on welfare could get a $103,000 mortgage on that cheap shack.

    My contention is that the CPA audit firms failed because they relied upon fair value estimates from "valuation experts" as being "reasonable." They should've instead done a deeper granular investigation of the mortgage investments themselves. There is precedent for this in auditing. In the early days of FAS 133, audit firms were aware that they were outsourcing too much to banks for the valuation of derivative financial instruments. Very quickly the audit firms purchased their own Bloomberg or Reuters Terminals and began to themselves value samplings of each client's investments in derivative financial instruments.

    Conclusion
    Hence, I would contend that instead of relying upon "independent valuation experts" for loan investments, CPA auditors should instead go granular on samplings of those loans to investigate the likelihood of paybacks on those loans.

    It did not even take an accounting degree to realize that Marvene was never going to pay back this loan once the mortgage lending firm sold it to Fannie Mae --- which was tantamount to sticking government with the Mervene's loan loss.
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze

    Respectfully,
    Bob Jensen


    "Fair-Value Rule (IFRS 13) Seeks Clearer M&A Deals:  Measuring fair value is more challenging than ever these days. But new IFRS reporting standards could help bring more transparency to the process, the rule-makers hope," by Kathleen Hoffelder, CFO.com, April 5, 2013 ---
    http://www3.cfo.com/article/2013/4/gaap-ifrs_gaap-ifrs-13-dell-google-fair-value-measurement

    In his desire to take Dell private, billionaire founder and CEO Michael Dell agreed in February to value his stake of more than 15% in the company at a lower share price than other shareholders. Hoping that would make the deal more attractive to potential suitors, he valued Dell at $13.65 a share, while analysts and other private equity firms claimed it was worth almost double that.  

    The Dell buyout saga shows how important measuring fair value (the price at which an asset can be sold in current markets) is, particularly for mergers and acquisition. And with changes in fair-value accounting going into effect during the next financial reporting periods for most corporations, CFOs and other senior executives will need to keep an even sharper focus on it—whether for acquisitions, or simply to re-value land or property.

    International Financial Reporting Standard No. 13, or IFRS 13, which gives guidance on how to measure an asset’s fair value, went into effect on January 1. But firms are still in the process of implementing the standard. Both the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued IFRS 13 in 2011 to provide investors with an easier and more consistent way to analyze corporate assets that would still be aligned with U.S. generally accepted accounting principles (GAAP).

    IFRS 13 applies to most corporations, explained David Larsen, managing director of the alternative asset advisory practice at Duff and Phelps. Speaking at a Duff and Phelps IFRS 13 webcast yesterday, he said the standard comes into play for any company that must disclose fair-value measurement for M&A activity, asset impairment, or activity involving investment entities (units which obtain funds from investors in exchange for investment management services), he said. “In many ways, that’s almost everybody.”

    Corporations must use fair-value measurement when they initiate impairment testing (required evaluations comparing an asset’s book value with its open-market value) under other financial-reporting standards, including, for instance, those covering Recognition and Measurement (IFRS 39), Financial Instruments (IFRS 9), and Business Combinations (IFRS 3).

    But not everyone is taking heed of some of the biggest changes outlined in IFRS 13, such as those involving disclosure. “The expansion of disclosures [about fair values] could be a new thing for many; a lot of judgment goes into the disclosure area” said Larsen.

    Specifically, corporations now must show more support for the assumptions made on their fair-value measurement and, particularly, more clarity in those assets that may be difficult to value. Under the standard, which has been in development for at least eight years, company's now must disclose fair values according to a three-level hierarchy: for those assets in which quoted prices in active markets are readily available (level 1); when that’s not available, corporations will have to disclose fair values using inputs other than quoted prices included within level 1 that are still observable (level 2); and if those aren't available, they need to disclose fair value using inputs that still based on market assumptions though they may be unobservable for the asset (level 3). 

    Disclosure also involves performing qualitative sensitivity analysis (where a company provides a narrative discussion if changing inputs would result in altermative assumptions about fair value) and initiating a quantitative disclosure for Level 3 inputs in addition to a quantitative one already in place in the regulation, according to the webcast.

    Continued in article

    Jensen Comment
    Note that valuing Michael Dell's stake in the company he founded is far more difficult that estimating the fair value of assets on the balance sheet. The reason is that many, many items of value such as human resources in his stake are not even booked in the accounting ledgers because they are too difficult to value ---
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    From the CFO Morning Ledger on January 15, 2013

    Companies are packing their annual audits full of details on how they value hard-to-price assets, like thinly traded securities, pension-fund assets and customer lists. The trend is a response to regulator warnings that companies and auditors don’t fully understand some of the figures they get from third-party valuation advisers and pricing services, CFOJ’s Emily Chasan writes in today’s Marketplace section.

    “The challenge for a CFO, or anyone in a financial reporting group, is that suddenly they are being asked to talk about investments as if they were a lifelong specialist in this category,” says Verne Scazzero, CEO of Harvest Investments, which helps companies review the value of their investments.

    Tighter mark-to-market rules have forced businesses to rely more on outside services that use computer modeling to help them appraise “their most-esoteric assets,” Chasan writes. But now, companies want to know more about those models. Corporate auditors are also consulting with their national offices on tricky valuations, and hiring more advisers to get a second opinion. “Auditors are going to be asking a lot more,” questions about how values were determined, said John Keyser, national director of assurance services at accounting firm McGladrey & Pullen. “The work is exponential.”

    Bob Jensen's threads on fair value accounting controversies ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue


    "FASB clarifies scope of nonpublic entity fair value disclosure exemption (No. 2012-59)," PwC, December 19, 2012 --- Click Here
    http://www.pwc.com/en_US/us/cfodirect/assets/pdf/in-brief/in-brief-2012-59-fasb-clarifies-scope-of-non-public-entity-fair-value-disclosure-exemption.pdf  

    What's new?

    On December 19, 2012, the FASB (the “board”) met to clarify the applicability of an exemption from a specific fair value disclosure for nonpublic entities.

    The board decided to clarify that all nonpublic entities are exempt from the requirement to disclose the categorization by level of the fair value hierarchy for items disclosed but not measured on the balance sheet at fair value.

    What were the key decisions?

    Certain nonpublic entities are excluded from the requirement to disclose the fair value of their financial instruments not measured at fair value on the balance sheet. Questions have arisen during the adoption of ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, regarding which nonpublic entities are excluded from the new requirement to disclose the categorization by level of the fair value hierarchy for items not measured at fair value in the balance sheet but for which fair value is disclosed. Some read the exemption to apply to only those nonpublic entities that are able to apply the general exemption to not disclose the fair value of their financial instruments.

    The board voted to clarify that all nonpublic entities are exempt from the requirement to disclose the level in the fair value hierarchy for items disclosed but not measured on the balance sheet at fair value. The board noted that this was its intent when it deliberated ASU 2011-04.

    Is convergence achieved?

    Although the issuance of ASU 2011-04 was the result of a joint project on fair value conducted with the IASB, the disclosure exemptions provided to nonpublic entities in ASU 2011-04 and confirmed at this board meeting are only for reporting entities applying U.S. GAAP. A similar scope exemption is not included in the IASB’s fair value standard.

    Who's affected?

    Nonpublic entities are affected by the clarification.

    What's the proposed effective date?

    ASU 2011-04 is effective for nonpublic entities for annual periods beginning after December 15, 2011. The clarification described above is not expected to have a different effective date.

    What's next?

    A proposed ASU with the clarified language is expected in January 2013. The board decided to provide a 15-day comment period.

    Questions?

    PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-780

    Authored by:

    Jill Butler
    Partner
    Phone: 1-973-236-4678
    Email: jill.butler@us.pwc.com

    Mia DeMontigny
    Managing Director
    Phone: 1-973-236-4012
    Email: mia.demontigny@us.pwc.com

    Maria Constantinou
    Director
    Phone: 1-973-236-4957
    Email: maria.constantinou@us.pwc.com

     


    Hi Pat,

    You wrote the following:

    To the best of my knowledge, credit sales are not "realized". The are considered "realizable" because companies claim to be able to estimate uncollectible accounts.

    You may wish to claim that unrealized changes in fair values of held financial assets are one step further away from being realizable, but it is the choice if the reporting entity not to realize those values rather than the choice if the customer to pay.

    Jensen Reply

    Yes I agree that the credit sales are a step further from unrealized fair value changes, although that step is a huge one because defaults on credit sales are enforceable by the the courts. Ups and downs of an investment in 10,000 shares of Apple stock or call options on Apple shares are only thin air gains and losses until sales transpire. Yes the step is a huge one! Might I use the word "cliff?"

    Example
    When I was on the faculty at the University of Maine in the 1970s I owned an ocean summer cottage on 11 acres of woods across the bay from Acadia National Park. In those days, when there were no fears of rising ocean levels, having a cottage 20 feet from the beach at high tide was sort of neat. All such shoreline cottages either had to be purchased entirely for cash or be partly seller financed. No commercial lenders like banks and savings and loans associations would finance shore property in the country, at least not in the 1970s.

    When I moved to Florida State University in 1978 I sold my Maine summer cottage on the basis of receiving 50% of the selling price in cash and a first mortgage on the remainder due. There was no market for my note investment on this property and default risk was virtually zero due to the huge cash down payment. As far as I was concerned this was a hold-to-maturity investment of a note that really had no trading market. If the new owner wanted to settle before the 20-year maturity date he had to pay me the amortized book value of the 12% note.

    It might have been possible for me to enter into a customized vanilla interest rate swap so that I could get a variable interest return on the swap contract. But interim changes in that derivative swap contract does not affect the notional. The changes value of the swap contract would be a speculation value change to be reported as earnings as FAS 133. But my mortgage note would still be held-to-maturity contract best valued at historical cost amortized value.

    More importantly, if the buyer of my cottage defaulted on the original note it would not matter to either party on the swap contract because the banks that negotiate such customized swaps guarantee the net swap payments but not the underlying notionals. If the buyer of my cottage defaulted on the original note, I would've commenced foreclosure proceedings. The last thing the buyer or his heirs would want is to lose over 50% of the equity in that shore property. The risk of default was virtually zero.

    Interestingly, I could use a Bloomberg terminal to estimate the interim changes in value of a swap contract ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

    But the value of the mortgage note was its amortized cost that did not vary since there was no market for such paper. If the buyer of the cottage wanted to refinance due to lower interest rates he had to first pay off the entire book value of his debt to me. That payoff value, unlike the swap contract, was not subject to market fluctuations. Reporting changes in the note's value due to changing interest rates would be pure fiction.

    The buyer actually did pay off the note at book value about twelve years later. Since interest rates had fallen so much I was surprised he waited that long. His problem was that commercial lenders would still not make loans on rural shore property.


    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

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue

     

     


    The Latest from the AECM's Denny Beresford:  Are interim fair value adjustments “accounting fictions” HTM investments?
    "Money market fund investments are often held to maturity and any discount or premium in the purchase price is realized by the fund."

    "Ex-FASB Chair: Accounting Rules Support Money Funds’ Stable Value," by Emily Chason, CFO Journal, November 1, 2012
    http://blogs.wsj.com/cfo/2012/11/01/ex-fasb-chair-accounting-rules-support-money-funds-stable-value/?mod=wsjpro_hps_cforeport

    While U.S. regulators are debating forcing money market funds to let their share values float, former Financial Accounting Standards Board Chairman Dennis Beresford defended the use of accounting standards that allow money funds to maintain their stable $1-per-share value.

    In a paper released Thursday by the U.S. Chamber of Commerce’s Center for Capital Markets, Beresford said the amortized cost accounting used for money market funds is not a gimmick that gives a false sense of security for the funds, but rather an efficient way to minimize differences between the carrying value and fair value of their investments.

    "Amortized Cost Accounting is “Fair” for Money Market Funds," U.S. Chamber of Commerce Center for Capital Markets Competitiveness, Fall 2012
    http://www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/Money-Market-Funds_FINAL.layout.pdf

    Summary

    Recent events have caused the U.S. Securities and Exchange Commission (SEC) to rethink the long-standing use of amortized cost by money market mutual funds in valuing their investments in securities. This practice supports the use of the stable net asset value (a “buck” a share) in trading shares in such funds. Some critics have challenged this accounting practice, arguing that it somehow misleads investors by obfuscating changes in value or implicitly guaranteeing a stable share price.

    This paper shows that the use of amortized cost by money market mutual funds is supported by more than 30 years of regulatory and accounting standard-setting consideration. In addition, its use has been significantly constrained through recent SEC actions that further ensure its appropriate use. Accounting standard setters have accepted this treatment as being in compliance with generally accepted accounting principles (GAAP). Finally, available data indicate that amortized cost does not differ materially from market value for investments industry wide. In short, amortized cost is “fair” for money market funds.

    Background

    Money market mutual funds have been in the news a great deal recently as the SEC first scheduled and then postponed a much-anticipated late August vote to consider further tightening regulations on the industry.1 Earlier, Chairman Mary Schapiro had testified to Congress about her intention to strengthen the SEC regulation of such funds, in light of issues arising during the financial crisis of 2008 when one prominent fund “broke the buck,” resulting in modest losses to its investors. Sponsors of some other funds have sometimes provided financial support to maintain stable net asset values. And certain funds recently experienced heavy redemptions due to the downgrade of the U.S. Treasury’s credit rating and the European banking crisis.

    Money market funds historically have priced their shares at $1, a practice that facilitates their widespread use by corporate treasurers, municipalities, individuals, and many others who seek the convenience of low-risk, highly liquid investments. This $1 per share pricing convention also conforms to the funds’ accounting for their investments in short-term debt securities using amortized cost. This method means that, in the absence of an event jeopardizing the fund’s repayment expectation with respect to any investment, the value at which these funds carry their investments is the amount paid (cost) for the investments, which may include a discount or premium to the face amount of the security. Any discount or premium is recorded (amortized) as an adjustment of yield over the life of the security, such that amortized cost equals the principal value at maturity.

    Some commentators have criticized the use of this amortized cost methodology and argued for its elimination. In a telling example of the passionate but inaccurate attention being devoted to this issue, an editorial in the June 10, 2012, Wall Street Journal described this longstanding financial practice in a heavily regulated industry as an “accounting fiction” and an “accounting gimmick.”

    . . .

    Reasoning for Use of Amortized Cost

    The FASB has been considering various aspects of the accounting for financial instruments for approximately 25 years. During that time it has issued standards on topics such as accounting for marketable securities, accounting for derivative instruments and hedging, impairment, disclosure, and others. Also, the FASB has issued standards or endorsed standards issued by the AICPA of a specialized nature applying to certain industry groups such as investment companies, insurance companies, broker/dealers, and banks. Further, the FASB is presently involved in a major project that has encompassed approximately the past 10 years, whereby it is endeavoring to conform its standards on financial instruments to the related standards issued by the International Accounting Standards Board. Aspects of that project have stalled recently, and the two boards have reached different conclusions on certain key issues. Other aspects of that project are moving forward.

    Over this 25-year period, probably the most controversial aspect of the financial instruments project has been to what extent those instruments should be carried at market or fair value in financial statements rather than historical cost. On several occasions the FASB has indicated a strong preference for fair value as a general objective. But there has been a great deal of opposition from many quarters, and the FASB has tended to determine the appropriate measurement attribute for particular instruments (fair value, amortized cost, etc.) in different projects based on the facts and circumstances in each case.

    . . . (very long passages from this 21-page article are not quoted here)

    Conclusion

    Accounting for investment securities by money market mutual funds appropriately remains based on amortized cost. The amortized cost method of accounting is supported by the very short-term duration, high quality, and hold-to-maturity nature of most of the investments held. The SEC’s 2010 rule changes have considerably strengthened the conditions under which these policies are being applied. As a result of the 2010 SEC rule changes, funds now report the market value of each investment in a monthly schedule submitted to the SEC that is then made publicly available after 60 days. That provides additional information for investors. And the FASB’s current thinking articulates this accounting treatment as GAAP.

     

    Jensen Comment
    My main objection to booking fair values of HTM investments is that the interim adjustments for fair values that will never be realized destroys the income statement. Of course, the FASB and IASB have systematically destroyed the concept of net earnings in many other standards to a point where these standard setters can no longer even define net earnings.

    Research Studies from the Chamber's Center for Capital Markets ---
    http://www.centerforcapitalmarkets.com/resources/publications/


    Hi Tom,

    Yes I think measuring earnings should be of primary index for all companies, because a good measure of earnings with realistic bad debt estimates may be a more important indicator of failures to come. Much of the S&L crisis was caused by phony real estate fair value estimates and speculation coupled with phony bad debt estimates. . I think the S&L crisis is a very poor basis for promoting fair value accounting --- it's the phony real estate fair value measurements that got us into trouble.


    Recall that I'm also recommending a side-by-side dual column model for presenting fair values. Analysts have a choice, which is why I like the  Harold Shroeder comment letter that I actually find commendable --- Click Here
    http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175821399483&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs 
    I liked this letter and thank you for pointing it out to me. I could've really used this letter in my accounting theory course.


    The importance of net income is illustrated somewhat in the Roaring 1990s tech bubble where companies with big losses were trying to inflate stock prices in every which way when reported losses were among the best predictors of their ultimate demise.


    In any case I am not talking about choosing one optimal reporting model. The fair value model should be shown alongside the traditional model along with information model on the degree of attestation. It's not like we must choose one model and hide the other model. What's important is how reliable the numbers are in all of the presentation models.

    Respectfully,
    Bob Jensen


    New Fair Value Disclosures are Required Under ASU 2011-04

    From Ernst & Young ---
    http://www.ey.com/Publication/vwLUAssetsAL/FairValueDisclosures_BB2375_10July2012/$FILE/FairValueDisclosures_BB2375_10July2012.pdf

    In accordance with ASU 2011-04, public companies were required to provide several new fair value measurement disclosures in their quarterly filings for periods ended 31 March 2012. Ernst & Young reviewed the fair value disclosures provided by 60 public companies across various industries in order to gain insights into how companies adopted the new requirements. The results of our analysis are presented in our publication, The new fair value disclosures: A snapshot of how public companies adopted the requirements of ASU 2011-04, which is now available on AccountingLink.


    Jensen Comment
    The phrase "survival of the fittest" is rooted in Darwin's Theory of Evolution  and biologist Herbert Spencer ---
    http://en.wikipedia.org/wiki/Survival_of_the_fittest

    Accounting Survival of Historical Cost
    The phrase "survival of the fittest" is now used in many other contexts. For example, among all the accounting systems available to business firms and accounting standard setters, one defense of "Historical Cost Accounting" is that it survived for over six centuries of double entry bookkeeping amidst all the would-be pretenders to the throne. Of course many of the pretenders to the throne (notably economic, entry, and exit values) are valuation alternatives whereas historical cost really is not a "valuation" alternative that pretends to generate balance sheet "values.". Instead historical cost is more focused on the income statement than the balance sheet according to the  "Matching Principle" that attempts to allocate historical costs (possibly price-level adjusted) to the revenues that they helped to generate ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#AccountingHistory
    Search for "Paton and Littleton".

    Of course AC Littleton turned over in his grave countless times as accounting standard setters corrupted parts (but certainly not all) of his pure historical cost accounting that admittedly required some arbitrary measures such as depreciation allocations and inventory cost flow assumptions and (shudder) conservatism adjustments to historical costs. But the subjectivity and arbitrary nature of historical cost computations are minor relative to measuring the economic-value's future cash flows of 300+ Days Inn Hotels, the appraised yard sale (exit) values of 300+ Days Inns Hotels, or the depreciation-adjusted current replacement (entry) values of 300+ Days Inn Hotels ---
    See illustrations below!

     

    A Book Review of "Darwin's Ghosts:  The Secret History of Evolution" by Rebecca Scott
    "How the Fittest Theory Survived:  In "Darwin's Ghosts,' Rebecca Stott traces the work of the many scholars, philosophers and scientists whose insights into nature and its laws culminated in 'Origin of Species.',"by Laura J. Snyder, The Wall Street Journal, July 4, 2012 ---
    http://professional.wsj.com/article/SB10001424052702303703004577476800626591224.html?mod=djemEditorialPage_t&mg=reno64-wsj

    In December 1859, a month after he published "Origin of Species," Charles Darwin was eagerly awaiting the verdict of its reviewers. He feared his book would meet the fate of an earlier anonymous work promoting evolution, "Vestiges of the Natural History of Creation," which had received the geologist Adam Sedgwick's most damning insult: It seemed to have been written with "the science gleaned at a lady's boarding-school."

    Darwin had not anticipated another type of criticism. In an otherwise complimentary letter, the Rev. Baden Powell, a mathematician and the father of the founder of the Scouting movement, Robert Baden-Powell, chastised Darwin for not giving sufficient credit to those who had proposed evolutionary theories before him.

    As Rebecca Stott recounts in "Darwin's Ghosts: The Secret History of Evolution," Darwin reacted by drawing up a brief discussion of those who had preceded him. This "Historical Sketch" ultimately included 36 names and was added as a preface to later editions of "Origin." The conceit of Ms. Stott's project is that men she considers Darwin's predecessors—including a number not included in his "Historical Sketch"—were his "ghosts."

    Ms. Stott describes the lives and work of these ghosts of Darwin: the Greek philosopher Aristotle, the ninth-century Arab scholar Al-Jahiz, the 15th-century artist-scientist Leonardo da Vinci, the 16th-century potter Bernard Palissy and, in the 18th century, the microscopist Abraham Trembley, the French natural historian Benoît de Maillet and the philosophe Denis Diderot. These chapters—focusing on men not part of the standard histories of evolutionary theory—are followed by chapters discussing evolution's "usual suspects": Erasmus Darwin, Jean-Baptiste Lamarck, Robert Grant, Robert Chambers and Alfred Russel Wallace.

    In telling the stories of these men, Ms. Stott—who is also a novelist—writes with a novelist's flair. Here we are with Aristotle peering at the fish in the waters around the island of Lesbos and with Al-Jahiz lighting fires on riverbanks, in courtyards and in forests, watching the variety of insects that approach the fire at each location. We listen in on Leonardo's musings about the "petrifications" brought to him by peasants: "rocks with strange markings and shapes, flecked with oyster shells and corals." We watch Palissy making his own "fossils" by entombing live creatures in plaster, which he used in grotto he was building for Catherine de' Médici; Trembley discovering that the sea polyp regenerates its amputated body parts; and Grant dissecting sea sponges at water's edge.

    Ms. Stott brings Darwin himself to life in a way consistent with what we know about him through his letters and notebooks: He comes off as an inquisitive, thoughtful and conscience-haunted man. Yet one sometimes wonders how Ms. Stott can be certain about what is going on in the mind of her subjects. "Conversations with Powell opened up in Darwin's head again and again, sometimes angry, sometimes defensive or apologetic. Christmas was no time to be defending one's reputation, he told himself."

    The case is more troubling when we are dealing with figures about whom less is known, like Aristotle. Although in his "History of Animals" he writes that "around Lesbos the fish of the outer sea or of the lagoon bring forth their eggs or young in the lagoon," we do not know exactly in what manner Aristotle made the piscine observations that Ms. Stott describes in so much detail.

    More egregious for the book's conceit is that, as Ms. Stott notes, Aristotle rejected the idea of evolution; he believed species are fixed, eternally unchanging. Ms. Stott points out that Darwin added Aristotle to his "Historical Sketch" in error, being led astray by an admirer of the Greek philosopher who had misread a passage in his works. Others whom Ms. Stott considers Darwin's ghosts—including Al-Jahiz, Leonardo and Trembley—were also strongly opposed to species evolution. Ms. Stott justifies their inclusion by explaining that these men were interested in issues that would later attract Darwin's attention, such as "adaptation"—the fact that species appear to be so well suited to their environments, like the duck, an aquatic bird, which has webbed feet that help it swim.

    That organisms are fitted to their environments, however, has long been used as evidence against evolution as well as for it. In Darwin's time, opponents of evolution saw instances of adaptation as signs of God's divine plan. At Cambridge University, Darwin read the works of William Paley, who argued that the physical world was like a watch: Both are so complex and well-ordered that they could not have come to be randomly but only through the work of an intelligent designer. Some of Ms. Stott's subjects are ghosts of Paley as much as ghosts of Darwin.

    The real story that Ms. Stott tells here is not the "secret" history of evolution but a larger, more fundamental history: the rise of an empirical, evidence-based approach to studying nature. As Ms. Stott notes of Leonardo: "In all his descriptions, he repeated the phrase 'I myself have seen it' again and again, invoking the Aristotelian imperative he lived by: never trust a fact unless you have seen it with your own eyes." Ms. Stott's "ghosts" spent their lives collecting facts about nature—"mountains of facts," as she says of French natural historian Benoît de Maillet—in order to gain insight into nature's laws.

    From Aristotle to the great inductive philosopher Francis Bacon in the 17th century and on to William Whewell and John Herschel, the 19th-century writers who were such great influences on Darwin, a vision of science arose that privileged observation and experiment over axiomatic deduction or wild speculation. Darwin spent more than 20 years collecting his own mountain of facts, worrying up to the eve of publication that "Origin of Species" would be seen as insufficiently supported by empirical evidence. Darwin and the "ghosts" so richly described in Ms. Stott's enjoyable book are the descendants of Aristotle and Bacon and the ancestors of today's scientists.

    Ms. Snyder is the author, most recently, of "The Philosophical Breakfast Club."

    Accounting History in a Nutshell ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#AccountingHistory 

    Underlying Bases of Balance Sheet Valuation ---
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting


    A Curious Case of Negative Goodwill
    "NEED PROFIT? BUY SOMETHING!" by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/733

    We first voiced our concern about an obscure accounting rule that allows companies to “create” profits when purchasing other businesses in the “Curious Case of Miller Energy’s 10-K and Its Huge Bargain Purchase.” The offending tenet relates to the treatment of something called “negative goodwill” which purportedly is created when a company makes an acquisition, and pays less than what the assets are worth. This fantastic “bargain purchase” creates a negative goodwill anomaly because the acquirer supposedly gets more assets than it pays for, as in this example:

    Continued in article

    Jensen Comment
    Yet another illustration of how the FASB and IASB made a black hole out of bottom-line earnings.

    Bob Jensen's threads on the radical new changes on the way ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay


    Hi Pat,

    Thank you for the elaboration, and I agree with your dislike for the mess we are now in with respect to revaluation practices. It certainly would complicate matters if Days Inns should revalue all its hotels versus having Holiday Inn decide to keep future earnings higher by not revaluing its hotels.

    I've not had a whole lot to say about revaluation of investment properties since these are sort of in the gray zone between operating items and financial instruments.

    I do get worried about auditors attesting to valuations of non-fungible items where they really do not have an expertise. The enormous problem with non-fungible items is the Peoria versus Tallahassee problem described below.

    In 1990 audit firms did not have an expertise when it came to valuing derivatives such as interest rate swaps. In the earlier years of FAS 133 they outsourced to banks for valuation of these contracts, but in time I suspect that auditors increasingly came to question those outsourced valuations and/or had difficulty certifying outsourced numbers that the auditors themselves could not verify.

    As a result by the turn of the Century, big audit firms commenced to have an internal expertise in valuing derivative financial instruments. For example, for interest rate swaps they all subscribed to Bloomberg Terminals and now derive their own swaps curves and other yield curves ---
    http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

    But gaining an expertise in valuing financial instruments is a whole lot easier for audit firms than gaining an expertise in appraising real estate and other non-fungible assets and liabilities. For example, in 1985 each of Days Inns 300+ hotels was a highly unique asset for which it takes local expertise to appraise the value of a Peoria Days Inn on one Interstate exit versus Tallahassee Days in on another Interstate exit.

    There's no Bloomberg Terminal for hotel yield curves to cover all geographic locations in the U.S. or the world. To appraise real estate in Tallahassee at a minimum you have to really, really understand the local Tallahassee real estate market. The same goes for Peoria where factors affecting real estate value may be significantly different than in Tallahassee.

    Thus, I think that when it comes to certifying exit values of hundreds of hotels, audit firms are totally dependent upon outsourcing to a profession (real estate appraisers) with a lousy reputation for professionalism.


    Respectfully,
    Bob Jensen


    Some Thoughts on Fair Value Accounting

    Our recent AECM regarding why accounting standard setters require mark-to-market (fair value) adjustments of marketable securities (except for HTM securities) and do not generally allow mark-to-market adjustments to inventories (except for precious metals and LCM downward adjustments for permanent impairments).

    Fungible --- http://en.wikipedia.org/wiki/Fungible
    I think this "inconsistency" in the accounting standards hinges on the concept of fungible. Marketable securities are generally fungible. A General Motors share of stock NYC is identical to other GM shares in Bavaria versus Hong Kong versus Sugar Hill, New Hampshire. One advantage of fair value accounting for marketable securities is that these securities are fungible until they become unique such as when companies go bankrupt.

    The classic example for fungible inventories that I always used in class is the difference between new cars in a dealer's lot and used cars in that same lot is that new cars are fungible (there are thousands or tens of thousands in the world exactly like that new car) and used cars are not fungible. There is no other car in the world exactly like any of the used cars in a dealer's parking lot. We have Blue Book pricing of used cars of every make and model, but these are only suggested prices before serious negotiations between buyers and a seller of used models with varying mileage, accident histories, flooding histories such as being trapped while being parked in flood waters, new parts installed such as a new engine or new transmission, etc.

    My point here is that it's almost impossible to accurately value a used car until a buyer and seller have negotiated a purchase price. And the variation from Blue Book suggested prices can be quite material in amount. Thus we can value General Motors common shares before we have a buyer, but we can't value any used car before we have a buyer.

    I used to naively claim that this was not the case of new cars because they were fungible like General Motors common shares. But on second thought I was wrong. New cars are not fungible items. Consider the case of a particular BMW selling for $48,963 in Munich. The same car will sell for varying prices in NYC versus Hong Kong versus Sugar Hill, NH. This variation is due largely to delivery cost differentials.

    Now consider the Car A and Car B BMW models that are exactly alike (including color) in a Chicago dealership lot. After three months, a buyer and the dealer agree on a $67.585 price for Car A. Car B sits in the lot for over 11 months before a buyer and the dealer agree on a price of $58,276. This discount is prompted mostly by the fact that the new models are out making Car B seem like its a year old even though it odometer has less than two miles.

    My point here is that until a dealer finds a buyer for either a new car or a used car, we really don't know what the inventory fair value is for those non-fungible items. Similarly the same grade and quality of corn in Minneapolis has a different price than identical corn in Chicago. Corn and other commodities like oil are not really fungible for inventory valuation purposes.

    There are numerous examples of where inventory product values really can't be known until a sales transaction takes place. We can fairly accurately estimate the replacement costs of some of the new items for sale although FAS 33 found that the cost of generally doing so accurately for inventory valuation purposes probably exceeds the value of such replacement cost adjustments at each financial reporting date.

    There's great moral hazards in allowing owners of non-fungible inventories to estimate fair values before sales transactions actually take place. Creative accounting would be increasingly serious if accounting standards allowed fair value accounting for non-fungible items that vary in value depending upon the buyer and the time and place of sales negotiations.

    Thus we can explain to our students that the reason we report marketable securities at fair value and inventories at transaction or production historical costs is that marketable securities are fungibles and most inventories are not fungible. The main reason is that estimating the value of truly fungible marketable securities is feasible before we have a sales transaction whereas the value of so many non-fungible (unique) items is not known until we have a sales transaction at a unique time and place.


    Fair Value Re-measurement Problems in a Nutshell:  (1) Covariances and (2) Hypothetical Transactions and (3) Estimation Cost
    It's All Phantasmagoric Accounting in Terms of Value in Use

     

    In an excellent plenary session presentation in Anaheim on August 5, 2008 Zoe-Vanna Palmrose mentioned how advocates of fair value accounting for both financial and non-financial assets and liabilities should heed the cautions of George O. May about how fair value accounting contributed to the great stock market crash of 1929 and the ensuing Great Depression. Afterwards Don Edwards and I lamented that accounting doctoral students and younger accounting faculty today have little interest in and knowledge of accounting history and the great accounting scholars of the past like George O. May --- http://en.wikipedia.org/wiki/George_O._May
    Don mentioned how the works of George O. May should be revisited in light of the present movement by standard setters to shift from historical cost allocation accounting to fair value re-measurement (some say fantasy land or phantasmagoric) accounting --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue
    The point is that if fair value re-measurement is required in the main financial statements, the impact upon investors and the economy is not neutral. It may be very real like it was in the Roaring 1920s.

    In the 21st Century, accounting standard setters such as the FASB in the U.S. and the IASB internationally are dead set on replacing traditional historical cost accounting for both financial (e.g., stocks and bonds) and non-financial (e.g., patents, goodwill, real estate, vehicles, and equipment) with fair values. Whereas historical costs are transactions based and additive across all assets and liabilities, fair value adjustments are not transactions based, are almost impossible to estimate, and are not likely to be additive.

    If Asset A is purchased for $100 and Asset B is purchased for $200 and have depreciated book values of $50 and $80 on a given date, the book values may be added to a sum of $130. This is a basis adjusted cost allocation valuation that has well-known limitations in terms of information needed for investment and operating decisions.

    If Asset A now has an exit (disposal) value of $20 and Asset B has an exit value of $90, the exit values can be added to a sum of $110 that has meaning only if each asset will be liquidated piecemeal. Exit value accounting is required for personal estates and for companies deemed by auditors to be non-going concerns that are likely to be liquidated piecemeal after debts are paid off.

    But accounting standard setters are moving toward standards that suggest that neither historical cost valuation nor exit value re-measurement are acceptable for going concerns such as viable and growing companies. Historical cost valuation is in reality a cost allocation process that provides misleading surrogates for "value in use." Exit values violate rules that re-measured fair values should be estimated in terms of the "best possible use" of the items in question. Exit values are generally the "worst possible uses" of the items in a going concern. For example, a printing press having a book value of $1 million and an exit value of $100,000 are likely to both differ greatly from "value in use."

    The "value in use" theoretically is the present value of all discounted cash flows attributed to the printing press. But this entails wild estimates of future cash flows, discount rates, and terminal salvage values that no two valuation experts are likely to agree upon. Furthermore, it is generally impossible to isolate the future cash flows of a printing press from the interactive cash flows of other assets such as a company's copyrights, patents, human capital, and goodwill.

    What standard setters really want is remeasurement of assets and liabilities in terms of "value in use." Suppose that on a given date the "value in use" is estimated as $180 for Asset A and $300 for Asset B. The problem is that we cannot ipso facto add these two values to $480 for a combined "value in use" of Asset A plus Asset B. Dangling off in phantasmagoria fantasy land is the covariance of the values in use:

    Value in Use of Assets A+B = $180 + $300 + Covariance of Assets A and B

    For example is Asset A is a high speed printing press and Asset B is a high speed envelope stuffing machine, the covariance term may be very high when computing value in use in a firm that advertises by mailing out a thousands of letters per day. Without both machines operating simultaneously, the value in use of any one machine is greatly reduced.

    I once observed high speed printing presses and envelope stuffing machines in action in Reverend Billy Graham's "factory" in Minneapolis. Suppose to printing presses and envelope stuffing machines we add other assets such as the value of the Billy Graham name/logo that might be termed Asset C. Now we have a more complicated covariance system:

    Value in Use of Assets A+B+C = (Values of A+B+C) + (Higher Order Covariances of A+B+C)

    And when hundreds of assets and liabilities are combined, the two-variate, three-variate, and n-variate higher order covariances for combined ""value in use" becomes truly phantasmagoric accounting. Any simplistic surrogate such as those suggested in the FAS 157 framework are absurdly simplistic and misleading as estimates of the values of Assets A, B, C, D, etc.

    Furthermore, if the "value of the firm" is somehow estimated, it is virtually impossible to disaggregate that value down to "values in use" of the various component assets and liabilities that are not truly independent of one another in a going concern. Financial analysts are interested in operations details and components of value and would be disappointed if all that a firm reported is a single estimate of its total value every quarter.

    Of course there are exceptions where a given asset or liability is independent of other assets and liabilities. Covariances in such instances are zero. For example, passive investments in financial assets generally can be estimated at exit values in the spirit of FAS 157. An investment in 1,000 shares of Microsoft Corporation is independent of ownership of 5,000 shares of Exxon. A strong case can be made for exit value accounting of these passive investments. Similarly a strong case can be made for exit value accounting of such derivative financial instruments as interest rate swaps and forward contracts since the historical cost in most instances is zero at the inception of many derivative contracts.

    The problem with fair value re-measurement of passive investments in financial assets lies in the computation of earnings in relation to cash flows. If the value of 1,000 shares of Microsoft decreases by -$40,000 and the value of 5000 shares of Exxon increases by +$140,000, the combined change in earnings is $100,000 assuming zero covariance. But if the Microsoft shares were sold and and the Exxon shares were held, we've combined a realized loss with an unrealized gain as if they were equivalents. This gives rise to the "hypothetical transaction" problem of fair value re-measurements. If the Exxon shares are held for a very long time, fair value accounting may give rise to years and years of "fiction" in terms of variations in value that are never realized. Companies hate earnings volatility caused by fair value "fictions" that are never realized in cash over decades of time.

    Now consider real estate fair value re-measurement:

    Levels of "Value" of an Entire Company

    General Theory

    Days Inns of America
    (As Reported September 30, 1987)

    Market Value of the Entire Block of Common Shares at Today's Price Per Share
    (Ignoring Blockage Factors)

    Not Available 
    Day Inns of America
    Was Privately Owned

    Exit Value of Firm if Sold As a Firm
    (Includes synergy factors and unbooked intangibles)

    Not Available for
    Days Inns of America

    Sum of Exit Values of Booked Assets Minus Liabilities & Pref. Stock
    (includes unbooked and unrealized gains and losses)

    $194,812,000 
    as Reported by Days Inns

    Book Value of the Firm as Reported in Financial Statements 

    $87,356,000 as Reported

    Book Value of the Firm as Reported in the Financial Statements  After General Price Level Adjustments

    Not Available for Days Inns

     

    Neither $87,356,000 book value is the residual historical cost nor the $194,812,000 is a reliable estimate of "value in use" of the net assets of Days Inns in 1987. At that time Days Inns was very much a private and highly successful going concern contemplating an initial public offering (IPO). FAS 157 excludes $197,812,000 as an estimate of "value in use" since piecemeal liquidation of the hotels is most likely the "worst possible use" of these hotels. Their values also have high covariance valuation components, especially the covariance of the real estate values with the goodwill value and human capital values of Days Inns. Furthermore, value in use of these properties will greatly change if the sign on each hotel is changed from Days Inn to Holiday Inn. The reason is that phantasmagoric summation of all the first order to n-th order covariance terms.

    Among the various reasons Days Inn never went to the trouble of having Landhauer Associates or any other real estate appraisal firm appraise the exit (sales) value of each of its hundreds of hotels is that the cost of getting these appraisals updated each year is prohibitive as well as being subject to huge margins of error. Days Inns went to considerable expense having its exit values appraised this one time in 1987 for purposes of improving the proceeds of an IPO. Obtaining these appraisals annually is far too costly for financial reporting purposes alone. Furthermore it is highly unlikely that these hotels will ever be sold piecemeal. If they will ever be sold, it is more likely that all the hotels or large subsets of these properties will be sold in block, and the block value is much different the sum of the appraisals of each property in the set. Value in use differs greatly from summations of piecemeal exit values

    It is useful to supplement historical cost allocation values with exit value estimates as well as other possible fair value estimates at a given point in time, but balance sheets summing component values as if no covariances exist is absurd except in the case of historical cost book values and passive financial investments and liabilities. Another problem is that realistic estimates of exit values of such things as the value of each of over 300 hotels is very costly to obtain on a periodic basis such as an annual basis. 

    April 3, 2009 message from Tom Selling [tom.selling@GROVESITE.COM]

    Bob,

    There are two sources of covariance that need to be dealt with: (1) covariances among assets recognized, and (2) covariances between recognized and non-recognized assets. I think replacement cost rules can easily cope with (1) without sacrificing additivity – i.e., that total assets on the balance sheet will represent the total minimum current cost of replacing the recognized assets of the business entity, assuming (for the moment) that there are no unrecognized assets. There may be issues of allocating the replacement cost among asset categories, but I don’t see that as a big problem, because everything adds up to the desired number.

    Since the nature of the assets we don’t recognize are very different in nature from the ones we recognize, I don’t see anything irrational (you may be able to enlighten me here) about having an expectation that the covariances of the second type, above, are 0. An expectation is different from a “declaration” or an “assumption.”

    I feel like a greased pig trying to escape your clutches! But unlike the pig, I’m learning a lot.

    Best,

    Tom

    April 4, 2009 reply from Bob Jensen

    Hi Tom,

    I agree with what you state about covariances of replacement cost estimates, but it is important to note that replacement cost accounting is really a cost allocation process rather than a valuation process for non-financial items subject to depreciation and amortization. Depreciation and amortization allocation formulas use such arbitrary estimates of economic lives, salvage values, and cost allocation patterns that it’s not clear why additive aggregation is any more meaningful under replacement cost aggregations than it is under historical cost aggregations. Neither one aggregates to anything we can meaningfully call value in use.

    Companies are no longer required to generate FAS 33-type comparisons.  The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for operations in hyperinflation nations.  Exit value accounting is required for firms deemed highly likely to become non-going concerns.  Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people).  Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities.  Exit value accounting is required for impaired items such as damaged inventories and inoperable machinery.

    Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting.  Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

    The FASB and the IASB state that "value in use" is the ideal valuation measure if it can be measured reliably at realistic estimation costs. Exit value and economic (discounted cash flow) generally do not meet these two criteria for value in use of non-financial items. There is nearly always no practical means of estimating higher order covariances. and additivity aggregations are meaningless without such covariances.  In the case of economic valuation, estimation of future cash flows and discount rates enters the realm of fantasy for long-lived items. Alsoreliable exit value estimation of some items like all the hotel properties of Days Inns can be very expensive, which is a major reason Days Inns only did it once for financial reporting purposes in 1987. Accordingly, "value in use" is an ideal which cannot be practically achieved under either exit or economic valuation methods.

    The FASB and the IASB state that "value in use" is the ideal valuation measure, but this ideal can never be achieved with cost allocation methods. Both historical cost and replacement (current, entry) value "valuation" methods are not really valuation methods at all. These are cost allocation methods that for items subject to depreciation or amortization in value are reliant upon usually arbitrary estimates of non-financial item useful lives, value decline assumptions such as straight line or double declining balance declines, and salvage value estimates. Under historical cost, the book value thus becomes an arbitrary residual of the rationing of original cost by arbitrary cost allocation formulas. Under replacement (current, entry) cost allocation the estimated current replacement costs are subjected to n arbitrary residual of the rationing of replacement cost by arbitrary cost allocation formulas.

    Although both historical and replacement cost allocations over time avoid covariance problems in additive aggregations of book values, the meanings of such aggregations are of very dubious utility to investors and other decision makers. For example suppose the $10 million 2008 book value of a fleet of passenger vans is added to the $200 million 2008 book value of Days Inn hotel properties, what does the $210 million aggregation mean to anybody?

    Both the passenger vans and hotel buildings have been subjected to arbitrary estimates of economic lives, salvage values, and depreciation patters such as double declining balance depreciation for vans and straight-line depreciation for hotel buildings. This is the case whether historical cost or current replacement costs have been allocated by depreciation formulas.

    Hence it is not clear that for going concern companies that have heavy investments in non-financial assets that any known addition of individual items makes any sense under economic, exit, entry, or historical cost book value estimation process. Aggregations might make some sense for financial items with negligible covariances, but for non-financial items. Attempts to estimate total value itself basted upon stock market marginal trades are misleading since marginal trades of a small proportion of shares ignores huge blockage factors valuations, especially blockage factors that carry managerial control along with the blockage purchase. Countless mergers and acquisitions repeatedly illustrate that estimations of total values of companies are generally subject to huge margins of error, especially when intangibles play an enormous part of the value of an enterprise.

    Both the FASB and the IASB require in many instances that exit value accounting be used for financial items. In part that is because for financial items it is often more reasonable to assume zero covariances among items. The recent banking failures caused by covariance among toxic mortgage investments lends some doubt to this assumption, but the issue of David Li’s faltering and infamous Gaussian copula function is being ignored by both the IASB and the FASB in recommending exit value accounting for many (most) financial items --- http://en.wikipedia.org/wiki/Gaussian_copula#Gaussian_copula
    For how the defect in this formula contributed to the 2008 fall of many banks see
    ---
    http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html 

    I might add that Bob Herz and the FASB as a whole recognize that additive aggregation in financial statement items is probably more misleading than helpful. This is why a very radical proposal is underway in the FASB to do away with aggregations, including the presentation of net income and earnings-per-share bottom liners --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay 

    The above link also discusses the vehement disagreement between Bob Herz and the financial community on the proposal to do away with the bottom line.

    This bottom line aggregation problem is also bound up in the “quality of earnings” controversy ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#CoreEarnings 
    However, the concept of reporting core earnings is not nearly as controversial as the proposal not to report any bottom lines.

    Bob Jensen's threads on fair value accounting are at various other links:

    Fair Value Accounting Controversies --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Return on Investment Theory --- http://faculty.trinity.edu/rjensen/roi.htm

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm


    "Is a fair value of fixed assets relevant?" by Asish K Bhattacharyya, Business Standard, July 23, 2012 ---
    http://www.business-standard.com/india/news/isfair-valuefixed-assets-relevant/481131/

    Companies provide financial information to shareholders and creditors through financial statements. Shareholders use the same to value the equity of the company and to evaluate the management in its stewardship function. Creditors, including lenders, use the same for evaluating credit risk. The objective is to provide financial information that is relevant in predicting the stream of cash flows, which the enterprise will generate in future. Information is relevant if it improves the estimate of amount, timing and risk of future cash flows. Accounting standard setters always balance relevance and reliability. Earlier the emphasis was on reliability. Now, it is shifted to relevance. International financial Reporting Standards (IFRS) uses fair value more extensively than the use of fair value in Indian accounting standards (AS) on the presumption that for certain assets and liabilities, the fair value attribute is more relevant than the historical cost. It might be interesting to examine whether those presumptions are logical. Let us examine the relevance of the information on the fair value of fixed asset.

    Enterprises use fixed assets to produce and sell products and services. They do not intend to realise cash by selling them.

    Items of fixed assets are initially measured at acquisition cost. As per AS, enterprises use the cost model to measure fixed assets for the purpose of presentation in the balance sheet. The initial acquisition cost is reduced by the accumulated depreciation and accumulated impairment loss. Impairment loss is recognised and the carrying amount of an item of fixed asset is reduced when the management estimates that the asset will not be able to recover its carrying amount either through use or sale.

    IFRS allows companies to choose either the cost model or the fair value model to measure items fixed assets. Fair value model can be used for measuring intangible assets only if an active market exists and it is expected that the same will continue to exist at the end of the useful life of the asset or some party has committed to buy the asset at the end of its useful life. Those conditions can be met rarely. IFRS does not allow cherry picking. A company has to decide once for all that whether it will use the fair value model for a particular class of asset (e.g. land). US GAAP mandates the use of the cost model and does not allow revaluation. AS mandates use of the cost model but allows revaluation of tangible assets. It does not allow cherry picking. Both the IFRS and AS require the company to recognise the revaluation gain outside the net profit.

    Analysts value enterprises based on the estimated free cash flow (FCF) stream that the enterprise will generate in future. FCF is the operating cash flow available for distribution to all the investors, including debt holders, after meeting internal demand for incremental investment in fixed assets and working capital. The market value of non-operating assets is added to the present value of FCF to estimate the enterprise value. Fair value of the operating assets is not relevant in valuing an enterprise.

    It may be argued that the fair value of fixed assets might be useful in evaluating the management in its stewardship function. For example, if the price of the land on which the factory is situated has gone up manifold and it benefits shareholders if the management unlocks the value of the land by shifting the factory to another site where the price of the land is much cheaper. Disclosure of the market value of land might trigger discussion among analysts and shareholders and they might solicit the management’s response. This argument might be valid. But if the market value is readily available every one shall have ready access to it. If market inputs are not available, the fair value will be much less reliable and shareholders and analysts will not attach any value to that information. Therefore, use of fair value in measuring fixed assets does not enhance relevance of the financial information even from this perspective.

    Continued in article

    Jensen Comment

    There are a number of issues for intense debate here.

    1. Booking versus Disclosure?
      There's a huge difference between booking fair values of operating assets versus merely disclosing them in a second column  --- as was done in the 1987 Days Inn annual report where only historical cost book values of 300+ hotels were audited by Price Waterhouse.

       
    2. Individual Items versus Subsets
      Secondly. what is an operating asset? Is it a single machine such as a farmer's tractor or is it the set of all the equipment on that farmer's farm. 

       
    3. Exit Value Versus Value in Use
      If a going concern is not even remotely considering selling off fixed assets piecemeal at exit values, then this is hardly a very useful type of accounting for except when such disposals are seriously being contemplated (such as in bankruptcy). Much more relevant is value-in-use that considers how those assets are being put to use in generating future profits. Here the analysis must shift from individual assets to subsets, because some operating assets individually may have almost no exit value even though they are crucial to the total operations of a company.

       
    4. The Inherent Problem of Unrealized Changes in Fair Value
      Consider a huge cattle spread in drought-ridden West Texas in August of 2012. Because he did not have sufficient water for hay and corn, the rancher has sold off his 4,000 herd of cows for 60 cents on the dollar. Real estate vultures will offer him 10 cents for every dollar of value that he paid for this land. The 40 cent loss of every dollar on his cows is a realized loss. But the 90 cents of every dollar fair value change in his land is unrealized. Should he mix the realized loss with the unrealized eps loss when reporting to investors and bankers?

      The other night I watched such a rancher being interviewed on ABC News. He had sold off his entire herd, but over the years he socked away millions to ride out droughts. He proudly proclaimed that he did not have to be plucked by vultures unless there is zero hope that West Texas will once again be viable for cattle ranching. In the latter case, even the vultures will not make him an offer since the chances for profits on a West Texas desert are virtually nil.

    Personally, I think eps and P/E ratios are nonsense if the don't break out the realized from the unrealized portions of earnings.

    Fortunately, I don't think there's a snowball's chance in hell that CPA auditors will commence attesting to fair value appraisals of operating assets, especially when 100 different "licensed" (ha ha) appraisers give 100 widely ranging estimates of fair value and another 100 ranging estimates of the fair values of subsets of those operating assets.

    It will be a sad day for annual financial reporting if and when we give companies big boxes of fair value crayons for their creative accounting coloring books.

    If and when the rancher should sell out to vultures is yet another matter that we, as armchair advisors, have not business recommending to the rancher. If his ranch, as he says, is more of a way of life to him than a business, this old guy's health will probably crash when he sells his beloved ranch to vultures.

    The Controversy Over Fair Value (Mark-to-Market) Financial Reporting
    Go to http://faculty.trinity.edu/rjensen/theory02.htm#FairValue
     

    Underlying Bases of Balance Sheet Valuation
    Go to http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting


    The Full List of NFL Team Valuations --- http://www.forbes.com/nfl-valuations/

    "Dallas Cowboys Lead NFL With $2.1 Billion Valuation," by Mike Ozanian, Forbes. September 5, 2012 ---
    http://www.forbes.com/sites/mikeozanian/2012/09/05/dallas-cowboys-lead-nfl-with-2-1-billion-valuation/

    The most famous quote attributed to legendary Green Bay Packers coach Vince Lombardi is “winning isn’t everything, it’s the only thing.” But if Lombardi had coached in this era instead of the 1960s he may have substituted the word “marketing” for “winning.”

    The Dallas Cowboys have not been to the Super Bowl in 16 years. But the lack of a title game appearance has done nothing to slow down the money that flows into the arms of Jerry Jones, the oilman who bought the National Football League team and lease to its stadium in 1989 for $150 million. The Cowboys are now worth $2.1 billion, more than any sports team on the planet, save Manchester United. And if the English soccer club, which recently sold shares to the public, stumbles, the Cowboys will run right past them because nobody in football can match Jones when it comes to marketing and squeezing cash from a stadium.

    Last season the Cowboys generated $500 million in total revenue, a record for an American sports team, and posted operating income (earnings before interest, taxes, depreciation and amortization) of $227 million, $108 million more than any other football team and more than either the entire National Basketball Association or National Hockey League. A prime example of what separates Dallas from the league’s other 31 teams is the more than $80 million in sponsorship revenue Cowboys Stadium rakes in from companies such as Ford Motor, Bank of America, PepsiCo, Dr. Pepper and Miller Brewing, almost $20 million more than any other football team. Sponsorship revenue, unlike the NFL’s national television fees with NBC, Fox, ESPN and CBS, are not shared equally with the other teams.

    Continued in article

    Jensen Comment
    I think it's more than just marketing. Another factor is location, Texas is a state where high schools will spend upwards of $60 million for a high school stadium and books and television shows like Friday Night Lights are written ---
    http://www.nbc.com/friday-night-lights/

    It also helps to be in a location where fans do not have to sit outdoors in below-zero weather and raging blizzards.

    Bob Jensen's threads on valuation ---
    http://faculty.trinity.edu/rjensen/roi.htm


    European-Styled Avoidance of Fair Value Earnings Hits for Loan Loss Impairments

    European banks circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

    European banks resorted to a number of misleading ploys to avoid taking fair value adjustment hits to prevent earnings hits due to required fair value adjustments of investments that crashed such a investments in the bonds of Greece, Ireland, Spain, and Portugal.

    The Market Transitory Movements Argument
    Fair value adjustments can be avoided if they are viewed as temporary transitory market fluctuations expected to recover rather quickly. This argument was used inappropriately by European banks hold billions in the Greece, Ireland, Spain, and Portugal after the price declines could hardly be viewed as transitory. The head of the IASB at the time, David Tweedie, strongly objected to the failure to write down financial instruments to fair value. The banks, in turn, threatened to pressure the EU lawmakers to override the IFRS 9 requirement to adjust such value declines to market.

    One of the major concerns of the  is that some nations at some points in time will simply not enforce the IASB standards that these nations adopted. The biggest problem that the IASB was having with European Banks is that the IASB felt many of many (actually most) EU banks were not conforming to standards for marking financial instruments to market (fair value). But the IASB was really helpless in appealing to IFRS enforcement in this regard.

    When the realities of European bank political powers, the IASB quickly caved in as follows with a ploy that allowed European banks to lie about intent to hold to maturity. The banks would probably love to unload those loser bonds as quickly as possible before default, but they could instead claim that these investments were intended to be held to maturity --- a game of make pretend that the IASB went along with under the political circumstances.

    "New accounting rule would ease Greek pain: IASB," By Silke Koltrowitz and Huw Jones,  Reuters, July 5, 2011 ---
    http://www.reuters.com/article/2011/07/05/us-accounting-idUSTRE7643WU20110705

    European Union banks would have more breathing space from losses on Greek bonds if the bloc adopted a new international accounting rule, a top standard setter said on Tuesday.

    The International Accounting Standards Board (IASB) agreed under intense pressure during the financial crisis to soften a rule that requires banks to price traded assets at fair value or the going market rate.

    This led to huge writedowns, sparking fire sales to plug holes in regulatory capital.

    The new IFRS 9 rule would allow banks to price assets at cost if they are being held over time.

    The European Commission has yet to sign off on the new rule for it to be effective in the 27-nation bloc, saying it wants to see remaining parts of the rule finalized first.

    Continued in article

     

    Dynamic Provisioning:  The Cookie Jar Argument If Banks Had Cookies in the Jar
    European Union officials knew this and let Spain proceed with its own brand of accounting anyway.
    "The EU Smiled While Spain’s Banks Cooked the Books," by Jonathan Weil, Bloomberg, June 14, 2012 ---
    http://www.bloomberg.com/news/2012-06-14/the-eu-smiled-while-spain-s-banks-cooked-the-books.html

    Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

    But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

    By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

    This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

    What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia (BKIA) group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

    Name Calling

    Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

    “Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”

    The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

    One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

    “They didn’t implement IFRS, and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS,” McCreevy said, according to a transcript of the meeting on the monitoring board’s website. “The Spanish regulator did not do that, and he survived this. His banks have survived this crisis better than anybody else to date.”

    Ignoring Rules

    McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, went on: “The rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them.”

    Why didn’t he take action? McCreevy said he was a fan of dynamic provisioning. “Why am I like that? Well, I’m old enough to remember when I was a young student that in my country that I know best, banks weren’t allowed to publish their results in detail,” he said. “Why? Because we felt if everybody saw the reserves, etc., it would create maybe a run on the banks.”

    So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

    Continued in article

    "Accounting Board Criticizes European Banks on Greek Debt," REUTERS, August 30, 2011 ---
    http://www.nytimes.com/2011/08/31/business/global/accounting-board-criticizes-european-banks-on-greek-debt.html 

    Some European financial institutions should have booked bigger losses on their Greek government bond holdings in recent results announcements, the International Accounting Standards Board said in a letter to market regulators.

    The criticism comes as Europe’s lenders face calls to shore up their balance sheets and restore confidence to investors unnerved by the euro zone debt crisis, funding market jitters and a slowing economy.

    In a letter addressed to the European Securities and Markets Authority, the I.A.S.B. — which aims to become the global benchmark for financial reporting — criticized inconsistencies in the way banks and insurers wrote down the value of their Greek sovereign debt in second-quarter earnings.

    It said “some companies” were not using market prices to calculate the fair value of their Greek bond holdings, relying instead on internal models. While some claimed this was because the market for Greek debt had become illiquid, the I.A.S.B. disagreed.

    “Although the level of trading activity in Greek government bonds has decreased, transactions are still taking place,” the board chairman Hans Hoogervorst wrote.

    The E.S.M.A. was not immediately available for comment.

    The letter, which was posted on the I.A.S.B.’s website Tuesday after being leaked to the press, did not single out particular countries or banks.

    European banks taking a €3 billion, or $4.2 billion, hit on their Greek bond holdings earlier this month employed markedly different approaches to valuing the debt.

    The writedowns disclosed in their quarterly results varied from 21 to 50 percent, showing a wide range of views on what they expect to get back from their holdings.

    A 21 percent hit refers to the “haircut” on banking sector involvement in a planned second bailout of Greece now being finalized. A 50 percent loss represented the discount markets were expecting at the end of June, the cut-off period for second-quarter results.

    Two French financial companies, the bank BNP Paribas and insurer CNP Assurances, on Tuesday defended their decision to use their own valuation models rather than market prices.

    “BNP took provisions against its Greece exposure in full agreement with its auditors and the relevant authorities, in accordance with the plan decided upon by the European Union on July 21,” a bank spokeswoman said.

    A CNP spokeswoman said the group’s Greek debt provisions had been calculated in accordance with the E.U. plan and in agreement with its auditors.

    Some investors see the issue as serious, however, even if the STOXX Europe 600 bank index was trading higher on Tuesday.

    “The Greek debt issue has been treated very lightly,” said Jacques Chahine, head of Luxembourg-based J. Chahine Capital, which manages €320 billion in assets. “And it’s not just Greek debt — all of it needs to be written down, Spain, Italy.”

    The E.S.M.A. was unable to impose a uniform Greek “haircut” across the E.U. and its guidance published at the end of July simply stressed the need for banks to tell investors clearly how they reflect Greek debt values.

    The I.A.S.B. also has no powers of enforcement in how banks book impairments but is keen to show the United States, which decides this year whether to adopt I.A.S.B. standards, that its rules are consistent and properly represent what’s happening in markets.

    Auditors warned at the time against a patchwork approach that will confuse investors and concerns over Greek haircut reporting will fuel calls for a pan-Europe auditor regulator.

    “The impact is more likely to be to further reduce investors’ confidence in buying bank debt, rather than sovereign debt,” said Tamara Burnell, head of financial institutions/sovereign research at M&G.

    Using the most aggressive markdown approach — namely marking to market all Greek sovereign holdings — would saddle 19 of the most exposed European banks with another €6.6 billion in potential writedowns, according to Citi analysts.

    BNP would take the biggest hit with €2.1 billion in remaining writedowns, followed by Dexia in Belgium with €1.9 billion and Commerzbank in Germany with €959 million, Citi said.

    The European Commission said on Monday that there was no need to recapitalize the banks over and above what had been agreed after a recent annual stress test .

     

    Spinning Debt Into Earnings With the Wave of a Fair Value Accounting Wand
    "Euro banks' £169bn in accounting alchemy," by: Lindsey White, Financial Times Advisor, January 19, 2009 --- Click Here

    European banks conjured more than £169bn of debt into profit on their balance sheets in the third quarter of 2008, a leaked report shows.

    Money Managementhas gained exclusive access to a report from JP Morgan, surveying 43 western European banks.

    It shows an exact breakdown of which banks increased their asset values simply by reclassifying their holdings.

    Germany is Europe's largest economy, and was the first European nation to announce that it was in recession in 2008. Based on an exchange rate of 1 Euro to £0.89, its two largest banks, Deutsche Bank and Commerzbank, reclassified £22.2bn and £39bn respectively.

    At the same exchange rate, several major UK banks also made the switch. RBS reclassified £27.1bn of assets, HBOS reclassified £13.7bn, HSBC reclassified £7.6bn and Lloyds TSB changed £3.2bn. A number of Nordic and Italian banks also switched debts to become profits.

    Banks are allowed to rearrange these staggering debts thanks to an October 2008 amendment to an International Accounting Standards law, IAS 39. Speaking to MM, IAS board member Philippe Danjou said that the amendment was passed in "record time".

    The board received special permission to bypass traditional due process, ushering through the amendment in a matter of days, in order to allow banks to apply the changes to their third quarter reports.

    However, it is unclear how much choice the board actually had in the matter.

    IASB chairman Sir David Tweedie was outspoken in his opposition to the change, publicly admitting that he nearly resigned as a result of pressure from European politicians to change the rules.

    Danjou also admitted that he had mixed views on the change, telling MM, "This is not the best way to proceed. We had to do it. It's a one off event. I'd prefer to go back to normal due process."

    While he was reluctant to point fingers at specific politicians, Danjou admitted that Europe's "largest economies" were the most insistent on passing the change.

    As at December 2008, no major French, Portuguese, Spanish, Swiss or Irish banks had used the amendment.

    BNP Paribas, Credit Agricole, Danske Bank, Natixis and Societe Generale were expected to reclassify their assets in the fourth quarter of 2008.

    The amendment was passed to shore up bank balance sheets and restore confidence in the midst of the current credit crunch. But it remains to be seen whether reclassifying major debts is an effective tactic.

    "Because the market situation was unique, events from the outside world forced us to react quickly," said Danjou. "We do not wish to do it too often. It's risky, and things can get missed."

    Jensen Comment
    European banks thus circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."


    Paul Williams wrote:
     "Anyone who has ever executed an estate knows the law is much more coherent on the matter of what is an asset -- what does the deceased possess that can be converted into cash to settle the "legal" (i.e., enforceable in law) claims against the estate."


    Jensen Comment
    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
     

    Bob Jensen's threads on fair value accounting are at ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue


    Teaching Case on Credit Derivatives and Fair Value Accounting

    Credit Derivative --- http://en.wikipedia.org/wiki/Credit_derivative

    From The Wall Street Journal Accounting Weekly Review on August 10, 2012

    J.P. Morgan 'Whale' Was Prodded
    by: Gregory Zuckerman and Dan Fitzpatrick
    Aug 03, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Derivatives, Fair Value Accounting, Fair-Value Accounting Rules, Internal Controls

    SUMMARY: "After reviewing emails and voice-mail messages, [J.P. Morgan Chase & Co.] has concluded that Bruno Iksil, the J.P. Morgan trader nicknamed for the large positions he took in the credit markets, was urged by his boss to put higher values on some positions than they might have fetched in the open market at the time....The bank believes they show the executive, Javier Martin-Artajo, pushing Mr. Iksil to adjust trade prices higher, according to people close to the bank's investigation."

    CLASSROOM APPLICATION: The article may be used to identify the purpose of fair value reporting under IFRS and U.S. GAAP. Questions then lead to helping the students understand that valuations are not exact and may "fall within a broad range set by the oversight group" responsible for monitoring valuation practices in bank control groups. A final question asks students to glean an understanding of the internal controls described in the article.

    QUESTIONS: 
    1. (Introductory) What investigation has J.P. Morgan undertaken into its own operations within its Chief Investment Office (CIO)? What specific operations and activities did the company investigate?

    2. (Advanced) What is the definition of fair value under U.S. generally accepted accounting principles (U.S. GAAP) and International Financial Reporting Standards (IFRS)? How is this definition the focus of accounting for financial assets and liabilities?

    3. (Advanced) According to the introductory paragraph, how did the executive known as the "London Whale" allegedly violate this definition? In your answer, state how and why internal corporate valuations are used to arrive at fair value estimates under U.S. GAAP and IFRS requirements.

    4. (Advanced) Does it seem from the description in the article that the alleged intent of the parties involved was to violate accepted accounting practices? Explain your answer.

    5. (Advanced) How can it be that fair values "fall within a broad range set by the oversight group" responsible for valuation practices at banks--aren't fair value amounts one number than can be specifically determined? Explain.

    6. (Introductory) Based on the description in the article, explain your understanding of the internal controls used at banks to ensure that fair values are appropriately determined.
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "J.P. Morgan 'Whale' Was Prodded," by: Gregory Zuckerman and Dan Fitzpatrick, The Wall Street Journal, August 3, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443545504577565062684880158.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj

    A J.P. Morgan Chase JPM -0.65% & Co. executive encouraged the trader known as the "London whale" to boost valuations on some trades, said a person who reviewed communications emerging from the bank's internal probe of recent trading losses.

    After reviewing emails and voice-mail messages, the bank has concluded that Bruno Iksil, the J.P. Morgan trader nicknamed for the large positions he took in the credit markets, was urged by his boss to put higher values on some positions than they might have fetched in the open market at the time, people familiar with the probe said.

    The bank's conclusion is based on a series of emails and voice communications in late March and April, as losses on his bullish credit-market bet mounted, the people said. The bank believes they show the executive, Javier Martin-Artajo, pushing Mr. Iksil to adjust trade prices higher, according to people close to the bank's investigation. At the time, Mr. Martin-Artajo was credit-trading chief for the company's Chief Investment Office, or CIO.

    Mr. Iksil agreed on repeated occasions to adjust the values, the people said. Those discoveries led the bank to determine last month that an earnings restatement was necessary. The prices he chose were within broad market ranges, but high enough to later raise concerns among the bank's investigators, the people said.

    Among the communications uncovered by the bank's investigation are two that the bank believes show Mr. Martin-Artajo prodding Mr. Iksil toward higher prices, the people familiar with the probe said.

    "We should not be showing" a certain amount of losses from the trades "until we see where the market is going," Mr. Martin-Artajo told the trader in one communication, according to people who have reviewed the communications from the probe, which is continuing.

    "I'd prefer" that a higher price be put on certain positions, Mr. Martin-Artajo told Mr. Iksil in another communication, said a person close to the investigation

    Last month, J.P. Morgan said both men had left the largest U.S. bank in assets and will be forced to relinquish compensation as part of the fallout from $5.8 billion in trading losses.

    Greg Campbell, a lawyer for Mr. Martin-Artajo, said his client "unequivocally denies any wrongdoing on his part and is confident that he will be completely exonerated when the investigations into these events have been completed." Mr. Iksil's lawyer, Raymond Silverstein, couldn't be reached but has previously denied any wrongdoing by Mr. Iksil.

    It isn't clear why Mr. Iksil decided to use the higher values. Accounting rules dictate that such investments be valued at the best estimate of where they might be sold.

    Some people at J.P. Morgan concluded, based in part on references in communications to accumulating losses, that the favorable valuations might have been aimed at giving the losing trades time to recover and avoid setting off potential alarms at the bank, according to the people familiar with the probe.

    At the same time, some people on the trading team say they had begun to doubt market prices and were convinced rivals were manipulating markets to the detriment of J.P. Morgan, the people said.

    The details of the probe, which haven't been disclosed publicly, are the latest sign of how risk-management breakdowns mushroomed into a trading loss that might exceed $7 billion, according to the bank's latest estimate. The mess has tarnished the reputation of J.P. Morgan Chief Executive James Dimon, who initially played down worries about the London whale as "a tempest in a teapot" but then said he was wrong.

    J.P. Morgan said July 13 that its review of roughly one million internal emails and tens of thousands of voice tapes suggested that some traders "may have been seeking to avoid showing the full amount of losses." The discovery prompted the New York company to declare a "material weakness" in its financial controls and restate earnings for the first quarter.

    Determining accurate prices for infrequently traded investments such as the bets made by Mr. Iksil can be difficult, and J.P. Morgan routinely reviewed the valuations made by traders. The oversight process by the bank's so-called valuation control group includes input from outside pricing companies and brokers, which the group uses to set what it considers an appropriate range for various investment positions. The arrangement is a common risk-management practice among large banks.

    Continued in article

    Bob Jensen's threads on credit derivatives are under the C-Terms at
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

     


    Megabanks Backing Away From Mark-to-Market Accounting
    "Change In Loan-Tallying Method," by Liz Rappaport, The Wall Street Journal, February 17, 2012 ---
    http://online.wsj.com/article/SB10001424052970204059804577227602059483034.html?mod=dist_smartbrief

    Goldman Sachs Group Inc. and Morgan Stanley have reduced their use of "mark-to-market" accounting, shielding them from swings in the value of some loans made to companies.

    After several months of internal discussion, the two companies are making an accounting change affecting a portion of corporate loans that have a combined value of more than $100 billion. The change will value that portion using so-called historical-cost accounting, according to financial filings and people familiar with the matter.

    Under that accounting method, assets generally are held at their original value or purchase price. Goldman and Morgan Stanley could set aside reserves against possible losses on the loans and hedge them in other ways.

    The banks are making the change in part because, as a result of regulators' rules, securities firms using historical-cost accounting won't have to hold much-larger amounts of capital against the assets if their values go down. There also will be less fluctuation in Goldman and Morgan Stanley's earnings, because marking the loans to market creates immediate gains or losses for the companies as the values of the loans fluctuate.

    Goldman reported a loss of $450 million in the fourth quarter on the New York company's overall portfolio of corporate loans, including losses or gains on hedges. At the end of the third quarter, its portfolio of loan commitments was $34 billion. Goldman hasn't disclosed the size of its portfolio in the fourth quarter. It also hasn't disclosed how much of its loan portfolio it plans change the accounting for.

    Morgan Stanley is likely to change over a portion of its $82 billion loan portfolio, said a person familiar with the matter. As of the end of the year, Morgan Stanley had already moved $9.7 billion of its loan portfolio to historical-cost accounting. The firms may use this accounting method for new loans and commitments.

    Morgan Stanley didn't disclose a gain or loss on its loan portfolio in the fourth quarter of 2011. In the third quarter, it took a loss of about $400 million on its portfolio of corporate loans.

    Goldman and Morgan Stanley became bank-holding companies in 2008, giving them access to emergency funds from the Federal Reserve's discount window. But both companies now are subject to Fed stress-test guidelines, which include weighing the financial impact of economic and market shocks.

    Under the stress tests and international capital rules, Goldman and Morgan Stanley would be required to set aside more than twice as much capital against the loans if they were marked down in value.

    Using the new accounting treatment, Goldman and Morgan Stanley must hold no capital against those loans. Instead, they set aside reserves to cushion against possible losses.

    "The focus on capital by the Fed and global regulators is driving Goldman and other dealers to re-evaluate their businesses and even accounting methodologies to improve their capital metrics," said Roger Freeman, an analyst at Barclays Capital.

    Goldman's Chief Financial Officer David Viniar said in a conference call in January that Goldman's contemplating the change was "driven by the more-onerous capital treatment."

    Goldman executives including its Chairman and Chief Executive Lloyd C. Blankfein have defended mark-to-market accounting, saying wider use of the method might have forced financial firms to reckon with their problems sooner during the crisis.

    Continued in article

     


    Pulling the New IFRS 13 Onto the Tarmac
    "Are you ready for the new fair value accounting?" by Francisco Roque A. Lumbres, Business World, January 23, 2012 ---
    http://www.bworldonline.com/content.php?section=Economy&title=Are-you-ready-for-the-new-fair-value-accounting?&id=45461

    Fair value accounting, often referred to as mark-to-market accounting, has been the subject of much discussion and controversy, and the fact that various ways of measuring fair value were spread among different International Financial Reporting Standards (IFRS) has contributed to many questions regarding fair value accounting.

    To create a uniform framework for fair value measurements that consolidates into one single standard the various ways of measuring fair value, the International Accounting Standards Board (IASB) issued IFRS 13, Fair Value Measurements to reduce complexity and improve consistency in the application of fair value measurements. IFRS 13 also aims to enhance fair value disclosures to help users assess the valuation techniques and inputs used to measure fair value. IFRS 13 was published last May 12, 2011 and will become effective by January 1, 2013. It is applied prospectively, and early adoption is allowed.
     

    IFRS 13 clarifies how to measure fair value when it is required or permitted in IFRS. It does not change when an entity is required to use fair value. Furthermore, IFRS 13 covers both financial and non-financial assets and liabilities.
     

    Key principles of IFRS 13
     

    IFRS 13 applies when another IFRS standard requires or permits fair value measurements or disclosures. It does not, however, apply to transactions within the scope of:

    • International Accounting Standards (IAS) 17, Leases;

    • IFRS 2 Share-Based Payments; and,

    • Certain other measurements that are similar but are not fair value, that are required by other standards, such as value in use in IAS 36, Impairment of Assets and net realizable value in IAS 2, Inventories.
     

    Fair value defined
     

    IFRS 13 now defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price). Therefore, the focus now is on exit price as against entry price.
     

    Market participant assumptions
     

    When measuring fair value, IFRS 13 requires an entity to consider the characteristics of the asset or liability as market participants would. Hence, fair value is not an entity-specific measurement; it is market-based.
     

    Principal or most advantageous market
     

    A fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the “principal market” for the asset or liability or, in the absence of a principal market, in the “most advantageous market” for the asset or liability.
     

    The principal market is the market with the greatest volume and level of activity for the asset or liability to which the entity has access to. On the other hand, the most advantageous market is the market that maximizes the amount that would be received for the sale of the asset or minimizes the cost to transfer the liability, after considering transaction and transport costs.
     

    Highest and best use
     

    The concept of “highest and best use” applies to non-financial assets only. Fair value considers a market participant’s ability to generate economic benefits by using the asset in its highest and best use. Highest and best use is always considered when measuring fair value, even if the entity intends a different use of the asset.
     

    Fair value hierarchy
     

    Fair value measurements are classified into three levels which prioritize the observable inputs to the valuation techniques used and minimize the use of unobservable data.

    • Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

    • Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.

    • Level 3: Unobservable inputs for the asset or liability.
     

    Valuation techniques and inputs
     

    IFRS 13 describes the valuation approaches to be used to measure fair value: the market approach, income approach and cost approach. IFRS 13 does not specify a valuation technique in any particular circumstance; it is up to the entity to determine the most appropriate valuation technique.

    • Market approach: Uses prices and other relevant information from market transactions involving identical or similar assets or liabilities. A commonly-used technique is the use of market multiples derived from “comparables.”

    • Income approach: Converts future amounts (e.g., cash flows or income and expenses) to a single current (discounted) amount. Valuation techniques may include a discounted cash flows approach, option-pricing models, or other present-value techniques.

    • Cost approach: Reflects the amount currently needed to replace the service capacity of an asset (also known as the current replacement cost)
     

    Disclosure requirements
     

    IFRS 13 expanded required disclosures to help the users understand the valuation techniques and inputs used to measure fair value and the impact of fair value measurements on profit and loss. The required disclosures include:

    • Information about the level of fair value hierarchy;

    • Transfers between levels 1 and 2;

    • Methods and inputs to the fair value measurements and changes in valuation techniques; and
     

    For level 3 disclosures, quantitative information about the significant unobservable inputs and assumptions used, and qualitative information about the sensitivity of recurring level 3 measurements.
     

    Business impact and next steps
     

    Practically all entities using fair value measurements will be subject to IFRS 13, which will require certain fair value principles and disclosures that will significantly impact application and practice. Therefore, management should:

    • Begin to assess the effect of IFRS 13 on valuation policies and procedures;

    • Have competent knowledge when making judgments in fair value measurements;

    • Consider whether it has appropriate expertise, processes, controls and systems to meet the new requirements in determining fair value and disclosures;

    • Revisit loan covenants, compensation plans, shareholder communications and analyst expectations;

    • Have discussions with systems vendors, appraisers, investment advisors and/or investment custodians; and,

    • Be able to demonstrate to regulators and its external auditors that it understands the requirements of IFRS 13. This will greatly assist both regulators and external auditors in their annual examination and audit.
     

    The mandatory implementation of this new standard is less than a year away. The clock is ticking; the time to act is now.
     

    Fair Value Accounting for Liabilities
    "VISA’s LITIGATION ESCROW FUND," by Anthony H. Catanach, Jr. and J. Edward Ketz, Grumpy Old Accountants, January 2, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/470

     


    December 19, 2010 message from Bob Jensen

    Hi Tom,

  • I was thinking mostly of accrual accounting which, of course, is not 500 years old. But as “the” basis of financial reporting, historical cost accounting on an accrual basis has been around at least as long as the railroads when heated arguments flared concerning depreciation accounting “rules” that companies and auditors would follow when accounting for rails and locomotives. When accountants commenced to argue about depreciation the focus shifted to earnings performance reporting extensions of stewardship accounting, although depreciation accounting also served stewardship objectives of not allowing companies to eat their own seed corn with excessive dividends that depleted capital.

  • The point is that historical cost accrual accounting, as portrayed in the Paton and Littleton 1941 monograph, is a bit Darwinian in terms of survival against mutations of pro forma entry value accounting, exit value accounting, and economic (present value) accounting. However, we can hardly argue that there is any single basis of accounting in the 21st Century where departures from historical cost are required in numerous GAAP rules from pension accounting to financial instruments to personal estate accounting (that requires exit values).

  • However, in the course of accounting evolution mutations have succeeded only when there is some basis of being objectively audited with reliability and validity. We use present value for defined-benefit pension plans because the cash flows are contractual. We do not use present value for an older Chrysler assembly line because there is no reliable and valid basis to audit a totally uncertain future revenue stream attributable to an assembly line.

  • Exit values of components of a going concern’s assembly line are meaningless since piecemeal liquidation is the worst possible use of the components. Entry values are highly questionable since a new assembly line would be radically different. The ASU 2010-6  FASB ASU says we should aggregate non-financial asset components into their “best use” subset for exit value reporting as a group, but I think finding the “best use” of a Chrysler grouping of assembly line assets  is like finding pie in the sky --- certainly not something that CPA firms can audit.
    Welcome to the ASU 2010-6 world of pro forma GAAP!

  • Both the FASB and the IASB are rushing us into replacement of transactions-based numbers with hypothetical “value” numbers based on subjective probabilities and cloudy assumptions to a point where we can truly answer a client’s question about “what did I earn?” with another question “what would you like us to show that you earned?”
    Welcome to the ASU 2010-6 world of pro forma GAAP!

  • Auditors in the future will have to learn a whole lot about the subjective probability philosophy of Reverend Bayes ---
    http://www.iasplus.com/dttletr/1007amortcost.pdf

  • AC Littleton will turn over in his grave. AC always argued that accounting really was not about valuation in the first place and felt that investors and creditors benefitted for having accounting rooted in the audit trail of real transactions.

  • Welcome to the ASU 2010-6 world of pro forma GAAP!

  • Personally, I think the real problem is the FASB and IASB effort to keep accounting as one-dimensional with a single dimensional mentality leading to a single reported eps. We should do away with reporting eps entirely and present multi-dimensional financial statements that vary as to degree of reliability and validity.

  • What was so wrong in FAS 33 by requiring that replacement cost accounting outcomes be disclosed in supplementary schedules? Why should it have to be “historical cost” versus “entry value” versus “exit value” versus “economic value” in a single-dimensional financial report?

  • In my lifetime I’ve seen the world of traditional GAAP and the world of pro forma going head to head. Pro forma was generally considered too subjective and unreliable. But in the 21st century, pro forma is winning with FASB and IASB rulings. Why does this make me happy that I’m becoming too old to care?
    I’ll let Deloitte do the caring ---
    http://www.iasplus.com/dttletr/1007amortcost.pdf

  • Bob Jensen

    December 21, 2010 message from Bob Jensen

  • I've really enjoy these intense friendly debates about single-column versus multiple column financial statements with Tom Selling and Patricia Walters on the AECM. But I do not want to leave anybody with the impression that I'm an advocate of historical costing balance sheets. I'm opposed to such balance sheets for reasons never envisioned by current value reporting scholars like Kenneth MacNeal, John Canning, Ray Chambers, Bob Sterling, Edgar Edwards, Phillip Bell, and others. I merely advocate a historical cost column in the balance sheet because I believe there is value added in reporting net earnings based upon only legally realized revenues and profits under the matching principle. I do think the historical cost balance accounts are residuals of the realized revenue matching concept that have enormous limitations in terms of evaluating financial opportunities and risks.

  • For one thing, historical cost balance sheets are too easy to abuse in terms of off-balance sheet financing. Secondly, historical cost balance sheets are bad alternatives for both speculation and hedging derivative financial instruments.

  • In 1941 Paton and Littleton could deal with some derivative financial instruments. Futures contracts presented no problems since they're cleared in cash each day. Purchased options were not viewed as being especially problematic for historical costing because financial risk was limited to cash lost in the rather nominal premiums paid. Covered written options were not problematic since they have an inherent hedge that limits financial risk. Naked written options were huge problems that I don't know that Paton and Littleton ever wrote about. But there is an escape clause in the Paton and Littleton monograph --- the escape clause that allows departures from historical cost based upon conservatism. Presumably, a company facing huge losses in naked written options must bring those estimated losses into the ledgers based upon conservatism. I don't think this escape clause is nearly as good as adding a current value column alongside a historical cost column in financial statements.

  • In their 1941 monograph Paton and Littleton did not envision interest rate swaps invented in 1984. Interest rate swaps are really portfolios of forward contracts and, as a matter of tradition, forward contracts usually have zero historical costs as counterparties take differing long and short positions without paying a premium like they would when buying or writing options. Until FAS 119 was passed in 1994, clients worldwide entered into over $100 trillion in interest rate swap notionals without even disclosing those swaps. One of the incentives to enter into such swaps was the ease of off-balance-sheet financing. These swaps also replaced U.S. Treasury note inventories as a means of managing cash.

  • In the early 1990's the Director of the SEC ordered the Chairman of the FASB to issue standards for disclosure and eventually booking of interest rate swaps on some basis other than historical costs since historical cost of a swap contract was $0. In doing so the Director of the SEC declared that the three main problems with financial reporting were "derivatives, derivatives, and derivatives." :

  • Video and audio clips of FASB updates on FAS 133 

      • Audio 1 --- Dennis Beresford in 1994 in New York City  BERES01.mp3
      • Audio 2 --- Dennis Beresford in 1995 in Orlando  BERES02.mp3
  • I support at least one required current value column alongside a historical cost column in every set of financial statements. I do not support the current mixed model, single-column financial statements under IFRS and FASB rules today because they're such a conglomeration of historical cost and fair value components that aggregations are meaningless and the mix of audited and unaudited numbers mangles the credibility of the presentation. I favor a historical cost column to that does not co-mingle realized revenues with unrealized price changes. I support a current value column that provides more insights into financial risks and risk management.

  • Maintaining any derivatives, including credit derivatives, in the historical cost column at zero historical cost or a nominal premium cost is totally non-informative of financial risks of the derivative contracts in their present state. I support maintaining the FAS 133 rules and their amendments in the current value column of a set of financial statements. In order to distinguish speculation derivatives from hedging derivatives I advocate allowing hedge accounting relief for qualified hedges even though the relief varies of cash flow and FX hedges using OCI for relief and fair value hedging that uses the "firm commitment" account for fair value hedges of unbooked purchase contracts at fixed future rates/prices.

  • I don't think historical cost accounting is suited for other types contracts in the 21st century, including securitization contracts, mezzanine debt, and variable interest entities (SPEs). It's impossible to conclude that that any single-column set of financial statements can be an optimal choice. What I believe is that the time has come to disaggregate the current mixed-model, single column GAAP reporting under current IFRS or FASB standards. My first suggestion would be to disaggregate the historical cost alternatives from the current value alternatives for two main reasons. The first would be to disaggregate realized income statement items from unrealized income statement items arising from changes in fair values. The second would be to disaggregate numbers that are audited from numbers that are either not audited at all or have audit-lite attestations to the actual numbers themselves such as auditor reviews of the fair value estimation process without attesting to the actual fair value numbers themselves. Flags should be put on numbers to indicate the degree of verification with the audit process. For example, cash balances are audited better than most anything else in traditional CPA audits. Current appraisal values of real estate cannot be attested to at all by CPA auditors under present auditing standards. I recommend putting these appraisals into the current value column with strong warnings that these numbers have not be verified by auditors.

  • I think Tom Selling and Patricia Walters and Bob Jensen are in full agreement on most things. The difference is that Tom and Pat seem to be advocating a single-column set of financial statements that inevitably becomes a mixed model that co-mingles too many bases of measurement. Bob Jensen advocates a multiple-column set of financial statements that segregates realized transaction outcomes from unrealized changes in current values. GAAP rules should cover all multiple columns.

  • I'm not a fan of having a pro-forma column because I think this makes it too easy for clients to manipulate the numbers outside of GAAP rules. Until GAAP contains strict rules about pro-forma reporting, auditors should not associate their names with any financial statements having a pro-forma column ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

  • Yes, multiple-column statements might create some short-term confusion among analysts and investors. But I think the current single-column financial statements create more confusion, especially with the co-mingling of realized revenues with unrealized current value changes.

  • Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


    Tom discusses changes to testing value impairment to Goodwill.

    He does not, however, touch upon what I consider to be an important inconsistency in the FASB/IASB new joint standard on fair value measurement itself. That joint standard prescribes that synergy value of assets "in use" be ignored and that each asset be valued at what is tantamount to what it will fetch by itself in a yard sale without any consideration of fact that it may be more value to Owner A in use than to Owner B in use.

    Obviously the new joint standard creates a much larger problem of Goodwill. Goodwill is created when Owner A purchases a set (bundle)  of assets at a price greater than the sum of all the yard sale values of the assets in the bundle. Since a credit must be made to something (e.g., cash or debt) for the purchase price of the bundle, how's the Goodwill Value = [Bundle Price-Sum of the Yard Sale Values} to be accounted for by the new owner? 

    Teaching Case on Fair Value Accounting Standards

    From The Wall Street Journal Accounting Review on May 20, 2011

    "Fair Value" Accounting Guidelines Tweaked
    by: Michael Rapoport
    May 14, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Advanced Financial Accounting, Fair Value Accounting, Fair-Value Accounting Rules, International Accounting, International Accounting Standards Board, Valuations

    SUMMARY: In furthering their convergence effort, the FASB and IASB are changing promulgated standards to provide a more consistent definition of fair value. As described in the article, most of the specific changes are relatively minor but are designed to achieve improvements in convergence. "Perhaps the most significant changes [result in requirements for companies to] disclose more about the processes and assumptions they use in their level 3 valuations." Changes also require disclosure of any movements of securities between Levels 1 and 2 of assets subject to fair value measurements.

    CLASSROOM APPLICATION: The article is useful to introduce the topics of convergence and/or fair value measurement in U.S. GAAP and International Financial Reporting Standards. Instructors wishing to direct their students to investigate the Accounting Standards Update (ASU) in the U.S. and the promulgated IFRS 13 may wish to delete the remainder of this paragraph from student assignments. The Accounting Standards Update on which this article is based is No. 2011104, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The international authoritative guidance is IFRS 13, Fair Value Measurement.


    QUESTIONS: 
    1. (Advanced) Describe the process of convergence of U.S. and international accounting standards. What factors are driving this convergence effort?



    2. (Introductory) How significant were the changes to U.S. GAAP discussed in this article? How significant were the changes to IFRS? Explain any difference in your answers between the two.



    3. (Advanced) What is fair value? Why must promulgated accounting standards include a definition of this concept?



    4. (Advanced) How is fair value measured under U.S.GAAP and IFRS?



    5. (Advanced) What are the three levels of measuring fair value under U.S.GAAP and IFRS? What new disclosures must be made in U.S. GAAP reporting about assets measured at fair value? Identify your source for this information. Explain what benefits you think will be provided by these disclosures



    6. (Advanced) When is this new standard to be applied by firms reporting under IFRS? How will this accounting change be handled? Identify your source for this information.
     

    Reviewed By: Judy Beckman, University of Rhode Island


     

    ""Fair Value" Accounting Guidelines Tweaked." by: Michael Rapoport, The Wall Street Journal, May 14, 2011 --- 
    http://online.wsj.com/article/SB10001424052748704681904576319600471689190.html?mod=djem_jiewr_AC_domainid

    Accounting rule makers tweaked their guidelines for valuing assets based on market prices, a move that will bring U.S. and international accounting rules closer together and will require companies to disclose more about how they value their most exotic assets.

    The changes adopted by the Financial Accounting Standards Board and the International Accounting Standards Board will provide a more consistent definition of "fair value," which is the market value or the closest approximation of it. Though most of the specific changes are relatively minor and won't affect the core aspects of how companies calculate fair value, the move better aligns U.S. and global accounting rules on asset valuation.


    Perhaps the most significant changes affect companies' disclosures about their "Level 3" assets, which are the risky, illiquid securities valued using a company's own estimates and models rather than market prices. Companies will have to disclose more about the processes and assumptions they use in their Level 3 valuations. They will also have to discuss what might happen to the company's valuations if the factors they are using were to change.


    Companies will have to disclose any movements of securities between the other two classes of fair-value assets: Level 1, those valued strictly using market prices, and Level 2, those for which a blend of market prices and a company's own models are used.


    The fair-value changes are part of the rule makers' "convergence" project, their attempt to bring U.S. and international rules closer together in an effort to standardize the accounting rules used world-wide. The Securities and Exchange Commission is expected to vote later this year on whether U.S. companies should switch to using international rules altogether.


    Most companies will adopt the fair-value measurement changes in early 2012.


     

    Making IFRS 9 Politically Correct
    Politically Adjusted Held-To-Maturity Fair Value Choices for Banks
    This may not go down well with fair value advocates
    European banks may now have an IFRS 9 choice for cost versus fair value whichever makes the financial statements look better
    Don't you just hate how bankers can manipulate accounting standard setters

    European-Styled Avoidance of Fair Value Earnings Hits for Loan Loss Impairments

    European banks circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

    European banks resorted to a number of misleading ploys to avoid taking fair value adjustment hits to prevent earnings hits due to required fair value adjustments of investments that crashed such a investments in the bonds of Greece, Ireland, Spain, and Portugal.

    The Market Transitory Movements Argument
    Fair value adjustments can be avoided if they are viewed as temporary transitory market fluctuations expected to recover rather quickly. This argument was used inappropriately by European banks hold billions in the Greece, Ireland, Spain, and Portugal after the price declines could hardly be viewed as transitory. The head of the IASB at the time, David Tweedie, strongly objected to the failure to write down financial instruments to fair value. The banks, in turn, threatened to pressure the EU lawmakers to override the IFRS 9 requirement to adjust such value declines to market.

    One of the major concerns of the  is that some nations at some points in time will simply not enforce the IASB standards that these nations adopted. The biggest problem that the IASB was having with European Banks is that the IASB felt many of many (actually most) EU banks were not conforming to standards for marking financial instruments to market (fair value). But the IASB was really helpless in appealing to IFRS enforcement in this regard.

    When the realities of European bank political powers, the IASB quickly caved in as follows with a ploy that allowed European banks to lie about intent to hold to maturity. The banks would probably love to unload those loser bonds as quickly as possible before default, but they could instead claim that these investments were intended to be held to maturity --- a game of make pretend that the IASB went along with under the political circumstances.

    "New accounting rule would ease Greek pain: IASB," By Silke Koltrowitz and Huw Jones,  Reuters, July 5, 2011 ---
    http://www.reuters.com/article/2011/07/05/us-accounting-idUSTRE7643WU20110705

    European Union banks would have more breathing space from losses on Greek bonds if the bloc adopted a new international accounting rule, a top standard setter said on Tuesday.

    The International Accounting Standards Board (IASB) agreed under intense pressure during the financial crisis to soften a rule that requires banks to price traded assets at fair value or the going market rate.

    This led to huge writedowns, sparking fire sales to plug holes in regulatory capital.

    The new IFRS 9 rule would allow banks to price assets at cost if they are being held over time.

    The European Commission has yet to sign off on the new rule for it to be effective in the 27-nation bloc, saying it wants to see remaining parts of the rule finalized first.

    Continued in article

     

    Dynamic Provisioning:  The Cookie Jar Argument If Banks Had Cookies in the Jar
    European Union officials knew this and let Spain proceed with its own brand of accounting anyway.
    "The EU Smiled While Spain’s Banks Cooked the Books," by Jonathan Weil, Bloomberg, June 14, 2012 ---
    http://www.bloomberg.com/news/2012-06-14/the-eu-smiled-while-spain-s-banks-cooked-the-books.html

    Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

    But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

    By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

    This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

    What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia (BKIA) group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

    Name Calling

    Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

    “Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”

    The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

    One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

    “They didn’t implement IFRS, and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS,” McCreevy said, according to a transcript of the meeting on the monitoring board’s website. “The Spanish regulator did not do that, and he survived this. His banks have survived this crisis better than anybody else to date.”

    Ignoring Rules

    McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, went on: “The rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them.”

    Why didn’t he take action? McCreevy said he was a fan of dynamic provisioning. “Why am I like that? Well, I’m old enough to remember when I was a young student that in my country that I know best, banks weren’t allowed to publish their results in detail,” he said. “Why? Because we felt if everybody saw the reserves, etc., it would create maybe a run on the banks.”

    So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

    Continued in article

    "Accounting Board Criticizes European Banks on Greek Debt," REUTERS, August 30, 2011 ---
    http://www.nytimes.com/2011/08/31/business/global/accounting-board-criticizes-european-banks-on-greek-debt.html 

    Some European financial institutions should have booked bigger losses on their Greek government bond holdings in recent results announcements, the International Accounting Standards Board said in a letter to market regulators.

    The criticism comes as Europe’s lenders face calls to shore up their balance sheets and restore confidence to investors unnerved by the euro zone debt crisis, funding market jitters and a slowing economy.

    In a letter addressed to the European Securities and Markets Authority, the I.A.S.B. — which aims to become the global benchmark for financial reporting — criticized inconsistencies in the way banks and insurers wrote down the value of their Greek sovereign debt in second-quarter earnings.

    It said “some companies” were not using market prices to calculate the fair value of their Greek bond holdings, relying instead on internal models. While some claimed this was because the market for Greek debt had become illiquid, the I.A.S.B. disagreed.

    “Although the level of trading activity in Greek government bonds has decreased, transactions are still taking place,” the board chairman Hans Hoogervorst wrote.

    The E.S.M.A. was not immediately available for comment.

    The letter, which was posted on the I.A.S.B.’s website Tuesday after being leaked to the press, did not single out particular countries or banks.

    European banks taking a €3 billion, or $4.2 billion, hit on their Greek bond holdings earlier this month employed markedly different approaches to valuing the debt.

    The writedowns disclosed in their quarterly results varied from 21 to 50 percent, showing a wide range of views on what they expect to get back from their holdings.

    A 21 percent hit refers to the “haircut” on banking sector involvement in a planned second bailout of Greece now being finalized. A 50 percent loss represented the discount markets were expecting at the end of June, the cut-off period for second-quarter results.

    Two French financial companies, the bank BNP Paribas and insurer CNP Assurances, on Tuesday defended their decision to use their own valuation models rather than market prices.

    “BNP took provisions against its Greece exposure in full agreement with its auditors and the relevant authorities, in accordance with the plan decided upon by the European Union on July 21,” a bank spokeswoman said.

    A CNP spokeswoman said the group’s Greek debt provisions had been calculated in accordance with the E.U. plan and in agreement with its auditors.

    Some investors see the issue as serious, however, even if the STOXX Europe 600 bank index was trading higher on Tuesday.

    “The Greek debt issue has been treated very lightly,” said Jacques Chahine, head of Luxembourg-based J. Chahine Capital, which manages €320 billion in assets. “And it’s not just Greek debt — all of it needs to be written down, Spain, Italy.”

    The E.S.M.A. was unable to impose a uniform Greek “haircut” across the E.U. and its guidance published at the end of July simply stressed the need for banks to tell investors clearly how they reflect Greek debt values.

    The I.A.S.B. also has no powers of enforcement in how banks book impairments but is keen to show the United States, which decides this year whether to adopt I.A.S.B. standards, that its rules are consistent and properly represent what’s happening in markets.

    Auditors warned at the time against a patchwork approach that will confuse investors and concerns over Greek haircut reporting will fuel calls for a pan-Europe auditor regulator.

    “The impact is more likely to be to further reduce investors’ confidence in buying bank debt, rather than sovereign debt,” said Tamara Burnell, head of financial institutions/sovereign research at M&G.

    Using the most aggressive markdown approach — namely marking to market all Greek sovereign holdings — would saddle 19 of the most exposed European banks with another €6.6 billion in potential writedowns, according to Citi analysts.

    BNP would take the biggest hit with €2.1 billion in remaining writedowns, followed by Dexia in Belgium with €1.9 billion and Commerzbank in Germany with €959 million, Citi said.

    The European Commission said on Monday that there was no need to recapitalize the banks over and above what had been agreed after a recent annual stress test .

     

    Spinning Debt Into Earnings With the Wave of a Fair Value Accounting Wand
    "Euro banks' £169bn in accounting alchemy," by: Lindsey White, Financial Times Advisor, January 19, 2009 --- Click Here

    European banks conjured more than £169bn of debt into profit on their balance sheets in the third quarter of 2008, a leaked report shows.

    Money Managementhas gained exclusive access to a report from JP Morgan, surveying 43 western European banks.

    It shows an exact breakdown of which banks increased their asset values simply by reclassifying their holdings.

    Germany is Europe's largest economy, and was the first European nation to announce that it was in recession in 2008. Based on an exchange rate of 1 Euro to £0.89, its two largest banks, Deutsche Bank and Commerzbank, reclassified £22.2bn and £39bn respectively.

    At the same exchange rate, several major UK banks also made the switch. RBS reclassified £27.1bn of assets, HBOS reclassified £13.7bn, HSBC reclassified £7.6bn and Lloyds TSB changed £3.2bn. A number of Nordic and Italian banks also switched debts to become profits.

    Banks are allowed to rearrange these staggering debts thanks to an October 2008 amendment to an International Accounting Standards law, IAS 39. Speaking to MM, IAS board member Philippe Danjou said that the amendment was passed in "record time".

    The board received special permission to bypass traditional due process, ushering through the amendment in a matter of days, in order to allow banks to apply the changes to their third quarter reports.

    However, it is unclear how much choice the board actually had in the matter.

    IASB chairman Sir David Tweedie was outspoken in his opposition to the change, publicly admitting that he nearly resigned as a result of pressure from European politicians to change the rules.

    Danjou also admitted that he had mixed views on the change, telling MM, "This is not the best way to proceed. We had to do it. It's a one off event. I'd prefer to go back to normal due process."

    While he was reluctant to point fingers at specific politicians, Danjou admitted that Europe's "largest economies" were the most insistent on passing the change.

    As at December 2008, no major French, Portuguese, Spanish, Swiss or Irish banks had used the amendment.

    BNP Paribas, Credit Agricole, Danske Bank, Natixis and Societe Generale were expected to reclassify their assets in the fourth quarter of 2008.

    The amendment was passed to shore up bank balance sheets and restore confidence in the midst of the current credit crunch. But it remains to be seen whether reclassifying major debts is an effective tactic.

    "Because the market situation was unique, events from the outside world forced us to react quickly," said Danjou. "We do not wish to do it too often. It's risky, and things can get missed."

    Jensen Comment
    European banks thus circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

     


    Among disclosure issues, fair value prompts the most SEC reviews
    As of Dec. 19, 2011 the SEC had sent 874 comment letters regarding fair value and estimates of assets and contracts, Audit Analytics reports.

    And we were led to believe that fair value accounting for financial instruments entailed little more than reading the closing prices in the financial data tables of The Wall Street Journal.

    Yeah right!

    "The Big Number: 874," by Maxwell Murphy, CFO.com, December 28, 2011 ---
    http://blogs.wsj.com/cfo/2011/12/28/the-big-number-874/?mod=wsjcfo_hp_cforeport

     

    ---------- Forwarded message ----------
    From: The Accounting Onion <tom.selling@grovesite.com>
    Date: Tue, May 31, 2011 at 7:09 AM
    Subject: The Accounting Onion
    To: rjensen@trinity.edu


    The Accounting Onion 


    "Goodwill Impairment" Accounting Could Become Less Costly – and Earnings Management a Lot Easier

    Posted: 31 May 2011 02:53 AM PDT

    When you start with a bogus asset like goodwill (itself a misnomer), it's hard to find quality in the rules that govern its measurement. The root of the problem is that business combination accounting relies on a fantasy: that an utterly ineffable plug to balance the business combination journal entry must somehow be an asset. The initial measurement of that plug is, at its theoretical best (i.e., assuming that management did not overpay, and all other assets and liabilities are completely and accurate recognized), an amalgamation of assets and liabilities that (unlike every other asset on the balance sheet) can neither be separated from the rest of the entity nor measured directly. Among the broad panoply of misnomers in financial accounting, "goodwill" is among the least subtle.

    If goodwill is a bogus asset, then testing it for impairment compounds the madness. But, there is at least some method to it. The propensity of management to overpay for corporate acquisitions is one of the most well-documented and uncontroverted phenomena in academic finance: with disturbing frequency, share price movements send a signal that investors believe that a corporate acquisition destroyed, rather than created, value. If goodwill is recognized as an asset, but not subject to either amortization or impairment, then management would be even more inclined to destroy shareholder value without having to worry that future earnings would suffer from profligate spending. Since 2001 (see SFAS 142), impairment testing, albeit replete with opportunities for earnings management, has been seen as the lesser of two silly charades. As currently set forth in U.S. GAAP (ASC Topic 350), this is how it is choreographed:

    • All of the goodwill currently on the balance sheet has to be assigned to "reporting units," another misnamed artifice, invented solely for the purpose of making the goodwill impairment test flexible and palatable.
    • The fair value of each reporting unit has to be assessed at least once a year – a costly undertaking.
    • The real mayhem begins if, heaven forbid, your estimate of the fair value of the reporting unit turns out to be less than its carrying amount. You must then estimate the "implied fair value" of goodwill, another artifice devised solely for goodwill impairment testing, and –
    • Write goodwill down to the implied fair value, if its carrying amount is greater.

    Recently, however, the FASB issued proposed Accounting Standards Update No. 2011-180, which if finalized would grant unfettered discretion to elect to avoid these processes altogether – so long as "qualitative factors" indicate that it is more likely than not (MLTN) that the fair value of a reporting unit is less than its carrying amount. The option to consider qualitative factors applies to any year and any reporting period.

    The existing goodwill impairment ballet can be a very costly production. While I am sympathetic to cost issues, I have a number of concerns with the way the FASB is addressing them:

    More management discretion means more earnings management – The Board ostensibly decided to give entities the discretion to skip any qualitative assessment at any time. The stated intention is to save entities the cost of performing the qualitative test in a period when breaching the MLTN threshold could be self-evident. Allow me to illustrate my skepticism for this explanation with a slight digression – an example of a similar impairment test that I got wind of just this week:

    I was contacted by an analyst who was concerned about a foreign energy producer that prepares its financial statements under IFRS. In accounting for its oil and gas field development costs, the company capitalizes the development costs associated with both successful and unsuccessful wells. The question I was asked pertained to a very large reported impairment charge from writing off the capitalized costs allocated to one particular dry well, one component of a block of wells comprising a "cash generating unit." The write off took place even though every other well in the cash generating unit was performing well beyond original expectations.

    I explained to the analyst that IFRS (see IAS 36) provides the option to assess impairment at the individual asset level at any time – ostensibly to allow an entity to provide more timely information regarding impairments. But, ulterior motives may have been at work: With oil prices (and revenues) so high lately, the entity likely had more than enough accounting profit to absorb impairment losses this year, and still meet earnings projections. Hence, the entity apparently elected to pave the way for higher future earnings by taking an impairment charge in the current year with the main effect being reduced future amortization of development costs.

    One of my philosophies of financial reporting – and a major theme of this blog – is that discretion in financial reporting invariably leads to abuse. In criticizing the proposal that entities may use the qualitative assessment at their own discretion, am I being too cynical. Or, is the Board being disingenuous? As you decide these questions for yourself, consider that a qualitative assessment in no-brainer circumstances shouldn't cost that much in the first place. Also, while there are already plenty of opportunity for earnings management in the FASB's extant goodwill impairment standard, there will certainly be times when entities will want to write off goodwill before issuing its financials, but can't because the MLTN threshold prevents it.

    The "more-likely-than-not" probability threshold is not auditable – I have conducted seminars on financial reporting to thousands of practicing accountants; and my own impression, which is corroborated by a colleague who has done even more of this kind of work than I, is that CPAs are not well-equipped, nor are they excited about, making probabilistic judgments. Yet, the latest fad among standards setters is to require them to do so (and in some cases – leases, loans, revenue recognition – to generate entire probability distributions). Again, my philosophy that discretion leads to abuse is directly applicable.

    Moreover, who shall review the 'reasonableness' of these probabilistic judgments? In the most important cases, it will be the "independent" auditors of large public companies, who are paid millions of dollars via checks bearing the signature of the company's CEO. I can see it now: two weeks before the Form 10-K is due at the SEC, a newly-hired auditor who still takes his job too seriously will question the reasonableness of the MLTN determination. Should the auditor require a re-assessment, the company won't have enough time to conduct its goodwill impairment test. Guess who gets inserted between a rock and a hard place?

    Non-existent cost-benefit analysis – Federal law requires the SEC to justify a new regulation with rigorous and transparent cost benefit analyses, generally with hard data and quantitative assessments. I find it strange that both the IASB and the FASB (essentially the SEC's agent when it comes to making accounting rules) can trumpet the rigor and extensiveness of their "due process" without the same. In ASU 2011-180, the FASB is proposing, without even acknowledging any potential negative consequences, to allow reporting entities to side-step a series of rules that clearly were intended to mitigate shareholder value destruction.

    More convergence nonsense – The Board mentions that it considered a number of other alternatives for changing goodwill impairment accounting. I won't get into the details here, but some of those alternatives make a lot more sense that the proposed rule changes. Irritatingly, much of the Board's rationalizations are based on their concern that a revised goodwill impairment standard should move U.S. GAAP closer to IFRS. But in point of fact, the goodwill impairment rules under IFRS are already as different from U.S. GAAP (with no plans for convergence) as night is from day. Under U.S. GAAP, the last long-lived asset to be tested for impairment, and written down, is always goodwill; but under IFRS, all long-lived assets are tested together, and the first asset to be written down is generally goodwill (subject to earnings management options that are currently not in U.S. GAAP).

    * * * * *

    Financial accounting costs too much because it is too darn complex. I am sympathetic towards efforts to reduce the costs of financial reporting, but in most cases, improvements are only slightly incremental and they come with too much baggage. The latest proposal for modifying "goodwill impairment" accounting is a case in point.

    .


    "Collaboration as an Intangible Asset,"  by Robert J. Thomas, Harvard Business Review Blog, June 15, 2011 --- Click Here
    http://blogs.hbr.org/cs/2011/06/collaboration_as_an_intangible.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    I did not see FAS 157 recommendations on how to capitalize and annually adjust the value of collaboration as an asset.

    Investors who rely upon the balance sheet sums of IFRS-FASB fair values as surrogates of economic value are missing the big picture as much as our accounting standard setters are helping to mislead those investors. AC Littleton emphasized that historical cost accounting is not valuation whereas exit value accounting is valuation.

    Bob Jensen's threads on intangibles and contingencies accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#TheoryDisputes


    Grumpy Old Accountants
    "What's Up with Cash Balances?" by: J. Edward Ketz and Anthony H. Catanach Jr, SmartPros, March 2011 ---
    http://accounting.smartpros.com/x71485.xml

    The past decade has yielded a growing number of cases of cash reporting problems among global firms. According to Audit Analytics, corporate restatements in the United States for cash-related reporting soared from 0.49 percent of all restatements in 2001 to over 13 percent in 2008.

    Between 2002 and 2005, Grant Thornton auditors failed to detect cash frauds totaling almost €4 billion at Parmalat, a global Italian dairy and food corporation.  In 2008, PricewaterhouseCoopers’ auditors missed a £1 billion in fraudulent cash balances at Satyam, the Indian technology outsourcing giant.  What’s going on?

    Historically, cash has not been that hard to audit or report, and junior accountants in their first and second years have routinely been tasked with auditing balances and preparing disclosures for these assets.  After all, how hard can it be to audit and report cash assets, when verification and valuation generally are not issues?

    Why aren’t companies reporting cash in an ethical and transparent manner? As analysts’ concern with earnings management has grown, they are devoting more attention to reported cash flows.  Global financial managers are aware of this new focus and have responded accordingly by either creatively or intentionally misreporting corporate cash flows.

    Initially, most of the gimmickry related to inflating operating cash flows (OCF) by simply misclassifying cash flows in the statement of cash flows (SCF). Investing or financing cash inflows are reported as operating activities, and operating cash outflows are included in the investing and financing sections of the SCF.  While such games continue even today, corporate accountants continue to develop more sophisticated schemes to artificially inflate cash balances and related flows.  Managers now commonly achieve OCF targets via asset liquidations, by delaying payments on payables, and even by counting receivable collections as cash before they are actually received, and employing special purpose entities.

    Note the following 8-K disclosure recently filed by Orbitz Worldwide, a leading global online travel company:

    The Company determined that credit card receipts in-transit at its foreign operations (which are generally collected within two to three days) should have been classified as “Accounts Receivable” rather than “Cash and Cash Equivalents.”

    The Pep Boys, a large U.S. automobile parts, tire, and service provider, also reported the following in its 10-K:

    All credit and debit card transactions that settle in less than seven days are also classified as cash and cash equivalents.

    Such practices clearly raise questions about the quality of reported cash balances and OCF, and recently the games have reached an all time low.  Managers now have decided to simply change the way they define cash in the balance sheet.  Every accounting student learns that a company reports as cash on their end-of-period balance sheet the amount reflected in the company’s general ledger; however, a growing number of companies are abandoning this generally accepted practice and now inflate their reported balance sheet cash flows by adding back outstanding checks (i.e., those than have not yet cleared the bank) written and mailed before period-end.  This practice not only increases reported cash balances, but also overstates OCF since the outstanding checks are added to accounts payable.  Note the following example from the recent 10-K of Dick’s Sporting Goods, a national U.S. sporting retailer:
     

    Accounts payable at January 30, 2010 and January 31, 2009 include $74.2 million and $74.8 million, respectively, of checks drawn in excess of cash balances not yet presented for payment.
     

    In this case, OCF were overstated by 89.16 percent in 2009 and 22.68 percent in 2010.  Then there is the case of Airgas, a nationwide distributor of gases, welding supplies, safety products, and tools, that reports in its 2010 10-K:

    Cash principally represents the balance of customer checks that have not yet cleared through the banking system…Cash overdrafts represent the balance of outstanding checks and are classified with other current liabilities.

    In this case, had the company reported its outstanding checks appropriately, its cash balance would have been negative at the end of 2010, and its OCF were overstated by $5.5 million as well.

    Continued in article

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm


    Teaching Case on Fair Value Measurement and Financial Statement Analysis

    Here's a pop quiz: Bank of America in the third quarter generated:
    a) 56 cents a share in earnings,
    b) 27 cents,
    c) a loss of two cents, or
    d) all of the above.

    From The Wall Street Journal Accounting Weekly Review on November 4, 2011

    Wall Street Reaps Profit Volatility It Sowed
    by: David Reilly
    Oct 31, 2011
    Click here to view the full article on WSJ.com
     

    TOPICS: Banking, Fair Value Accounting, Fair-Value Accounting Rules, Financial Accounting Standards Board, SEC, Securities and Exchange Commission

    SUMMARY: Author David Reilly uses Bank of America's recent disclosures highlighting the impact of special items to say that analysts and others cannot clearly identify what results banks are achieving. He highlights the bank's use of the fair value option for structured notes-bank debt that was issue with an embedded derivative so that "the ultimate payout to the holder typically depends on changes in some other instrument such as the S&P 500...." Mr. Reilly expresses concern with comparability across bank financial statements because of differing disclosures about the effects of using the fair value option to account for structured debt. He calls for the SEC to "issue guidance so that all banks label these changes similarly and present them in the same way."

    CLASSROOM APPLICATION: The article is useful in advanced undergraduate or graduate level financial reporting classes to cover the qualitative characteristic of comparability and to discuss the fair value option banks are using in accounting for their own debt.

    QUESTIONS: 
    1. (Introductory) On what basis does the author of this article, David Reilly, argue that Bank of America's fourth quarter results could be measured in three ways?

    2. (Advanced) Define the terms "mark-to-market accounting" and "fair value option". What authoritative accounting guidance defines how to use these accounting methods?

    3. (Introductory) Why are banks opting to use fair value reporting for their structured notes even when not being required to do so? In your answer, define the term "structured notes" on the basis of the description in the article.

    4. (Advanced) What are the primary and supporting qualitative characteristics of financial information? Where are they found in authoritative accounting literature?

    5. (Advanced) Which qualitative characteristic does Mr. Reilly indicate is being violated in reporting by from big banks such as Citigroup, J.P. Morgan Chase, Morgan Stanley, and Goldman Sachs Group?

    6. (Introductory) What entity does Mr. Reilly indicate should solve the reporting issues highlighted in the article? Is this the only entity responsible for establishing financial reporting standards in this U.S.?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     


    "Wall Street Reaps Profit Volatility It Sowed," by: David Reilly, The Wall Street Journal, October 31, 2011 ---
    http://online.wsj.com/article/SB10001424052970204505304577004223202476152.html?mod=djem_jiewr_AC_domainid

    Here's a pop quiz: Bank of America in the third quarter generated:
    a) 56 cents a share in earnings,
    b) 27 cents,
    c) a loss of two cents, or
    d) all of the above.

    The answer is "d," thanks to a dozen special items investors can include or exclude when trying to figure out how the bank actually performed. Chief among them were $6.2 billion in gains due to falls in the value of the bank's own debt.

    And investors may have to brace for more of the same in the current quarter. With the European crisis off the boil, debt values for big banks have regained some ground. The cost of protecting against default at Bank of America has fallen about 26% since Sept. 30, following a 170% increase in the third quarter. If the decline continues, last quarter's gains could reverse, resulting in fourth-quarter hits to profit.

    Confused? Plenty of investors are. Even analysts and bankers have had a tough time figuring out how to compare results at big banks like Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley and Goldman Sachs Group. That's due to the counterintuitive nature of these gains. Since banks book them as their own debt loses value, a firm would theoretically mint money while going bankrupt. Making matters worse, individual banks often use different terms to describe these gains—and disclose them in different ways.

    This is spurring debate about whether accounting-rule changes are needed. But there's a little-known irony: The problem is largely of Wall Street's own making. And it highlights how big banks repeatedly play for short-term advantages that often end up working against them.

    To understand why, consider that banks aren't actually required to record most gains or losses due to changes in the value of their debt. (Unlike with derivatives, which must be marked.) They choose to do so. And when banks do mark debt, it tends to affect only small portions of their total liabilities. In the second quarter, Bank of America marked to market $60.7 billion out of $427 billion in long-term debt. That was equal to only about 3% of the bank's total liabilities, which totaled $2.04 trillion.

    Plus, banks that mark portions of their debt often do so because they issue so-called structured notes. These notes are bonds with a twist—the ultimate payout to the holder typically depends on changes in some other instrument such as the S&P 500 index or a basket of commodities.

    Big banks like these instruments because they generally result in a cheaper cost of funding. By embedding a derivative in the instrument, they can also generates fees and may lead to more trading business. There was a catch, though. For accounting purposes, banks couldn't hedge that embedded derivative.

    So in the mid-2000s, Wall Street pushed for an accounting-rule change that allowed them to use market prices for almost anything on their balance sheet. This made it easier to avoid accounting mismatches. But it also meant Wall Street could mark these structured notes to market prices, allowing them to hedge the derivative for accounting purposes.

    At the time, banks weren't worried about big changes in the value of their own debt coming into play. Bonds were pretty stable, and the credit-default-swap market was nascent. The financial crisis changed that. As banks teetered, their bonds and default swaps moved sharply. This led to the kind of outsize gains and losses now whipsawing bank results.

    Continued in article

    Jensen Comment
    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's threads on fair value accounting ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue

    Bob Jensen's threads on financial statement analysis ---
    http://faculty.trinity.edu/rjensen/roi.htm


    Judging the Relevance of Fair Values for Financial Statements

    Since fair value accounting is arguably the hottest accounting theory/practice topic among accounting standard setters and financial analysts these days, I was naturally attracted to the following accountics science research article:
    "Judging the Relevance of Fair Values for Financial Statements,"
    by Lisa Koonce, Karen K. Nelson, and Catherine M. Shakespeare, The Accounting Review, Volume 86, 2075-2098.November 2011, pp. 2075-2098

    ABSTRACT: 

    We conduct three experiments to test if investors' views about fair value are contingent on whether the financial instrument in question is an asset or liability, whether fair values produce gains or losses, and whether the item will or will not be sold/settled soon. We draw on counterfactual reasoning theory from psychology, which suggests that these factors are likely to influence whether investors consider fair value as providing information about forgone opportunities. The latter, in turn, is predicted to influence investors' fair value relevance judgments. Results are generally supportive of the notion that judgments about the relevance of fair value are contingent. Attempts to influence investors' fair value relevance judgments by providing them with information about forgone opportunities are met with mixed success. In particular, our results are sensitive to the type of information provided and indicate the difficulty of overcoming investors' (apparent) strong beliefs about fair value.

    . . .

    Fair value proponents maintain that, no matter the circumstance, fair value provides information about forgone opportunities that affect the economics of the firm (Hague and Willis 1999). That is, proponents of fair value would argue that such information is always relevant to evaluating a firm.

    To be concrete, consider the following example. Company X issues bonds payable at par in the amount of $1,000,000. Two years after issuing the bonds, interest rates fall and so the fair value of the bonds is $1,200,000. From a discounted cash flow perspective, although the cash outflows have not changed, the discount rate has decreased. This denominator change leads to a greater negative present value associated with Company X having debt with fixed cash outflows—that is, it leads to a fair value loss. A fair value advocate would argue that the $200,000 loss is always relevant to the evaluation of the firm as it represents a forgone opportunity—that is, the present value of the additional interest cost (i.e., above current market rates) that Company X will pay over the remaining term of the bond, essentially because Company X did not refinance before rates changed (Hague and Willis 1999). Accordingly, fair value advocates would maintain that Company X's valuation should decrease as its cash flows are higher than an otherwise identical company (say, Company Y) that financed after the rate decrease. Stated differently, at the end of the financing period, Company X's cash balance will be lower than Company Y's (because X is paying a higher interest rate) and, thus, each firm's valuation should reflect this real economic difference.4

    If investors follow the logic of the fair value advocate and consider fair value gains and losses as representing forgone opportunities, they are essentially engaging in a process that psychologists call counterfactual reasoning (Roese 1997). In this type of reasoning, individuals “undo” outcomes by changing (or mutating) the cause that led to them. For example, if only the driver had not taken an unusual route home late at night, he would not have gotten into an accident. In the fair value domain, the calculation of fair value is based on the same type of simulation as counterfactual reasoning—“undoing” the actual contractual interest rate and replacing it with the current market rate of interest that the company would be paying if management had undertaken an alternative set of actions (i.e., the forgone opportunity). As the above numerical example illustrates, determining the amount of the fair value gain or loss is fairly mechanical once an interest (or discount) rate change occurs. The more subtle effect is whether the investor considers the fair value gain or loss as a forgone opportunity and thus relevant to evaluating the firm. If investors do (do not) follow a process similar to counterfactual reasoning, they are more (are less) likely to judge fair value measurements as relevant.

    Thinking about fair value in terms of counterfactual reasoning is helpful, as this theory suggests when investors' fair value judgments are likely to depend on context. Prior research in psychology indicates that counterfactual thinking is more likely when events are seen as abnormal versus normal, when negative rather than positive events occur, when the outcome or antecedent is mutable or changeable, or when the outcome is close versus more distant in time (Roese and Olson 1995). Drawing on this research, we identify three fair value contexts for financial instruments—namely, assets versus liabilities, gains versus losses, and held to maturity versus sold/settled soon—that we posit will cause investors to change their fair value relevance judgments.5 That is, we predict that investors' views about the relevance of fair value will not be unwavering, as proponents of fair value would maintain, but rather will be contingent on context. Relevance of Fair Value Depending on Context

    Fair value accounting is currently being used for financial instruments that are either assets or liabilities (but not for equity items). In addition, fair value accounting produces both gains and losses. Accordingly, a natural question is whether investors reason differently about the relevance of fair value for assets versus liabilities and for gains versus losses. Counterfactual reasoning theory suggests that investors treat these situations differently.

    Turning first to gains and losses, prior literature (e.g., Roese 1997) indicates that counterfactual reasoning is more likely when undesirable outcomes occur. Here, individuals tend to evaluate the undesirable outcome by determining how easy it is to mentally undo it. In the fair value context, this would entail reasoning about how the fair value loss could have been avoided. In contrast, counterfactual reasoning is less likely with desirable outcomes like fair value gains. In the case of such desirable outcomes, individuals have less need to understand the cause of the gain and are unlikely to mentally undo the outcome (Roese 1997). Accordingly, we hypothesize: H1: 

    Individuals will judge fair value losses as more relevant than fair value gains.

    In the context of assets versus liabilities, counterfactual reasoning theory suggests that the more mutable an item is (i.e., the easier an outcome can be undone), the more likely an individual will engage in counterfactual reasoning (McGill and Tenbrunsel 2000). For example, if a parachuter falls to his death, individuals are more likely to consider mutable factors in considering how he could have avoided death. That is, “if only he had rechecked the safety cord before jumping” is more likely to be considered (i.e., it is more mutable) than “if only gravity were not at work.”

    We predict that, in the eyes of investors, financial assets are perceived to be more mutable than financial liabilities. In other words, it is easier to consider an alternative set of actions for assets than for liabilities. This idea comes from the line of reasoning that individuals generally think they can more easily sell, for example, a bond investment than they can settle a home loan. That is, it is easier for them to simulate an alternative set of actions for (i.e., counterfactually reason about) assets than liabilities.6 Accordingly, we hypothesize: H2: 

    Individuals will judge the fair value of financial assets as more relevant than the fair value of financial liabilities.

    Finally, we posit that management's intent likely influences investors' judgments about fair value relevance. Research shows that perceived closeness to an outcome affects whether individuals engage in counterfactual reasoning (Meyers-Levy and Maheswaran 1992). For example, a traveler who misses his/her flight by five minutes is more likely to engage in counterfactual reasoning (i.e., “if only I had run the yellow stop light, I'd have made it to the gate on time”) than a traveler who misses the flight by one hour. Drawing on this idea, we maintain that individuals will be more inclined to think about “if only” when the financial instrument is to be sold/settled soon as compared to when it is to be held to maturity. Counterfactual reasoning seems particularly likely here, particularly in the case of loss outcomes. Individuals will likely think, for example, “if only the company had sold the investment before the fair value decreased, they would not be in this position today.” Accordingly, we hypothesize: H3: 

    Individuals will judge the fair value of financial instruments that are to be sold/settled soon as more relevant than those that are to be held to maturity. Changing Investor Judgments about Fair Value Relevance

    Because we conjecture that investors' judgments about fair value relevance will depend on the context, we believe it is possible to desensitize their judgments to context (Arkes 1991). In particular, we surmise that providing information about forgone opportunities should influence investors' understanding of the fair value change and, ultimately, will influence their fair value relevance judgments. This approach of providing individuals with a summary of the information that they may not normally consider is frequently employed as a “fix” in various decision settings (Arkes 1991). We summarize our expectations in the following hypothesis. H4: 

    Individuals will judge the relevance of fair value for financial instruments as greater when they are given information about forgone alternatives.

    Continued in article

    Jensen Comment
    I like this paper in terms of it's originality and clever ideas in terms of accounting theory, especially the concept of counterfactual reasoning.

    But like nearly all accountics behavioral experiments reported over the past four decades, I'm disappointed in how the hypotheses were actually tested. I'm also disappointed in the virtual lack of validity testing and replication of behavioral accounting studies, but it's too early to speculate on future replication studies of this particular November 2011 article.

    To their credit, Professors Koonce, Nelson, and Shakespeare conducted three experiments rather than just one experiment, although from a picky point of view these would not constitute independent replications in science ---
    http://faculty.trinity.edu/rjensen/TheoryTAR.htm

    Also to their credit the sample sizes are large enough to almost make statistical inference testing superfluous.

    But I just cannot get excited about extrapolating research findings form students as surrogates for investors and analysts in the real world. This is a typical example of where accountics researchers tried to do their research without having to set foot off campus.

    Even if these researchers had stepped off campus to conduct their experiments on real-world investors and analysts, I have difficulty with assigning the research subjects artificial/hypothetical tasks even though my own doctoral thesis entailed submitting hypothetical proxy reports to real-world security analysts. My favorite criticism is an anecdotal experience with one banker who was an extremely close friend when I lived in Bangor, Maine while on the faculty of the University of Maine. I played poker or bridge with this banker at least once a week. With relatively small stakes in a card game he was a reckless fool in his betting and nearly always came up a money loser at the end of the night. But in real life he was a Yankee banker who was known in the area for his tight-fisted conservatism.

    And thus I have a dilemma. Even if there are ten replications of these experiments using real world investors and analysts I cannot get excited about the accountics science outcomes. I would place much more faith in a protocol analysis of one randomly selected CFA, but protocol researchers are not allowed to publish their small sample studies in TAR, JAR, or JAE. They can, however, find publishing outlets in social science research journals.
    http://en.wikipedia.org/wiki/Protocol_analysis

    The best known protocol analysis in accounting and finance was the award-winning doctoral thesis research of Geoffrey Clarkson at Carnegie-Mellon, although the integrity of his research was later challenged.

    Protocol Analysis

    "Can thinking aloud make you smarter?" Barking Up the Wrong Tree, August 12, 2010 ---
    http://www.bakadesuyo.com/can-thinking-aloud-make-you-smarter

    Few studies have examined the impact of age on reactivity to concurrent think-aloud (TA) verbal reports. An initial study with 30 younger and 31 older adults revealed that thinking aloud improves older adult performance on a short form of the Raven's Matrices (Bors & Stokes, 1998, Educational and Psychological Measurement, 58, p. 382) but did not affect other tasks. In the replication experiment, 30 older adults (mean age = 73.0) performed the Raven's Matrices and three other tasks to replicate and extend the findings of the initial study. Once again older adults performed significantly better only on the Raven's Matrices while thinking aloud. Performance gains on this task were substantial (d = 0.73 and 0.92 in Experiments 1 and 2, respectively), corresponding to a fluid intelligence increase of nearly one standard deviation.

    Source: "How to Gain Eleven IQ Points in Ten Minutes: Thinking Aloud Improves Raven's Matrices Performance in Older Adults" from Aging, Neuropsychology, and Cognition, Volume 17, Issue 2 March 2010 , pages 191 - 204

    Here's an explanation of what Raven's Matrices are.

    Speaking of smarts and genius, if you haven't read it, Dave Eggers' book A Heartbreaking Work of Staggering Genius is a lot of fun. I highly recommend the introduction, oddly enough.

    Jensen Comment
    Protocol Analysis --- http://en.wikipedia.org/wiki/Protocol_analysis

    This takes me back to long ago to "Protocol Analysis" when having subjects think aloud was documented in an effort to examine what information was used and how it was used in decision making. One of the first Protocol Analysis studies that I can recall was at Carnegie-Mellon when Geoffrey Clarkson wrote a doctoral thesis on a bank's portfolio manager thinking aloud while making portfolio investment decisions for clients. Although there were belated questions about the integrity of Jeff's study, one thing that stuck out in my mind is how accounting choices (LIFO vs. FIFO, straight-line vs. accelerated depreciation) were ignored entirely when the decision maker analyzed financial statements. This is one of those now rare books that I still have in some pile in my studio:
    Geoffrey Clarkson, Portfolio Selection-A Simulation of. Trust Investment (Englewood Cliffs, N. J.: Prentice-Hall,. Inc., 1962)
    Clarkson reached a controversial conclusion that his model could choose the same portfolios as the live decision maker. That was the part that was later questioned by researchers.

    Another application of Protocol Analysis was the doctoral thesis of Stan Biggs.
    As cited in The Accounting Review in January, 1988 ---  http://www.jstor.org/pss/247685
    By the way, this one one of those former years when TAR had a section for "Small Sample Studies" (those fell by the board in later years)

    Also see http://onlinelibrary.wiley.com/doi/10.1002/bdm.3960060303/abstract

    Bob Jensen's threads on fair value accounting and other bases of accounting measurement are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


     

    Added Jensen Comment
    An early precursor of the concept of "counterfactual reasoning" is "functional fixation"

    Accounting History Trivia
    What accounting professors coined the phrase "functional fixation" in 1966 and in what particular accounting context?

    Hint 1
    One of the professors was also one of my professors, a former Dean of the Graduate School of Business at Stanford University, and the last Chairman of Enron's Audit Committee.

    Hint 2
    Bob Ashton did some cognitive experimentation of functional fixation that was published in the Journal of Accounting Research a decade later in 1976.

     


    "Did Fair-Value Accounting Contribute to the Financial Crisis?"
    by Christian Laux, Christian Leuz
    NBER Working Paper No. 15515 Issued in November 2009 NBER Program(s): CF

    The recent financial crisis has led to a major debate about fair-value accounting. Many critics have argued that fair-value accounting, often also called mark-to-market accounting, has significantly contributed to the financial crisis or, at least, exacerbated its severity. In this paper, we assess these arguments and examine the role of fair-value accounting in the financial crisis using descriptive data and empirical evidence. Based on our analysis, it is unlikely that fair-value accounting added to the severity of the current financial crisis in a major way. While there may have been downward spirals or asset-fire sales in certain markets, we find little evidence that these effects are the result of fair-value accounting. We also find little support for claims that fair-value accounting leads to excessive write-downs of banks' assets. If anything, empirical evidence to date points in the opposite direction, that is, towards overvaluation of bank assets.

    "Barclays Bank Criticizes 'Fair Value' Accounting," SmartPros, November 14, 2011 ---
    http://accounting.smartpros.com/x73021.xml

    LONDON - The finance director of Barclays Bank has called for the abolition of an accounting rule that he believes distorts the profitability of banks.

    In a letter published Monday in the Financial Times, Chris Lucas criticized the "fair value accounting of own debt" which boosted the third-quarter results of several major banks, including Barclays. The gain is based on the deteriorating market value of debt, a price at which a bank could theoretically buy back the debt.

    Lucas wrote that this accounting rule "misrepresents actual business profitability," and he urged the European Commission and other regulators to move quickly to adopt a revised rule proposed by the International Accounting Standards Board.

    "Barclays Bank Criticizes 'Fair Value' Accounting," SmartPros, November 14, 2011 ---
    http://accounting.smartpros.com/x73021.xml

    LONDON - The finance director of Barclays Bank has called for the abolition of an accounting rule that he believes distorts the profitability of banks.

    In a letter published Monday in the Financial Times, Chris Lucas criticized the "fair value accounting of own debt" which boosted the third-quarter results of several major banks, including Barclays. The gain is based on the deteriorating market value of debt, a price at which a bank could theoretically buy back the debt.

    Lucas wrote that this accounting rule "misrepresents actual business profitability," and he urged the European Commission and other regulators to move quickly to adopt a revised rule proposed by the International Accounting Standards Board.

    Don't Blame Fair Value Accounting Standards (except in terms of executive bonus payments)
                          This includes a bull crap case based on an article by the former head of the FDIC
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValue


    Question
    What do the U.S. Department of Education's financial responsibility calculations and FASB/IASB fair value accounting standards have in common?

    "Education Dept. Miscalculates 'Financial Responsibility' Scores, Private Colleges Say," by Goldie Blumenstyk, Chronicle of Higher Education, September 7, 2011 ---
    http://chronicle.com/article/Education-Dept-Miscalculates/128900/

    . . .

    The critics also contend that aspects of the 14-year-old formula used to calculate the scores are flawed and outdated.

    . . .

    But Naicu contends that the Education Department's misapplication of its own rules has given a false impression of the number of colleges on the brink. The data for the 2009 fiscal year showed 149 private degree-granting institutions received composite scores of 1.5 or below, the cutoff for passing the test. "There's just not 150 schools that are at the risk of closure, or even close to that," Ms. Flanagan says.

    She and other critics say that, for 2009 in particular—a year of significant losses for investors—the department's treatment of endowment declines (it counts a decline in endowment value as if it were an expenditure) improperly put many more colleges on the "failed" list than should have been there.

    Continued in article

    Jensen Comment
    Note that in fair value accounting under FAS 157 or IFRS 9, most unrealized gains and losses in fair value are included along with realized gains and losses in computing bottom-line net income, eps, P/E ratios, etc. This is particularly misleading for items intended to be held to maturity or for a long number of years due to various factors, particularly transactions costs of trading some financial instruments. For example, bond liabilities can have high transactions costs due to call back penalties. Bonds receivable can have high transactions costs due to relatively high commissions of bond traders. Often short-term fluctuations in bond values are due to interest rate fluctuations and have little or nothing to due with changed credit risks.

     

     

     


    Credibility?

    Question
    Do credible CPA audit firms add benefits to clients that exceed the audit costs?

    Tom Selling conjectures (tongue in cheek) that a CPA audit does not add total value to an audit client over and above the costs of an audit?
    He then asks me to find evidence to support the counter argument.
    I could pull a "Calvin" here and ask him to support his own conjecture, but I will resist a Calvinistic response in this case.

    This thread commenced when Patricia Walters questioned my assumption of the value of requiring credibility for numbers reported in financial statements? It appears that in her eyes unaudited fair values, such as real estate appraisals and management estimates of long-term executory contract fair values, are as valuable or even more valuable than more credible numbers that are attested to by auditing firms in financial statements. She does not seem to worry much about moral hazards of unaudited numbers that CPAs either will not or are not allowed to attest to on financial statements. I might add that at the moment fair values of financial contracts are required or soon will be required to be audited by independent CPA auditors. She, however, supports aggregating  non-audited fair values of non-financial items like real estate with the audited numbers like Cash, Accounts Receivable, and Notes Receivable.

    I don't mind when clients provide separate schedules of many unaudited fair values, but I think that all items in the main financial statements should be subject to attestation. In my opinion, separate schedules or columns are required when unaudited numbers are less credible. I think aggregating audited numbers with unaudited numbers presents clients with enormous moral hazards.

    Anecdotal Evidence
    Let me first provide anecdotal evidence where more concern with credibility of audited numbers might've prevent billions of dollars from being bilked in various hedge fund Ponzi schemes. The SEC has obscure jurisdiction over over hedge funds and completely failed public investors, in spite of receiving credible warnings at the SEC, while Bernie Madoff stole over a billion dollars in his infamous Ponzi scheme. The SEC and thousands of investors assumed that since Madoff engaged a CPA "auditor" that Madoff's stewardship over their investments was legitimate.
    Ponzi Schemes Where Madoff was King --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#Ponzi

    The SEC did not bother to investigate whether this lone and obscure Madoff hedge fund auditor was even licensed to be a CPA auditor. Nobody, including the SEC, questioned whether the audit firm was credible --- it was not! The moral of this story is that there are degrees of credibility of a CPA auditing firms, and one test of credibility is to verify the licensure and general auditing reputation of that firm. Another test is to investigate the depths of the pockets of a CPA auditing firm in lawsuits and the proportion of its audits that end up in civil court. If Deloitte had been engaged by Madoff, investors would've lost much less even in the case where  Deloitte conducted an incompetent or fraudulent audit. And, contrary to what Francine and Tom would like us to believe, the proportion of Deloitte's audits that end up in civil court or are settled out of court is a miniscule in terms of the number of all audits conducted globally by Deloitte auditors.

    As a second piece of anecdotal evidence of non-cpa firm auditor lack of credibility we might lament why taxpayers do not question the credibility of government auditors in local, state, and federal agencies when it came to auditing public pension funds. It turns out that undetected accounting and accountability frauds, yes outright deliberate frauds, have now brought entire states to the brink of bankruptcy ---
    The Sad State of Governmental Accounting and Accountability --- http://faculty.trinity.edu/rjensen/Theory02.htm#GovernmentalAccounting
    Try suing California for pension reporting audit failures when California cannot even pay its public pension liabilities.

    Historical Evidence
    There is a long history of historical evidence that CPA certifications of GAAP conformance by credible auditors lowers a client's cost of capital. The evidence here is the voluntary choice of clients to pay for CPA audits of GAAP conformance prior to when such audits became required by the SEC in the 1930s. It would seem that if CPA audits did not lower costs of capital that clients would not of their own free will pay for such audits.

    There is also evidence today when clients like charities and universities, that are not required by the SEC to have CPA audits, still choose to pay for such audits --- such as when stakeholders feel that CPA audits will keep manager agents more accurate and honest.

    Empirical Evidence
    Hypothesis
    As the global reputation of an auditing firm declines a point is reached where engaging that firm as an auditor raises cost of capital relative to cost of capital when the client engages a more credible auditing firm.

    Loss of Reputation is a Kiss of Death for One Public Accounting Firm: 
    An Empirical StudyAndersen Audits Increased Clients' Cost of Capital Relative to Clients of Other Auditing Firms

    "The Demise of Arthur Andersen," by Clifford F. Thies, Ludwig Von Mises Institute, April 12, 2002 ---
    http://www.mises.org/fullstory.asp?control=932&FS=The+Demise+of+Arthur+Andersen

    From Yahoo.com, Andrew and I downloaded the daily adjusted closing prices of the stocks of these companies (the adjustment taking into account splits and dividends). I then constructed portfolios based on an equal dollar investment in the stocks of each of the companies and tracked the performance of the two portfolios from August 1, 2001, to March 1, 2002. Indexes of the values of these portfolios are juxtaposed in Figure 1.

    From August 1, 2001, to November 30, 2001, the values of the two portfolios are very highly correlated. In particular, the values of the two portfolios fell following the September 11 terrorist attack on our country and then quickly recovered. You would expect a very high correlation in the values of truly matched portfolios. Then, two deviations stand out.

    In early December 2001, a wedge temporarily opened up between the values of the two portfolios. This followed the SEC subpoena. Then, in early February, a second and persistent wedge opened. This followed the news of the coming DOJ indictment. It appears that an Andersen signature (relative to a "Final Four" signature) costs a company 6 percent of its market capitalization. No wonder corporate clients--including several of the companies that were in the Andersen-audited portfolio Andrew and I constructed--are leaving Andersen.

    Prior to the demise of Arthur Andersen, the Big 5 firms seemed to have a "lock" on reputation. It is possible that these firms may have felt free to trade on their names in search of additional sources of revenue. If that is what happened at Andersen, it was a big mistake. In a free market, nobody has a lock on anything. Every day that you don’t earn your reputation afresh by serving your customers well is a day you risk losing your reputation. And, in a service-oriented economy, losing your reputation is the kiss of death.

    The Total Benefits of an Audit are Impossible to Measure:  Errors and Frauds That Might've Transpired Without Audits

    If we exclude incompetent surgeons, the costs in 2010 of errors made by credible surgeons who made mistakes is enormous in terms of pain, suffering, costs of correcting mistakes, and death. But it would be absurd to conjecture that the total benefits of credible surgeons was less than the "costs" of their mistakes.

    Along a somewhat similar vein,  the costs in 2010 of errors made by credible auditors who made mistakes is enormous in terms of pain, suffering, costs of correcting mistakes, and possibly even death (yes some of Madoff's investors in despair committed suicide). But it would be absurd to conjecture that the total benefits of credible auditors were less than the "costs" of their mistakes and frauds.

    Tom and Patricia fail to mention the tremendous benefit from CPA audits in terms of GAAP errors and financial frauds that might've transpired if clients were not subjected to audits. I conjecture that it's impossible to measure benefits of error and fraud prevention.

    1.  Error Prevention
    The fact that external CPA auditors will be looking for GAAP errors makes clients more responsible in understanding GAAP and installing internal controls that prevent GAAP errors and embarrassments accompanying CPA auditor discovery of GAAP errors.
     

    2. Fraud Prevention
    CPA auditors aren't generally engaged to detect frauds that do not significantly impact the numbers on financial statements. In truth they are usually not very good at even detecting such frauds even when engaged to do so. But existence of remote chances that frauds such as kiting will be detected by external CPA auditors probably prevents trillions of dollars from being pilfered by employees around the world.

    Think of the cost and  trouble it took for Lehman to conspire (with auditor consent) a way of hiding poisoned assets in such a manner that its CPA auditors would go along with in the financial statements. If Lehman was not subjected to CPA firm audits Lehman  would've quite simply not disclosed the extent of the poison and would've not had to concoct expensive Repo 105/108 schemes required by its auditors.

    There's an added benefit to CPA audits that might be termed an externality. Tom is thinking more in terms of benefits to clients that are audited. When Enron and WorldCom and other huge audit failures came to light near the beginning of the 21st Century, there was genuine concern in Congress that the entire financial markets system would collapse because millions of investors were losing faith in the credibility of the financial markets themselves. This is the primary reason that Congress enacted the controversial Sarbox legislation that greatly enhanced the profitability of CPA audits.

    In other words, if we are to consider the "total benefits" of CPA audits we must consider the externalities as well as the direct benefits to clients who are seeking lower costs of capital by paying for CPA audits.

    This does not mean that there are no credible alternatives to CPA audits as we know them today.
    I think shifting CPA audits from the private sector to the public sector is a bad idea given the track record of public sector auditors over the years and the degree to which government auditors are pressured by politicians and lobby powers. But there are some other alternatives to private sector "auditing."

    Josh Ronen at NYU is a long-time advocate in replacing CPA assurance with insurance --- - http://pages.stern.nyu.edu/~jronen/ 

    CPA audit firms in essence would become insurance firms that reimburse investors and creditors for a client's violations of GAAP. Such insurance schemes would probably not totally eliminate client audits but insurance might change many auditing procedures, e.g., more analytical reviews and less detail testing. Presumably small auditing firms would not necessarily be driven out of business if they participated in insurance pools.

    But it would take many years of research and experimentation before insured CPA audits could be implemented. One of the biggest challenges lies in determining the insurance payoffs for violations of GAAP and the problems of moral hazards. If customers throw banana peelings on supermarket floors and then sue for spine injuries, there will also be employees in clients that cause GAAP violations to collect the insurance money for their girl friends and third cousins. As long as the law is lenient with offenders, insurance schemes are doomed to failure ---
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#CrimePays


    IASB's Additions to IFRS 9 Address "Own Credit" Problem," Journal of Accountancy, October 28, 2010 ---
    http://www.journalofaccountancy.com/Web/20103496.htm

    With the new requirements, an entity choosing to measure a liability at fair value will present the portion of the change in its fair value due to changes in the entity’s own credit risk directly in the OCI section of the income statement, rather than within P&L.

    “The new additions to IFRS 9 address the counterintuitive way a company in severe financial trouble can book a large profit based on its theoretical ability to buy back its own debt at a reduced cost,” said IASB Chairman Sir David Tweedie in the news release.

    Continued in article

    Jensen Comment
    Sadly that does not take the fiction out of fair value accounting that could best be described as "held-to-maturity" because of enormous transactions costs of buying the debt back and reissuing new debt. Somehow fair value proponents just slide over transactions cost as quickly as  Bode Miller slides over moguls

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     


    I ran across this oldie in my Music links page ---
    http://faculty.trinity.edu/rjensen/music.htm#Humor
    Mark-to-market country song (dedicated to the FASB) --- http://www.youtube.com/watch?v=VFPCztVle7k

    Exit Value Surrogates
    Whenever value in use cannot be reasonably estimated, exit value theorists fall back on using resale markets as surrogates of fair value. But resale in such markets is tantamount to making viable going concern look like it is going into bankruptcy. In fact, if auditors decide to report the firm as a non-going concern there may be no change in the exit value balance sheets.

    Exit value theorists might instead argue that the firm as a whole might be valued but this runs into problems mentioned below.


    We have to have market-to-market accounting as a theoretical purity
    "Incurious Inquiry Was there,"
    by Holman W. Jenkins, Jr., The Wall Street Journal, April 14, 2010 ---
    http://online.wsj.com/article/SB10001424052702303695604575181882291373488.html?mod=djemEditorialPage_t

    Those who say nothing useful came from last week's hearings of the Financial Crisis Inquiry Commission exaggerate—by, say, one or two percent.

    From Citigroup's Chuck Prince we learned that the bank felt it must continue to participate in some markets even when it thought pricing had become crazy, because otherwise it would lose the employees who specialized in that business.

    . . .

    Collateralized Debt Obligations, or CDOs, are not so hard to fathom. A company is formed to collect, for instance, the payment streams of mortgage bonds and pay them out to investors who buy new securities of different grades—the best, or "super senior," get every dime coming to them before holders of the lower grades get anything.

    Citi held or committed itself to hold some $40 billion of these on its balance sheet of more than $2 trillion—commitments that senior management didn't even know existed until late in the game, because their underlings saw them as near-riskless, not least because they were backed by bond insurance.

    What exactly was it about these securities that caused a global panic—that caused, in the words of Goldman Sachs, a situation in which "institutions were hoarding cash and were unwilling to transact with each other"?

    Was it fear that banks wouldn't be able to sell these now-illiquid securities to meet their own obligations?

    Was it fear that government would force banks to recognize accounting losses on them so great that the banks would be rendered insolvent?

    The question is crucial because panic was the key actor in the drama—turning a severe housing correction in a handful of U.S. states into a global calamity.

    The most interesting panel of witnesses consisted of several Citi executives who ran this business. A question the inquisitors failed to ask is how these supposedly super-safe securities are performing today. Have they been able to withstand the surge in mortgage defaults? Do they continue to pay? The question begged to be asked, but Mr. Thomas was too busy assuring the Citi executives that the commission's final report "won't contain one word of what you folks just told us" and then promptly berating them over whether they lost "one night of sleep over what happened."

    Where curiosity might have been useful, the commissioners preferred to shower disdain on the Citi executives for failing to forecast a complex disaster practically no one forecasted—unprecedented downgrades to the CDOs by the rating agencies that previously had blessed them, as well as downgrades to the bond insurers, which together forced Citi to recognize huge accounting losses on its CDO holdings.

    The closest we got to the important follow-up question came when Mr. Prince, unbidden, blurted out: "It's entirely possible that at some point in the future people will make a lot of money from these instruments because they will pay out. But, again, the debate now isn't about those kinds of issues. The debate is about, 'We have to have market-to-market accounting as a theoretical purity.'"

    Continued in article

    Bob Jensen's threads on some of the theoretical impurities of mark-to-market accounting are shown below.


    "Of geeks and goalies," The Economist Magazine's Babbage Blog, June 26, 2010 ---
    http://www.economist.com/blogs/babbage?fsrc=nlw|pub|03_30_2010|publishers_newsletter

    . . .

    Subsequent analysis revealed 15 previously unknown indicators of where the ball might go (he also tested 12 indicators which had already been studied in sports literature). Three patterns of coordinated "distributed movements" turned out to be telltales. As Mr Diaz explains in a press release:

    "When a goalkeeper is in a penalty situation, they can't wait until the ball is in the air before choosing whether to jump left or right--a well-placed penalty kick will get past them. As a consequence, you see goalkeepers jumping before the foot hits the ball. My question is: Are they making a choice better than chance (50/50), and if so, what kind of information might they be using to make their choice?"

    "When, for example, you shift the angle of your planted foot, perhaps in an attempt to hide the direction of the kick, you're changing your base of support. In order to maintain stability, maybe you have to do something else like move your arm. And it just happens naturally. If this happens over and over again, over time your motor system may learn to move the arm at the same time as the foot. In this way the movement becomes one single distributed movement, rather than several sequential movements. A synergy is developed."

    The next step was to see how good 31 novices were at predicting the trajectory when shown an animation of the motion capture data which blacked out at the point of contact between the foot and the ball. Although fifteen were no better than chance, the remaining 16 were. One observed difference between the two groups was the response time, longer for the successful predictors. (Responses which took more than half a second following the blackout went unrecorded.) Whether this would ultimately translate into better performance remains moot. England's keeper may well hope so. Its strikers probably don't.

    PS To be fair, this time England are approaching possible penalties very methodically, even enlisting the help of statisticians.

    PPS The following anecdote is entirely extraneous to the topic at hand but it cries out for a mention. In the 2006 shoot-out against Argentina Germany's then goalkeeper, Jens Lehmann, notoriously carried a list of where the rival strikers put their penalties tucked in his sock. He actually went in the right direction--clearly a prerequisite for success--every time, saving two Argentine attempts. As Esteban Cambiasso steadied himself for the decisive shot, the German goalie conspicuously consulted a crumpled piece of paper pulled out from under his shin pad. Discomfited, the striker sent the orb to the right, directly into the hands of the lunging Lehmann. Adding insult to injury, it later transpired that he wasn't even on the list.

    This is only the ending part of the article

    Related items from Jensen's archives:

  • Goal Tenders versus Movers and Shakers
    Skate to where the puck is going, not to where it is.

    Wayne Gretsky (as quoted for many years by Jerry Trites at http://www.zorba.ca/ )

    Jensen Comment
    This may be true for most hockey players and other movers and shakers, but for goal tenders the eyes should be focused on where the puck is at every moment ---  not where it's going. The question is whether an accountant is a goal tender (stewardship responsibilities) or a mover and shaker (part of the managerial decision making team). This is also the essence of the debate of historical accounting versus pro forma accounting.

    Graduate student Derek Panchuk and professor Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed the most comprehensive, on-ice hockey study to determine where elite goalies focus their eyes in order to make a save. Simply put, they found that goalies should keep their eyes on the puck. In an article to be published in the journal Human Movement Science, Panchuk and Vickers discovered that the best goaltenders rest their gaze directly on the puck and shooter's stick almost a full second before the shot is released. When they do that they make the save over 75 per cent of the time.
    "Keep your eyes on the puck," PhysOrg, October 26, 2006 --- http://physorg.com/news81068530.html


    Question
    What are two of the most  Freakonomish and Simkinish processes in accounting research and practice?

    Accounting researchers may want to track Freakonomics publications along with the works of Mikhail Simkin at UCLA

    Freakonomish and Simkinish processes in auditing pracice
    The IASB and FASB are moving us ever closer into requiring subjective evaluations of unique items for which CPA auditors have no comparative advantages in evaluation. For example, CPAs have no comparative advantage in estimating the value of unique parcels of real estate (every parcel of real estate is unique). Another example would be the ERP system of Union Carbide that has value to Union Carbide but cannot be dismantled and resold to any other company.

    The problem with many subjective evaluations is that the so-called experts on those items are not consistent in their own evaluations. For example, real estate appraisers are notoriously inconsistent, which is what led to many of the subprime mortgage scandals when appraisers were placing enormous values on tract housing as if the real estate bubble would never burst. And placing a fair value on the ERP system of Union Carbide is more of an art than a science due to so many unknowns in the future of that worldwide company.

    Freakonomish and Simkinish processes in accounting research
    Secondly, accounting researchers may want to track Freakonomics and  the related works of Mikhail Simkin at UCLA. Professor Simkin made quite a name for himself evaluating subjective evaluators and in illustrating the art and science of subjective and science evaluations ---
    http://www.ee.ucla.edu/~simkin/

    And the tendency of accounting researchers to accept their empirical and analytical academic publications as truth that does not even need a single independent and exacting replication if Freakonomish and Simkinish in and of itself ---
    http://faculty.trinity.edu/rjensen/TheoryTAR.htm

    "Measuring The Quality Of Abstract Art: Abstract artists are only 4 per cent better than child artists, according to a controversial new way of evaluating paintings," MIT's Technology Review, June 14, 2011 ---
    http://www.technologyreview.com/blog/arxiv/26882/?nlid=4597

    Here's a bit of mischief from Mikhail Simkin at the the University of California, Los Angeles.

    Simkin has a made a name for himself evaluating the relative performance of various groups and individuals. On this blog, we've looked at his work on the performance of congress, physicists and even World War I flying aces.

    Today, he turns his attention to abstract artists. For some time now, Simkin has a run an online quiz in which he asks people to label abstract pictures either real art or fake. It's fun--give it a go.

    One average, people answer correctly about 66 per cent of the time, which is significantly better than chance.

    Various people have interpreted this result (and others like it) as a challenge to the common claim that abstract art by well-know artists is indistinguishable from art created by children or animals.

    Today, Simkin uses this 66 per cent figure as a way of evaluating the work of well known artists. In particular, he asks how much better these professional artists are than children.

    First, he points out the results of another well known experiment in which people are asked to evaluate weights by picking them up. As the weights become more similar, it is harder to tell which is heavier. In fact, people will say that a 100g weight is heavier than a 96g weight only 72 per cent of the time.

    "This means that there is less perceptible difference between an abstractionist and child/animal than between 100 and 96g," says Simkin.

    So on this basis, if you were to allocate artistic 'weight' to artists and gave an abstract artist 100g, you would have to give a child or animal 96g. In other words, there is only a 4 per cent difference between them.

    That's not much!

    Simkin goes on to say this is equivalent in chess to the difference between a novice and the next ranking up, a D-class amateur.

    Continued in article

    Bob Jensen's threads on lack of replication in accounting research ---
    http://faculty.trinity.edu/rjensen/TheoryTAR.htm


    PwC recommends the following on January 20, 2009 --- Click Here

    Bob Jensen’s PowerPoint slides (to date) --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/10FairValueFSU.ppt


    "The Real Story Behind Those "Record" Corporate Profits," by Justin Fox, Harvard Business Review Blog, November 25, 2010 --- Click Here
    http://blogs.hbr.org/fox/2010/11/the-real-story-behind-those-re.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

    Jensen Comment
    A couple of nights ago the controversial liberal commentator Keith Olbermann (MSNBC) lambasted all critics of President Obama who claim Obama is anti-business. Olbermann's "proof" is that, under President Obama, corporations have reported record profits for 2010 ---
    http://www.msnbc.msn.com/id/3036677/#40363881

    What Keith fails to mention is that those record profits are largely the result, during present economic recovery, of dubious accounting, deep cost cutting by plant closings, labor layoffs, outsourcing overseas, and as in GM's case profits mainly arising from accounting tricks and profitability of foreign operations such as GM plants in Brazil.

    President Obama is being given all sorts of credit for saving the auto industry without mentioning that the biggest new Chrysler automobile manufacturing plant will be in Mexico to make Fiats destined for the U.S. market, and that GM invested over $1 billion of its bailout money to build a new plant in Brazil.

    My main point, however,  is that the media commentators like Keith Olbermann and Rush Limbaugh often make too much of profit reports of corporations whether the news is good or bad.
    One huge problem is double entry bookkeeping that requires offsets to changes in highly dubious valuations of some things like goodwill, financial instruments, derivative financial instruments, and intangibles in  ledger accounts. In the opinion of some accounting experts, including me, GM's financial statements may have been more misleading than helpful to investors bidding on shares of its highly successful IPO in November 2010. I'm also dubious of reported "record profits" of the private sector in 2010.

    One problem of fair value accounting is the many-to-one mapping of balance sheet fair value adjustments to a single eps resicual number. As with nearly all aggregations, many-to-one mapping is a systemic problem that is too severe (link nutritional ratings of vegetables) ---
    http://faculty.trinity.edu/rjensen/FraudConclusion.htm#BadNews

    Early extinguishment of debt instruments is often impractical because of transactions costs of buying back debt plus transactions cost of issuing replacement debt.
    Investors who track earnings/eps often fail to appreciate how the FASB and the IASB are obsessed with balance sheet reporting accounting standards that leave earnings statements of dubious value for even informed investors. Both accounting  standard setting bodies have conceptual framework definitions for assets and liabilities but leave the concept of earnings somewhere off in the residual either. For example, in corporate fair market value (mark-to-market) adjustments of assets and liabilities, the offsetting adjustments to earnings probably include many adjustments to accrued earnings that will never be realized in cash. For example, if a company has fixed-rate debt that is marked-to-market, the unrealized earning adjustments over the years will never be realized if the company holds that debt to maturity. All those intervening interim earnings adjustments are certain to sum to zero even though they went up and down in a misleading way before final maturity of the debt.

     

    I might add that my intention at this point in time is to vote for President Obama in 2010, and I do not think this President is anti-business. Because of Obama's ability to silence his overwhelmingly liberal constituency, President Obama probably has the best chance among future 2012 rivals for the Presidency of reducing the trillion+ dollar annual budget deficits.

    In fact the November 20, 2010 edition of The Economist magazine has a front cover picture of President Obama in a lumberjack shirt while holding a huge budget cutting chain saw. I doubt that any contender to the Presidency has any chance compared to President Obama of cutting the trillion-dollar deficits. Liberals can just take on the liberal media in ways that conservatives would find their budget chain saws pushed back to their throats. This is not to say that legislators, be they liberal or conservative, will work with President Obama to cut the deficit. In fact, the politics of cost cutting probably make it impossible for any chain saw cuts in the federal budget. States, however, will be forced to cut budgets because, unlike Ben Bernanke, they can't simply print money without taxation or borrowing.

    "Speak softly and carry a big chainsaw:  Sorting out America’s fiscal mess is relatively simple. What’s needed is political courage," The Economist, November 20, 2010 ---
    http://www.economist.com/node/17522328?story_id=17522328

    LAST week Asia, this week Europe: no wonder Barack Obama has been to so many foreign summits since his party took a pounding in the mid-term elections. With the prospect of gridlock at home, a president naturally turns abroad. Yet Mr Obama badly needs to show that he can still lead on domestic policy. He should start by cajoling Congress into an agreement to tackle America’s ominous fiscal arithmetic.

    Conventional wisdom says such an agreement is impossible: the problem is too big, the politics too difficult. But it is wrong to suppose that the deficit is unfixable, as two proposals for fixing it have shown this month (see article). And even the politics may not be totally intractable.

    A trillion-dollar trove

    The scale of America’s fiscal problem depends on how far ahead you look. Today’s deficit, running at 9% of GDP, is huge. Federal debt held by the public has shot up to 62% of GDP, the highest it has been in over 50 years. But that is largely thanks to the economy’s woes. If growth recovers, the hole left by years of serial tax-cutting and overspending can be plugged: you need to find spending cuts or tax increases equal only to 2% of GDP to stabilise federal debt by 2015. But look farther ahead and a much bigger gap appears, as an ageing population needs ever more pensions and health care. Such “entitlements” will double the federal debt by 2027; and the number keeps on rising after then. The figures for state and local debt are scary too.

    The solution should start with an agreement between Mr Obama and Congress on a target for a manageable level of publicly held federal debt: say, 60% of GDP by 2020. They should also agree on the broad balance between lower spending and higher taxes to achieve this. This newspaper believes that the lion’s share of the adjustment should come on the spending side. Entitlements are at the root of the problem and need to be trimmed, and research has shown that although spending cuts weigh on growth in the short run, they hurt less than higher taxes. And in the long run later retirement and other reforms will expand the labour force and thus potential output, whereas higher taxes dull incentives to work and invest.

    Yet even to believers in small government, like this newspaper, there are good reasons for letting taxes take at least some of the strain. Politically, this will surely be the price of any bipartisan agreement. Economically, there is sensible room for manoeuvre without damaging growth. American taxes are relatively low after the reductions of recent years. In an ideal world the tax burden would be gradually shifted from income to consumption (including a carbon tax). But that is politically hard—and there is a much easier target for reform.

    America’s tax system is riddled with exemptions, deductions and credits that feed an industry of advisers but sap economic energy. Simply scrapping these distortions—in other words, broadening the base of taxation without any new taxes—could bring in some $1 trillion a year. Even though some of this would have to go in lowering marginal rates, it is a little like finding money behind the sofa cushions. The tax system would be simpler, fairer and more efficient. All this means that America can sensibly aim for a balance between spending cuts and higher taxes similar to the benchmark set by Britain’s coalition government. A ratio of 75:25 is about right.

    There is legitimate concern that, done hastily, austerity could derail a weak recovery. But this strengthens the case for a credible deficit-reduction plan. By reassuring markets that America will control its debt, the government will have more scope to boost the economy in the short term if need be—for instance by temporarily extending the Bush tax cuts.

    Mr Obama and the Republicans are brimming with ideas for freezing discretionary spending, which covers most government operations from defence to national parks. They have found common cause in attacking “earmarks”, the pet projects that lawmakers insert into bills. But discretionary outlays, including defence, are less than 40% of the total budget. Entitlements, in particular Social Security (pensions) and Medicare and Medicaid (health care for the elderly and the poor), represent the bulk of spending and even more of spending growth.

    On pensions, the solution is clear if unpopular: people will need to work longer. America should index the retirement age to longevity and make the benefit formula for upper-income workers less generous. The ceiling on the related payroll tax should be increased to cover 90% of earnings, from 86% now.

    Health-care spending is a much tougher issue, because it is being fed by both the ageing of the population and rising per-person demand for services. Richer beneficiaries should pay more of their share of Medicare, while the generosity of the system should be kept in check by the independent panel set up under Mr Obama’s health reform to monitor services and payments. The simplest way for the federal government to restrain Medicaid would be to end the current system of matching state spending and replace this with block grants, which would give the states an incentive to focus on cost-control.


    Chainsaw you can believe in

    Devising a plan that reduces the deficit, and eventually the debt, to a manageable size is relatively easy. Getting politicians to agree to it is a different thing. The bitter divide between the parties means that politicians pay a high price for consorting with the enemy. So Democrats cling to entitlements, and Republicans live in fear of losing their next party nomination to a tea-party activist if they bend on taxes. Even the president’s own bipartisan commission can’t agree on what to do.

    But true leaders turn the hard into the possible. Two things should prompt Mr Obama. First, the politics of fiscal truth may be less awful than he imagines. Ronald Reagan and Bill Clinton both won second terms after trimming entitlements or raising taxes. Polls in other countries suggest that nowadays tough love can sell. Second, in the long term economics will tell: unless it changes course, America is heading for a bust. If Mr Obama lacks the guts even to start tackling the problem, then ever more Americans, this paper and even those foreign summiteers will get ever more frustrated with him.


    ."Fair Value or Not Fair Value:  The loan is the question," by Marco Trombetta, WebCPA, October 27, 2010 ---
    http://www.webcpa.com/news/Fair-Value-Not-Fair-Value-56078-1.html

    At first glance these two situations seem pretty common and standard. Consequently, the general public could think that the accounting for these situations should be pretty uncontroversial and straightforward.

    However, anyone who is familiar with recent accounting debates is aware that this is far from being the case. These are two of the most controversial items when the issue of accounting for financial instruments is examined. Moreover, they are at the heart of the conflicting areas of the convergence process put in place by FASB and the IASB, which is due to be completed by 2011.

    Two official documents have been recently released on the subject. In November 2009, the IASB issued IFRS 9 (Financial Instruments), the new international standard on financial instruments, which established the new rules to classify and account for financial assets. For financial liabilities, the old IAS 39 (Financial Instruments: Recognition and Measurement) is still the valid standard.

    On the other side of the Atlantic, in May 2010, FASB issued an exposure draft on “Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities.”

    These documents contain important areas of disagreement on how to account for financial instruments. In particular, the two documents openly disagree in prescribing how to account for the situations described above.

    The Financial Crisis and Fair Value Accounting

    Accounting for financial instruments has always been controversial. IAS 32 and IAS 39 were already the most controversial standards in the debate that preceded the official endorsements of International Accounting Standards by the European Union in 2005.

    However, the financial crisis that began in 2007 further fueled the debate. At its heart lies the question of whether we want to account for financial instruments at historical cost or fair value. Many commentators have argued that the impact of the financial crisis on the markets was aggravated by the use of FV accounting, as many of the financial assets involved in the collapsing of financial markets around the world.

    Was this the case?

    On a theoretical basis the argument can be solidly defended. An article by Guillaume Plantin of the London Business School, Haresh Sapra of the Booth School of Business, and Hyun Song Shin of Princeton University, published in the Journal of Accounting Research in 2008, has been frequently quoted to advocate this argument. In that article, the authors model a market where trading returns are also determined based, at least partially, on the behavior of the rest of the market and not only on the intrinsic feature of the asset traded.

    In such a setting FV accounting may lead to high inefficiencies because of a sort of snowball effect that creates artificial volatility. This is true in particular when the assets traded are senior, illiquid and long-lived — three features shared by many of the so-called toxic assets involved in the crisis. More generally, FV accounting, by creating a feedback loop effect from the market price to the accounting system, can induce fire sales of assets that again affect the market price. The final consequence is a vicious circle that can potentially amplify any initially small outside shock to prices.

    From an empirical point of view, it has been difficult to sustain this theoretical argument. Christian Leuz of the Booth School of Business and Christian Laux of Goethe-University Frankfurt provide a thorough analysis of the actual working of FV accounting rules in the U.S. to provide evidence against this idea. They show that most of the assets that were accounted at FV by banks before and after the start of the crisis were actually so-called Level 3 fair value assets. This means that their valuations were isolated from the behavior of the market prices and were conducted by using an internal model. They also provide a comprehensive review of other academic studies that question the empirical relevance of the theoretical vicious circle argument.

    However, the debate about accounting for financial instruments has certainly played an important role in the drafting of the two recent regulatory documents.

    Accounting Regimes and Financial Decisions

    A related aspect of the debate has to do with the question of whether accounting regimes are “neutral” or have the power to influence the investment decisions of financial institutions. This question was addressed in a recent theoretical paper that I developed together with Silviu Glavan of the University of Navarra. We show that if accounting numbers are used as the contractual basis to distribute returns among shareholders, then the portfolio chosen by that financial institution is determined by the adopted accounting regime.

    In particular, FV accounting induces a more conservative (less risky) portfolio choice than HC accounting. Is this good or bad? It depends on the ultimate objective of the regulators. If the aim is to reduce the level of risk in the system, then this is a desirable outcome.

    However, in terms of consumption smoothing over time (an important aspect of the role played by the financial institutions in the system), the FV outcome can be more inefficient than the HC outcome.

    From an empirical point of view, again, it is difficult to establish a conclusive result. However, we can use Europe as a test. We can interpret the shift in 2005 from previous national standards to IFRS as a move towards a more extensive use of FV. Looking at the resistance voiced by financial institutions before IFRS adoption in Europe, it seems to be how it was perceived in the financial world. We studied a sample of European banks and analyzed the composition of their portfolio before and after 2005 and found preliminary evidence in favor of our theoretical predictions: the proportion of risky assets diminished after the adoption of IFRS.

    In summary, academic research on accounting for financial instruments gives us a couple of insights.

    First, the choice of the accounting regime for financial instruments may have real effects, but they seem to be more evident at the micro level of portfolio choice than at the macro level of the overall stability of financial markets. In other words different accounting regimes may affect the composition of the investment choices made in the markets, but they are less likely to play an active role in the possible destabilization of the markets.

    Second, long-term debt type instruments may play a crucial role in determining the effects of different accounting regimes in the economy.

    FASB vs. IASB

    Both the models proposed by FASB and the IASB attempt to simplify the prescriptions of standards in this delicate area because they basically reduce the old three-category model to a new two-category model.

    With respect to the accounting for instruments held for trading purposes, both have advocated an FV model. However, it is not surprising that the major area of difference between IFRS 9 and FASB’s exposure draft involves the accounting for loan type instruments held with the intention to collect the contractual flows.

    According to IFRS 9, these instruments should be accounted for at amortized cost, whereas FASB’s exposure draft proposes to account for them at fair value. This difference is particularly relevant for banks because it affects the accounting for their loan portfolios and for companies because it affects the accounting for their “own credit.” Many of the comment letters on the exposure draft have been highly critical of the FV model proposed by FASB and have advocated a mixed measurement model similar to the one proposed by the IASB. For this reason the final outcome of the changes proposed by FASB is not clear.

    However, it is fair to say that a substantial part of the final degree of success of the convergence process depends on how the issue of accounting for financial instruments will be resolved.

    Professor Marco Trombetta is vice dean of research at IE Business School in Madrid, Spain.

     

    Jensen Comment
    Thank you Edith for the heads up in sending me the link to
    http://www.webcpa.com/news/Fair-Value-Not-Fair-Value-56078-1.html


    Although Edith did not mention it, I find it interesting that an accountic research finding from JAR is cited in a practitioner journal. It would've been more exceptional had the author himself been a practitioner. Sadly, not this time.


    I don't think Tom Selling is going to like this article, but then Tom is not really concerned about temporal earnings volatility caused by obsessions with the balance sheet. Fair value proponents don't seem to care about the quality of earnings in a bouncing ball eps.


    I made a somewhat similar argument years ago, but a FASB member (not yet appointed to the Board) said it made no sense to him and walked out of my vsdr presentation ---
    http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm
    Of course my own paper is probably unduly complex. I never tried to have it published and elected to stop confusing my audiences and my students with this case.

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     


    "DataLine 2010-34: Changes to Financial Instruments Accounting -- Impacts for Nonfinancial Services Companies," PwC Direct, August 26, 2010 ---
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-88PUWY&SecNavCode=TMCB-4L9HAT&ContentType=Content

    Summary:
    The FASB's proposal to change the accounting for financial instruments and hedge accounting could have broad implications to companies across all industries, including those in commercial and industrial industries. The proposed changes could result in a significant expansion of the use of fair value. Such changes would require greater valuation expertise and result in increased earnings volatility in many cases. Common instruments including investments in equity and debt instruments, accounts receivable and issuances of convertible debt, among others, would be affected. Companies should consider evaluating the impacts of the proposed changes now and consider providing feedback to the FASB on this very important proposal, which is open for comment through September 30, 2010. This DataLine discusses a few of the more common instruments and transactions that could be affected if proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, is adopted in its current form.

    Jensen Comment
    I still have to give more thought on how fair value accounting will increase earnings volatility. It will certainly increase volatility if commodities (other than precious metals and gemstones) like corn inventories are one day in the future required to be carried at fair value. But thus far the new FASB and IASB standards only are expanding  fair value accounting to more types of financial instruments.

    Fair value accounting will certainly increase earnings volatility for unhedged booked financial instruments that were previously carried in AFS or HTM classifications under FAS 115. That one is a no brainer.

    For fair value hedges of booked financial hedge items FAS 133 requires that the hedged items be carried at fair value during the hedging period so not much of substance changes here during the hedging period. Outside the hedging period, however, fair value accounting will create more earnings volatility for securities previously classified as AFS or HTM. For unbooked hedged items we still use that the account called "Firm Commitment" invented by FAS 133. It would be absurd for "Firm Commitment" account balances to be charged to current earnings, because then firms hedging for fair value would be unfairly hammered asymmetrically in terms of earnings volatility for unbooked hedged items.

    For cash flow hedges, there was no fair value risk before hedging.  Unless fair value is driven by something other than changes in interest rates the booked value of the bond should remain constant. When value changes by factors other than interest rate risk, I do see how the new fair value accounting might increase earnings volatility. If the hedged item was previously carried at amortized cost rather than fair value, the change to fair value accounting will impact current earnings if those fair value changes are not booked to AOCI. In the past, under the old FAS 115, changes in value of AFS securities could be posted to AOCI even when those changes in value were do to things other than changes in interest rates. This will change under the new rules for financial instruments accounting since there are no longer any AFS safe harbors.

    What is not clear to me is whether the supposed IFRS principles based standards will allow auditors to have more flexibility in offsetting fair value changes in financial instruments to AOCI. Perhaps this will be one of those areas in the revised IFRS 9 that adds bright lines requiring that offsets go to current earnings. I don't think IFRS 9 will give auditors flexibility about using AOCI with discretion.

     


    The IASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    Whereas firms are increasingly pressured by the FASB and the IASB to maintain financial assets at fair value, maintaining financial liabilities at fair values is much more controversial since the future cash flows of fixed-rate debt may depart greatly from current fair value. For cash flows of a fixed rate mortgage are well defined whereas the fair value of those cash flows may fluctuate day-to-day with interest rates. Fair value adjustments of debt that the firm either cannot or does not intend to liquidate may be quite misleading regarding financial risk.

    The same cannot be said for derivative financial instruments where FAS 133 and IAS 39 require maintaining the current reported balances at fair value.

    However, the FASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    "Exposure Draft on measurement of financial liabilities," IAS Plus, May 11, 2010 --- http://www.iasplus.com/index.htm

    The IASB has published for public comment an exposure draft (ED) of proposing to amend the way the fair value option in IAS 39 Financial Instruments: Recognition and Measurement is applied with respect to financial liabilities. Many investors and others have said that volatility in profit or loss resulting from changes in an entity's own credit risk is counter-intuitive and does not provide useful information – except for value changes relating to derivatives and liabilities held for trading (such as short sales). The IASB is proposing, therefore, that all gains and losses resulting from changes in 'own credit' for those financial liabilities that an entity chooses to measure at fair value should be recognised as a component of 'other comprehensive income', not in profit or loss. The ED does not propose any other changes for financial liabilities. Consequently, the proposals will affect only those entities that elect to apply the fair value option to their financial liabilities. Importantly, those who prefer to bifurcate financial liabilities when relevant may continue to do so. That is consistent with the widespread view that the existing requirements for financial liabilities work well, other than the 'own credit' issue that these proposals cover.

    Unlike FAS 133, IAS 39 no longer requires bifurcation of embedded derivatives that are not "clearly and closely related" to the host instrument.

    The worst part of all this is that students, let’s call them classic sophomores, are willing to jump to conclusions like the following:

    • 1.       Historical cost accounting, even when price-level adjusted, leads to ancient balances of assets and liabilities that are seriously out of date with current market values whether markets are entry or exit value markets.

    • 2.       Therefore, to the extent possible assets and liabilities should be carried at fair values (exit or entry) with changes in fair values reported in current earnings.

    What these sophomores do not understand that fair value adjustments create utter fiction for held-to-maturity or other “locked-in” items. Adjusting some assets and liabilities to fair values is utter fiction if there is no option or intent for fair value transactions to transpire before some shock such as contractual maturity or abandonment of a manufacturing operation (that makes factory real estate finally available for sale). The classic example is fixed-rate debt for which there is no embedded option to pay off the debt prematurely or purchase it back in an open market. If the cash flow stream is thus set in stone until maturity, any adjustments to fair value are accounting fictions. Temporal changes in current earnings for fictional accounting value changes are more misleading than helpful.

    Creditors might propose deals for early retirement, but they do so when it is not particularly advantageous for the debtor. Conversely, debtors may propose deals for early retirement, but they will do so when it is not particularly advantageous for the creditors. Hence such debt is usually retired early only when either the debtor or the creditor is willing to negotiate a heavy penalty. Without a willingness to incur heavy penalties, changes in earnings for accounting fictions are highly misleading in terms of fictional earnings volatility.

    When we have contracts that provide debtors more embedded options for premature settlements, then we might begin to think more seriously about adjusting the debt to fair value. Many debt contracts have embedded options for the debtor to pay the debt off before retirement (often at some contracted penalty such as bond call back prices). In the case of financial assets, we now have the classifications “Hold-to-Maturity” versus “Available-for-Sale” that we apply to financial assets.

    It seems that under the proposed IAS 39 amendment, providing an option to carry debt at fair value, we could allow debtors to similarly classify debt as “Hold-to-Maturity” versus “Available-for-Buy-Back” where the debtor declares an intent to buy the debt back if the fair value of the debt in the market fair value becomes attractive. This often happens for fixed-rate marketable bonds when interest rates rise and market values of the bonds decline. In fact, Exxon invented “in-substance defeasance” to simulate debt buy backs when the transactional cost penalties for actual buy backs were too high. Until FAS 125 no longer allowed removing defeased debt from the balance sheet, this was a means by which Exxon could report realized gains on debt value reduction and remove debt from the balance sheet without truly abandoning payoff obligations ---
    http://faculty.trinity.edu/rjensen/Theory01.htm

    In-Substance Defeasance
    In-substance defeasance used to be a ploy to take debt off the balance sheet. It was invented by Exxon in 1982 as a means of capturing the millions in a gain on debt (bonds) that had gone up significantly in value due to rising interest rates. The debt itself was permanently "parked" with an independent trustee as if it had been cancelled by risk free government bonds also placed with the trustee in a manner that the risk free assets would be sufficient to pay off the parked debt at maturity. The defeased (parked) $515 million in debt was taken off of Exxon's balance sheet and the $132 million gain of the debt was booked into current earnings ---
    http://www.bsu.edu/majb/resource/pdf/vol04num2.pdf

    Defeasance was thus looked upon as an alternative to outright extinguishment of debt until the FASB passed FAS 125 that ended the ability of companies to use in-substance defeasance to remove debt from the balance sheet. Prior to FAS 125, defeasance became enormously popular as an OBSF ploy
    .

    Since companies now have the option of classifying financial assets as HTM versus AFS, it seems symmetrical in the proposed IAS 39 amendment to allow financial liabilities to be classified as HTM versus AVBB (available-for-buy-back). However, in both the AFS and the AVBB classifications, the unrealized changes in fair values should be charged to AOCI rather than current earnings. This keeps accounting fictions out of current earnings, at least with respect to financial asset and liability value change fictions.

    One thing I propose for the proposed IAS 39 amendment is that the mandatory value changes for AFS financial assets not be declared optional for AVBB debt. The changes should be mandatory (not optional) for AVBB liabilities just as they are mandatory for AFS assets. In both instances, however, changes in value should not impact current earnings until the changes in value are realized.

    Of course the AFS and AVBB classifications are built upon management declarations of intent. But the IASB imposes heavy penalties on companies that renege on their HTM classifications (that allow retention of historical cost accounting). Companies that renege on HTM classifications may long regret not staying true to their declared intent --- at bit like the penalty Tiger Woods is now paying for not staying true to marriage vows.

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm


    Accounting valuation models for securities do not, to my knowledge, allow for the "value added" by the middle men/women hawking/touting those securities. For example, it is common to value derivatives based upon yield curves generated in a Bloomberg or Reuters terminal or turn to Steve Penman's textbook recommendations for valuing a potential investment.

    It turns out that those middle men/women make a huge difference in sales volume and prices of securities. This is something that I certainly neglected to teach back when I was teaching valuation, and I suspect many other accounting and finance teachers and researchers have been just as negligent.

    The success of hawking/touting may have some really undesirable implications for fair value accounting.
    Has this ever been taken up in the literature of fair value accounting or in standard setting commentaries?

    I missed this one until Simoleon Sense and Jim Mahar picked up on this in recent blog postings.

    "Spam Works: Evidence from Stock Touts and Corresponding Market Activity," by Laura Frieder and Jonathan Zittrain, SSRN, March 14, 2007 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=920553

    Abstract:
    |We assess the impact of spam that touts stocks upon the trading activity of those stocks and sketch how profitable such spamming might be for spammers and how harmful it is to those who heed advice in stock-touting e-mails. We find convincing evidence that stock prices are being manipulated through spam. We suggest that the effectiveness of spammed stock touting calls into question prevailing models of securities regulation that rely principally on the proper labeling of information and disclosure of conflicts of interest as means of protecting consumers, and we propose several regulatory and industry interventions.

    Based on a large sample of touted stocks listed on the Pink Sheets quotation system and a large sample of spam emails touting stocks, we find that stocks experience a significantly positive return on days prior to heavy touting via spam. Volume of trading responds positively and significantly to heavy touting. For a stock that is touted at some point during our sample period, the probability of it being the most actively traded stock in our sample jumps from 4% on a day when there is no touting activity to 70% on a day when there is touting activity. Returns in the days following touting are significantly negative. The evidence accords with a hypothesis that spammers "buy low and spam high," purchasing penny stocks with comparatively low liquidity, then touting them - perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing - in order to increase or maintain trading activity and price enough to unload their positions at a profit. We find that prolific spamming greatly affects the trading volume of a targeted stock, drumming up buyers to prevent the spammer's initial selling from depressing the stock's price. Subsequent selling by the spammer (or others) while this buying pressure subsides results in negative returns following touting. Before brokerage fees, the average investor who buys a stock on the day it is most heavily touted and sells it 2 days after the touting ends will lose close to 5.5%. For those touted stocks with above-average levels of touting, a spammer who buys on the day before unleashing touts and sells on the day his or her touting is the heaviest, on average, will earn 4.29% before transaction costs. The underlying data and interactive charts showing price and volume changes are also made available.

    Bob Jensen's threads on valuation are at
    http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     


    Inefficiencies in the Information Thicket
    "Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis," by Robert P. Bartlett III, Harvard Law School Forum, May 27, 2010 ---
    http://blogs.law.harvard.edu/corpgov/2010/05/27/inefficiencies-in-the-information-thicket/

    In the paper, Inefficiencies in the Information Thicket: A Case Study of Derivative Disclosures During the Financial Crisis, which was recently made publicly available on SSRN, I provide an empirical examination of the effect of enhanced derivative disclosures by examining the disclosure experience of the monoline insurance industry in 2008. Conventional wisdom concerning the causes of the Financial Crisis posits that insufficient disclosure concerning firms’ exposure to complex credit derivatives played a key role in creating the uncertainty that plagued the financial sector in the fall of 2008. To help avert future financial crises, regulatory proposals aimed at containing systemic risk have accordingly focused on enhanced derivative disclosures as a critical reform measure. A central challenge facing these proposals, however, has been understanding whether enhanced derivative disclosures can have any meaningful effect given the complexity of credit derivative transactions.

    Like AIG Financial Products, monoline insurance companies wrote billions of dollars of credit default swaps on multi-sector CDOs tied to residential home mortgages, but unlike AIG, their unique status as financial guarantee companies subjected them to considerable disclosure obligations concerning their individual credit derivative exposures. As a result, the experience of the monoline industry during the Financial Crisis provides an ideal setting with which to test the efficacy of reforms aimed at promoting more elaborate derivative disclosures.

    Overall, the results of this study indicate that investors in monoline insurers showed little evidence of using a firm’s derivative disclosures to efficiently resolve uncertainty about a monoline’s exposure to credit risk. In particular, analysis of the abnormal returns to Ambac Financial (one of the largest monoline insurers) surrounding a series of significant, multi-notch rating downgrades of its insured CDOs reveals no significant stock price reactions until Ambac itself announced the effect of these downgrades in its quarterly earnings announcements. Similar analyses of Ambac’s short-selling data and changes in the cost of insuring Ambac debt securities against default also confirm the absence of a market reaction following these downgrade announcements.

    Based on a qualitative examination of how investors process derivative disclosures, to the extent the complexity of CDOs impeded informational efficiency, it was most likely due to the generally low salience of individual CDOs as well as the logistic (although not necessarily analytic) challenge of processing a CDO’s disclosures. Reform efforts aimed at enhancing derivative disclosures should accordingly focus on mechanisms to promote the rapid collection and compilation of disclosed information as well as the psychological processes by which information obtains salience.

    The paper is available for download from
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1585953

    Bob Jensen's tutorials on accounting for derivative financial instruments and hedging activities ---
    http://faculty.trinity.edu/rjensen/caseans/000index.htm


    On May 26, 2010, the FASB issued a proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out its proposed comprehensive approach to financial instrument classification and measurement, and impairment, and revisions to hedge accounting. Also, extensive new presentation and disclosure requirements are proposed.

    Here’s a “brief” from PwC on the new May 26 ED from the FASB --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=THUG-85UVWW&SecNavCode=MSRA-84YH44&ContentType=Content

    PwC points out some of the major differences between these proposed FASB revisions versus the IASB provisions.

    Click Here to download the ED  http://snipurl.com/fasb5-26-2010  

    The proposal also aims at providing more timely information on anticipated credit losses to financial statement users by removing the “probable” threshold for recognizing credit losses. It seeks to better portray the results of asset-liability management activities at financial institutions. But there is much, more that I both agree and disagree with at this proposal stage.

    From: Jensen, Robert
    Sent: Friday, May 28, 2010 6:39 AM
    To: AECM@LISTSERV.LOYOLA.EDU
    Subject: May 26 FASB ED Mush http://snipurl.com/fasb5-26-2010

    Hi again Paul,

    Subject the May 26 FASB ED  http://snipurl.com/fasb5-26-2010  

    Thank you Paul for telling me this ED was finally released …. On second thought a “thank you” for this mush is being too polite.

    It will be interesting to compare the comment letters sent to the FASB regarding this mush with the comment letters sent in on an earlier (2008) ED ---
    http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=1218220137090&project_id=1590-100
    Some comments might be carbon copies with new dates.
    But watch for the comments that change between the 2008 ED versus the new 2010 ED.
    For corporations that prefer mush to standards, I predict some glowing praise for going carte blanch on financial instruments standards.

    It was late yesterday when I rushed out a reply to you that appears at the bottom of this current update message. I corrected a couple of bothersome typos.

    Hedge accounting basically means that changes in the fair value of the hedging derivative get charged to AOCI rather than current earnings to eliminate earnings volatility due to hedging contracts that have not yet net settled. For example, firms that lock in future commodity prices or interest rates with a forward, futures, swap, or possibly an option contract will not see earnings fluctuate wildly because they hedged cash flows of forecasted transactions. But the AOCI can be charged only to the extent that the hedge is effective. Ineffectiveness must be charged to current earnings.

    Those who want to see hedge effectiveness testing under the 80-125 bright line dollar offset guide (that was written into the original IAS 39) and implied in FAS 133 may do so at the following links:

    Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for the following case:  “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,” by Pamela A. Smith and Mark J. Kohlbeck
         Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118
    Bob Jensen's Amendment is at http://faculty.trinity.edu/rjensen/CaseAmendment.htm

     

    Also scroll down to the term “Ineffectiveness” in my glossary at
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms

     Some hedges are likely to be more effective than others. These usually include forward, futures, and swap contracts. Purchased options are notoriously ineffective due, in large measure, to the conservatism of commodity traders vis-à-vis commodity options traders. Commodities contracts and commodities options contracts are traded in separate markets. Because options are so notoriously ineffective as hedges, most companies only charge intrinsic value portions of price changes of options (when the options are in-the-money) to AOCI and charge changes in time value to current earnings. Under the 80-125 dollar offset rule, purchased options would otherwise not generally be eligible for any hedge accounting relief. The Smith and Kohlbeck case cited above illustrates how options rarely meet the 80-125 test. Smith and Kohlbeck simplified their case to their peril by not testing for hedge effectiveness. Virtually all their hedges were in fact ineffective. The case now makes a good example of what can happen if hedge effectiveness testing is ignored.

    Paragraph 146 of the original IAS 39 reads as follows:

    146. A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80 per cent to 125 per cent. For example, if the loss on the hedging instrument is 120 and the gain on the cash instrument is 100, offset can be measured by 120/100, which is 120 per cent, or by 100/120, which is 83 per cent. The enterprise will conclude that the hedge is highly effective. 

    Delta ratio D = (D option value)/ D hedged item value)
    range [.80 <
    D < 1.25] or [80% < D% < 125%]     
    (FAS 133 Paragraph 85)
    Delta-neutral strategies are discussed at various points (e.g., FAS 133 Paragraphs 85, 86, 87, and 89)

     A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80-125% (IAS 39 Paragraph 146).  The FASB requires that an entity define at the time it designates a hedging relationship the method it will use to assess the hedge's effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged (FAS 133 Paragraph 62).  In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument.  The Statement permits (but does not require) an entity to exclude all or a part of the hedging instrument's time value from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).

    Hedge ineffectiveness would result from the following circumstances, among others:

    a) difference between the basis of the hedging instrument and the hedged item or hedged transaction, to the extent that those bases do not move in tandem.

    b) differences in critical terms of the hedging instrument and hedged item or hedged transaction, such as differences in notional amounts, maturities, quantity, location, or delivery dates.

    c) part of the change in the fair value of a derivative is attributable to a change in the counterparty's creditworthiness (FAS 133 Paragraph 66).

    Because the dollar offset method is quite restrictive, many companies prefer accepted regression tests of hedge effectiveness. Regression, however, often does not bring hedge accounting relief for purchased options.
    Hedge Effectiveness:  The Wild Card in Accounting for Derivatives," by Ira C. Kawaller ---
    http://www.kawaller.com/pdf/AFP-Hedge Effectiveness.pdf
    Also see http://www.cs.trinity.edu/~rjensen/Calgary/CD/HedgeEffectiveness.pdf

    I also have a hedge effectiveness testing tutorial (in PowerPoint) at
    http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/ 
    (click on the 06effectiveness.ppt file)

    Companies have a lot of trouble both in quantitative testing for hedge effectiveness and in meeting the guidelines for a hedge to be effective. With a magic wave of the wand (http://snipurl.com/fasb5-26-2010 ), the IASB and FASB now propose to allow “qualitative testing” which in my viewpoint is tantamount to qualitative mush. Companies will soon be able to declare most any hedge as effective when they say their prayers faithfully night.

    The Smith and Kohlbeck case shows what might happen in the future if management simply declares the hedging contracts as qualitatively effective.

    Boo on that idea in http://snipurl.com/fasb5-26-2010  

    I don’t mind elimination of the short-cut method, because that was limited only to interest rate swaps and was not allowed in general for other types of hedging contracts.

    I still have not really poured over all parts of the ED at http://snipurl.com/fasb5-26-2010
    But I will ask if turning “standards” into qualitative judgment mush is the way to go whenever the former standards were complicated.

    Is this the magical wave of the wand for convergence of FASB and IASB standards?

    At what point does qualitative judgment mush cease to be a “standard?”

    Bob Jensen 

    From: AECM, Accounting Education using Computers and Multimedia [mailto:AECM@LISTSERV.LOYOLA.EDU] On Behalf Of Jensen, Robert
    Sent: Thursday, May 27, 2010 7:04 PM
    To: AECM@LISTSERV.LOYOLA.EDU
    Subject: Re: The Accounting Onion

    Hi Paul,

    Thanks for the heads up!

    I’ve really not had time yet to go through the complex May 26 ED at http://snipurl.com/edmay26-2010

    Some things really confuse me in what I’ve seen so far. One bothersome feature is the asymmetry between reported fair values of financial assets versus liabilities. Suppose Company D sells 10% of a bond issue  to Company B for $850 per bond. On December 31 Company B reports the December 31 trading price of the bond at $1,010 as the fair value of each investment bond. Company D, however, has had no change in credit rating for the year ended December 31. Hence, it reports a fair value of $850 for each bond indebtedness that Company B reports as an asset worth $1,010 per bond. Debtors must somehow factor in the change in fair value of credit rating, whereas the investor only looks at change in trading fair value.

    There’s also an issue of timing. Presumably credit rating agencies are not going to normally change Company D’s credit rating until after Company D releases its audited financial statements. Hence, changes in credit rating might have an awfully long lag in terms of current fair value adjustments to bond liabilities. This all must be as clear as mud to investors and creditors reading financial statements.

    Some other parts of the ED seem like even worse mush. Effectiveness testing for hedge accounting seems more subjective and ambiguous than most anything that I’ve ever seen proposed accounting standards. It’s pure mush at this point relative to the 80-125 (egads a bright line) guideline suggested in the original version of IAS 39. How we can expect any kind of consistency between companies or even consistency between different hedging contracts within the same company is a mystery to me without some bright line guides.

    Hedge effectiveness testing will essentially become more subjective than a beauty contest. If auditors could not say no to Repo 105 debt masking, how in the world can they buck clients who rate the beauty of their hedging contracts?

     Bob Jensen

    From: AECM, Accounting Education using Computers and Multimedia [mailto:AECM@LISTSERV.LOYOLA.EDU] On Behalf Of Paul Polinski
    Sent: Thursday, May 27, 2010 3:44 PM
    To: AECM@LISTSERV.LOYOLA.EDU
    Subject: Re: The Accounting Onion

    Hi Bob.  Late yesterday the FASB posted their financial instrument exposure draft to their web site.

    Paul


    From: "Jensen, Robert" <rjensen@TRINITY.EDU>
    To: AECM@LISTSERV.LOYOLA.EDU
    Sent: Thu, May 27, 2010 1:15:31 PM
    Subject: Re: The Accounting Onion

    The lame duck Superman zooms in to aid the SEC’s Superwoman!

    "IASB Chairman Outlines Approach for Reconciling Financial Instrument Standards,"
    by Matthew G. Lamoreaux,   Journal of Accountancy, June 2010 ---
    http://www.journalofaccountancy.com/Web/20102960.htm

    Jensen Comment
    What interests me is the ever-changing plans for revision of IAS 39. Hedging transactions are like staff infections that just will not go away no matter how much Sir David Tweedie wishes upon a star.

    Bob Jensen's threads on FASB-IASB standards convergence are at
    http://www.journalofaccountancy.com/Web/20102960.htm

    Robert E. (Bob) Jensen
    Trinity University Accounting Professor (Emeritus)
    190 Sunset Hill Road
    Sugar Hill, NH 03586
    Tel. 603-823-8482
    www.trinity.edu/rjensen


    "FASB Would Drop Fair Value for Pension Plan Loans," Journal of Accountancy, September 2010 ---
    http://www.journalofaccountancy.com/Web/20103236.htm

    FASB this week issued a Proposed Accounting Standards Update (ASU) that is intended to clarify how defined contribution pension plans should classify and measure loans to participants. Under the Proposed ASU, Plan Accounting—Defined Contribution Pension Plans (Topic 962), Reporting Loans to Participants by Defined Contribution Pension Plans (a consensus of the FASB Emerging Issues Task Force), loans to participants would no longer be presented at fair value.

     

    Participant loans are currently classified as an investment in accordance with the defined contribution pension plan guidance in Accounting Standards Codification (ASC) paragraph 962-325-45-10. ASC Subtopic 962-325 requires most investments held by a plan, including participant loans, to be presented at fair value. The amendments in the Proposed ASU would require that participant loans be classified as notes receivable from participants, which are segregated from plan investments and measured at their unpaid principal balance plus any accrued but unpaid interest. The proposed changes would affect any defined contribution pension plan that allows participant loans.

     

    The proposal says that the classification of participant loans as receivables acknowledges that participant loans are unique from other investments in that a participant taking out such a loan essentially borrows against his or her own individual vested benefit balance. FASB said the task force concluded that it is more meaningful to measure participant loans at their unpaid principal balance plus any accrued but unpaid interest, rather than at fair value.

     

    Amendments in the proposal would be applied retrospectively to all prior periods presented. The effective date will be determined after the EITF considers comments. Early adoption would be permitted. The proposal lists specific questions for respondents to consider when submitting comments, which are due Sept. 7.

    Jensen Comment
    By whatever name a rose is still a rose and a held-to-maturity security is still an amortized cost receivable/liability. Fair value adjustments add pure fiction to the balance sheet (other than general price level adjustments). I've never been in favor of fair value adjustments of any financial instrument that is truly HTM. Participant loans are not strictly HTM, but they are a unique type of financial instruments for which fair value accounting is pure fiction.


    In my opinion, Bill Isaac is an ignorant advocate of horrible and dangerous bank accounting
    First of all he blamed the subprime collapse of thousands of banks on the FASB requirements for fair value accounting (totally dumb) --- http://faculty.trinity.edu/rjensen/2008bailout.htm#FairValue

    Now he wants the FASB to continued to grossly under estimate loan loss reserves (now that the FASB is finally trying to fix the problem)
    “AccountingWEB Exclusive: Former FDIC Chief says FASB proposal is 'irresponsible'," AccountingWeb, June 3, 2010 ---
    http://www.accountingweb.com/topic/accounting-auditing/aw-exclusive-former-fdic-chief-says-fasb-proposal-irresponsible

    Banks are notorious for underestimating loan loss reserves and auditors are notorious for letting them get away with it ---
    http://faculty.trinity.edu/rjensen/2008bailout.htm#AuditFirms

    On May 26, 2010 the FASB issued an exposure draft that would make it more difficult to enormously underestimate load losses. International standards are expected to be changed accordingly.

    On May 26, 2010, the FASB issued a proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out its proposed comprehensive approach to financial instrument classification and measurement, and impairment, and revisions to hedge accounting. Also, extensive new presentation and disclosure requirements are proposed.

    Here’s a “brief” from PwC on the new May 26 ED from the FASB --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=THUG-85UVWW&SecNavCode=MSRA-84YH44&ContentType=Content

    PwC points out some of the major differences between these proposed FASB revisions versus the IASB provisions.

    Click Here to download the ED  http://snipurl.com/fasb5-26-2010  

     

     


    From The Wall Street Journal Accounting Weekly Review on June 4, 2010

    ECB Warns Write-Downs Could Reach $239 Billion
    by: David Enrich and Stephen Fidler
    Jun 02, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Bad Debts, Banking, Treasury Department

    SUMMARY: "...The European Central Bank warned late Monday that euro-zone banks face ?195 billion ($239.26 billion) in write-downs this year and the next due to an economic outlook that remained 'clouded by uncertainty.' ...The ECB in May launched a series of initiatives to help banks, including the purchases of government debt from banks and the renewal of a program to give cheap six-month loans to banks....The moves helped provide some stability to the banks, but Europe's intertwined banking system remains stressed." Factors leading to this predicament stem from heavy exposure for real estate loans in Spain, Portugal, and Greece. Another contributing point is the fact that Europe did not replenish their banks' capital in 2008 and 2009 as did the U.S. and U.K., partly with taxpayer funds.

    CLASSROOM APPLICATION: The article is useful in discussing bank balance sheets and loan losses as they relate to an overall economy.

    QUESTIONS: 
    1. (Introductory) What is the underlying problem that began leading to concerns about the overall health of European banks?

    2. (Introductory) What bank write-downs may reach ?195 billion ($239.26 billion) this year and next? How does an economic slow down lead to this situation?

    3. (Advanced) Explain why "some European banks have less capital and more leverage than their U.S. counterparts"? In your answer, define the terms capital and leverage. Comment on the formula for leverage used in the chart entitled "In Deeper" sourced from the Organization for Economic Cooperation and Development (OECD).

    4. (Advanced) What is the European banks' "stress test" that was begun in 2009 and is now being prepared for the second time?

    5. (Introductory) Describe factors on both sides of the argument as to whether to disclose these stress test results that were not disclosed last year and that the European Central Bank (ECB) may not disclose this year as well.

    Reviewed By: Judy Beckman, University of Rhode Island

    "ECB Warns Write-Downs Could Reach $239 Billion," by David Enrich and Stephen Fidler, The Wall Street Journal, June 1. 2010 ---
    http://online.wsj.com/article/SB10001424052748703406604575278620471963334.html?mod=djem_jiewr_AC_domainid

    In the latest indication that European banks are in ill health, the European Central Bank warned late Monday that euro-zone banks face €195 billion ($239.26 billion) in write-downs this year and the next due to an economic outlook that remained "clouded by uncertainty."

    The ECB news, part of its semiannual financial-stability report, comes on the heels of a campaign by governments and central banks to ease sovereign-debt problems in southern Europe. The efforts have failed to calm worries that a banking crisis may be forming on the Continent. That has led to escalating pressure on regulators and governments to do more.

    European governments already have cobbled together a €110 billion bailout for Greece and a €750 billion rescue for other weak economies of the euro zone. The ECB in May launched a series of initiatives to help banks, including the purchases of government debt from banks and the renewal of a program to give cheap six-month loans to banks, while the U.S. Federal Reserve reactivated a swap line to provide European banks with dollars.

    The moves helped provide some stability to the banks, but Europe's intertwined banking system remains stressed. Investors have hammered the sector, banks are stashing near-record amounts of deposits at the ECB—€305 billion as of Friday—instead of lending the funds to other institutions, risk-wary U.S. financial institutions are reducing their exposure to euro-zone banks, and U.S. government officials are pushing their case for Europe to disclose publicly the results of stress tests for euro-zone banks.

    ECB Vice President Lucas Papademos defended the central bank's response to the banking crisis and said results of European Union-wide stress tests of banks should be completed in July, providing further details on the capacity of the region's banks to withstand shocks. The results of stress tests last year of individual banks weren't released publicly. Some European countries are opposed to the public release of results.

    . . .

    Like the financial crisis two years ago that was sparked by the unraveling of the U.S. subprime-mortgage industry, Europe's banking problems originated in a tiny patch of the global economy: Greece.

    But the problems run deeper than the highly publicized fiscal woes facing Greece, prompting similar concerns about Portugal, Ireland and Spain. Credit-ratings firms have reduced these countries' rankings and have warned about possible future downgrades, with Fitch reducing Spain's triple-A rating by one notch on Friday.

    All told, more than €2 trillion of public and private debt from Greece, Spain and Portugal is sitting on the balance sheets of financial institutions outside the three countries, according to a Royal Bank of Scotland report last week. Investors, bankers and government officials are worried that as that debt loses value, banks across Europe could be saddled with losses.

    "Make no mistake: This is big," said Jacques Cailloux, RBS's chief European economist and the report's author. "We're talking about systemic risk [and] the potential for contagion."

    Concerns also are mounting about how European banks will finance themselves in coming years. The banks have hundreds of billions of euros in debt maturing by 2012, analysts and bankers say. Replacing those funds could be difficult and costly, given fierce competition for deposits and skittishness among bond investors. The situation has alarmed bankers and government officials, and it helped fuel last week's selloff in bank stocks.

    With funding scarce, some banks are becoming more dependent on the ECB. The central bank has doled out more than €800 billion in loans to banks, nearing its all-time high, according to UBS analysts. The ECB warned Monday that the "continued reliance" of some midsize banks on credit from the central bank remains "a cause for concern."

    The U.S. and U.K. moved aggressively in 2008 and 2009 to replenish their banks' capital buffers, sometimes with taxpayer funds.

    Most of Europe didn't follow suit, because their banking systems were largely spared the carnage of their Anglo-American counterparts. But as a result, most European banks today have thinner capital cushions and heavier debt loads than their U.S. and U.K. rivals, leaving them vulnerable to an economic slowdown.

    "Some European banks have less capital and more leverage than their U.S. counterparts and…the crisis in Europe seems to have lagged behind that in the U.S. in both the writing off of losses and in the speed of raising more capital," said Angel Gurria, secretary-general of the Organization for Economic Cooperation and Development, in a speech in May.

    OECD figures show that a selection of major U.S. banks are operating with leverage ratios—the ratio of assets to common equity—of between 12 and 17. By comparison, the same ratio for a group of major European banks ranged from 21 to 49, according to the OECD.

    European policy makers have been trying to address that disparity by working on a global overhaul of banking regulations, to be enacted in 2012, that would require banks to hold more capital and liquidity. "But the regulatory fixes aren't going to solve the problem right now," said Michael Ben-Gad, an economics professor at City University London.

    European governments and central bankers had hoped bailing out Greece and launching a liquidity program would relieve immediate pressure on other governments and the banking sector. But that hasn't happened, and new pressures could arise soon. The ECB last summer doled out €442 billion in one-year loans to euro-zone banks. Those loans come due June 30, potentially causing banks to scramble for a fresh source of cash this month.

    European officials face calls from the banking industry, the investment community and foreign government leaders, including U.S. Treasury Secretary Timothy Geithner, to redouble efforts to stabilize the banking system through new initiatives.

    RBS's Mr. Cailloux argues that the ECB should expand its recently launched program to buy government bonds and should broaden the effort to include private-sector debt as well.

    That could ease concerns that banks will suffer heavy losses, potentially blowing holes in their balance sheets, on their portfolios of sovereign and corporate bonds tied to some European economies. But such a move also could expose the central bank to potential losses.

    Citigroup Inc. last week circulated a paper calling on the ECB to launch a sort of insurance program to allow holders of government bonds—a group largely consisting of European banks—to sell the securities to the ECB in case of default. "Time is now of the essence and the authorities should continue to be bold and innovative in working to accelerate the impact of the available lines of support," Nazareth Festekjian, a Citigroup managing director, wrote in the paper.

    The ECB had no comment on calls to increase the size of the bond-buying program or on the Citigroup recommendations.

    Others want local European bank regulators to play a more proactive role monitoring their banks' exposures to troubled countries.

    In the U.K., the Financial Services Authority has been conducting repeated stress tests of major British banks' exposures to southern Europe. Similarly intense efforts don't appear to be under way elsewhere in Europe, said Pat Newberry, chairman of the U.K. financial-services regulatory practice at PricewaterhouseCoopers LLP.

    Mr. Newberry said conducting such tests would help European governments and banks get a better handle on their individual and collective vulnerabilities and to understand "how a series of unfortunate events can aggregate to turn a problem into a catastrophe."

    U.S. authorities believe that stress tests can help restore market confidence. The tests the U.S. conducted last year helped inject greater transparency and confidence in the banking system, U.S. officials have said.

    Banks are notorious for underestimating loan loss reserves and auditors are notorious for letting them get away with it ---
    http://faculty.trinity.edu/rjensen/2008bailout.htm#AuditFirms

    On May 26, 2010 the FASB issued an exposure draft that would make it more difficult to enormously underestimate load losses. International standards are expected to be changed accordingly.

    On May 26, 2010, the FASB issued a proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out its proposed comprehensive approach to financial instrument classification and measurement, and impairment, and revisions to hedge accounting. Also, extensive new presentation and disclosure requirements are proposed.

    Here’s a “brief” from PwC on the new May 26 ED from the FASB --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=THUG-85UVWW&SecNavCode=MSRA-84YH44&ContentType=Content

    PwC points out some of the major differences between these proposed FASB revisions versus the IASB provisions.

    Click Here to download the ED  http://snipurl.com/fasb5-26-2010  

     

     


    Question
    To what extent should the FASB and the IASB modify accounting standards for new theories of structured finance and securitization?

    "The Economics of Structured Finance," by Joshua D. Coval,  Jakub Jurek, and  Erik Stafford, Working Paper 09-060, Harvard Business School, 2008 ---
    http://www.hbs.edu/research/pdf/09-060.pdf

    The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.

    We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. First, we show that most securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities’ default risks, and how likely defaults were to be correlated. Using the prototypical structured finance security – the collateralized debt obligation (CDO) – as an example, we illustrate that issuing a capital structure amplifies errors in evaluating the risk of the underlying securities. In particular, we show how modest imprecision in the parameter estimates can lead to variation in the default risk of the structured finance securities which is sufficient, for example, to cause a security rated AAA to default with reasonable likelihood.

    A second, equally neglected feature of the securitization process is that it substitutes risks that are largely diversifiable for risks that are highly systematic. As a result, securities produced by structured finance activities have far less chance of surviving a severe economic downturn than traditional corporate securities of equal rating. Moreover, because the default risk of senior tranches is concentrated in systematically adverse economic states, investors should demand far larger risk premia for holding structured claims than for holding comparably rated corporate bonds. We argue that both of these features of structured finance products – the extreme fragility of their ratings to modest imprecision in evaluating underlying risks and their exposure to systematic risks – go a long way in explaining the spectacular rise and fall of structured finance.

    For over a century, agencies such as Moody’s, Standard and Poor’s and Fitch have gathered and analyzed a wide range of financial, industry, and economic information to arrive at independent assessments on the creditworthiness of various entities, giving rise to the now widely popular rating scales (AAA, AA, A, BBB and so on). Until recently, the agencies focused the majority of their business on single-name corporate finance—that is, issues of creditworthiness of financial instruments that can be clearly ascribed to a single company. In recent years, the business model of credit rating agencies has expanded beyond their historical role to include the nascent field of structured finance.

    From its beginnings, the market for structured securities evolved as a “rated” market, in which the risk of tranches was assessed by credit rating agencies. Issuers of structured finance products were eager to have their new products rated on the same scale as bonds so that investors subject to ratings-based constraints would be able to purchase the securities. By having these new securities rated, the issuers created an illusion of comparability with existing “single-name” securities. This provided access to a large pool of potential buyers for what otherwise would have been perceived as very complex derivative securities.

    During the past decade, risks of all kinds have been repackaged to create vast quantities of triple-A rated securities with competitive yields. By mid-2007, there were 37,000 structured finance issues in the U.S. alone with the top rating (Scholtes and Beales, 2007). According to Fitch Ratings (2007), roughly 60 percent of all global structured products were AAA-rated, in contrast to less than 1 percent of the corporate issues. By offering AAA-ratings along with attractive yields during a period of relatively low interest rates, these products were eagerly bought up by investors around the world. In turn, structured finance activities grew to represent a large fraction of Wall Street and rating agency revenues in a relatively short period of time. By 2006, structured finance issuance led Wall Street to record revenue and compensation levels. The same year, Moody’s Corporation reported that 44 percent of its revenues came from rating structured finance products, surpassing the 32 percent of revenues from their traditional business of rating corporate bonds.

    By 2008, everything had changed. Global issuance of collateralized debt obligations slowed to a crawl. Wall Street banks were forced to incur massive write-downs. Rating agency revenues from rating structured finance products disappeared virtually overnight and the stock prices of these companies fell by 50 percent, suggesting the market viewed the revenue declines as permanent. A huge fraction of existing products saw their ratings downgraded, with the downgrades being particularly widespread among what are called “asset-backed security” collateralized debt obligations—which are comprised of pools of mortgage, credit card, and auto loan securities. For example, 27 of the 30 tranches of asset-backed collateralized debt obligations underwritten by Merrill Lynch in 2007, saw their triple-A ratings downgraded to “junk” (Craig, Smith, and Ng, 2008). Overall, in 2007, Moody’s downgraded 31 percent of all tranches for asset-backed collateralized debt obligations it had rated and 14 percent of those nitially rated AAA (Bank of International Settlements, 2008). By mid-2008, structured finance activity was effectively shut down, and the president of Standard & Poor’s, Deven Sharma, expected it to remain so for “years” (“S&P President,” 2008).

    This paper investigates the spectacular rise and fall of structured finance. We begin by examining how the structured finance machinery works. We construct some simple examples of collateralized debt obligations that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. We then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. We then conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.

    Continued in article

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    Book Review by Robert Sack, The Accounting Review, May 2010, pp. 1122-1125
    DAVID MOSSO, Early Warning and Quick Response: Accounting in the Twenty-First Century (Bingley, U.K.: Emerald Group/JAI Press, 2009, ISBN 978-1-84855-644-7, pp. viii, 86).

    This is an engaging book with compelling arguments for a complete overhaul of our current set of accounting standards and of the process by which they are set.1 David Mosso is well qualified to comment on both, having served as a member of the Financial Accounting Standards Board FASB from 1978 to 1987, as Vice Chair of the Board from 1986 to 1987, and as the FASB’s Assistant Director of Research from 1987 to 1996. He came to the Board with extensive experience in governmental accounting and, after his work with the FASB, served as Chair of the Federal Accounting Standards Advisory Board from 1997 to 2006. He is quick to acknowledge his role in the development of our current Generally Accepted Accounting Principles (GAAP) and to express his regret for their failings.

    In essence, Mosso argues that we must replace our current mixed-attribute GAAP with full fair value accounting. His proposal, which he calls the Wealth Measurement Model, would recognize all assets and liabilities, as he defines them, at their current fair value, as defined by SFAS No. 157. That fair value balance sheet would measure the entity’s wealth at that date. Changes in the entity’s wealth from one period to the next would act as an early warning of potential trouble to all of the entity’s constituents. As to the standard-setting process, Mosso argues that the standard setter should outline the principles of the Wealth Measurement Model and then observe practice, being alert for aberrations in the way those principles are applied. New standards would mostly be interpretations of the basic principles and so could be issued quickly with a minimum of due process.

    The primary line of thought in Mosso’s book is a proposal to radically revise our current accounting model. On pages 11–12, he proposes six principles for his Wealth Measurement Model, quoted as follows:

    • The objective of accounting is to measure an entity’s economic wealth net worth and income earnings for the purpose of diagnosing the entity’s financial health.

    • All measurable assets and liabilities of an entity must be recognized on the entity’s balance sheet, along with the owners’ equity in those assets and liabilities.

    • All balance sheet assets and liabilities, and changes in them, must be measured at fair value

    • All issues and redemptions of owners’ equity shares must be measured at fair value with gain or loss recognition in earnings for any difference between the fair value of the shares and the fair value of things received or given in exchange.

    • All major nonmeasureable assets, liabilities, commitments, and contingencies of an entity must be disclosed in notes to the financial statements.

    • The primary financial statements … must be segmented and supplemented in a manner to facilitate the diagnosis of an entity’s financial health and future prospects.

    Mosso argues that these principles must be mandatory and applicable to every entity. He observes that issuing the FASB’s Concept Statements as nonauthoritative guidance was a mistake, leading them to be seen as a basis for debate rather than as a basis for decision-making.

    . . .

    In Chapters 9 and 10, Mosso redefines assets, liabilities, and equity in the context of his six wealth measurement principles. An asset is an economic resource that is controlled by an entity (p. 46). That definition clarifies the FASB’s current definition in that it leaves out the criteria “probable” and “future economic benefit,” both of which he argues have been confusing in practice. A liability is an unfulfilled binding promise made by an entity to transfer specified economic benefits in determinable amounts at determinable times or on demand p. 47.That definition differs from the current FASB definition in that it uses a broader “promise” criterion in lieu of the difficult-to-apply idea of a “probable future sacrifice.” Interestingly, Mosso argues that, by using these definitions, receivables and payables will be reciprocal—there will be a mutual understanding of the claim between the two parties to the transaction. That understanding will be established by a triggering act as, for example, the performance of an earnings event. We have not insisted on mutuality in our current accounting for assets and liabilities, allowing for different assessments of “probability” by the holder of the asset and the obligor.

    . . .

    Following on Mosso’s challenge, and the FAF’s door-opening, the academic community ought to seize on the opportunity for a larger place at the table, where we can bring our unbiased skills to bear—even beyond the work of the individual academic Board member and the contributions of the AAA Financial Accounting and Reporting Section’s Financial Reporting Policy Committee. That challenge is perhaps the key message from this thoughtprovoking book.

    Jensen Comment
    Financial assets and liabilities tend to be sufficiently independent such that the sum of the exit values of the parts is the sum of the value of the whole baring blockage discounts and issues of subsidiary control interactions.

    But I take issue with valuation of non-financial assets where an asset's exit value is the worst possible use of the asset. Value in use entails looking at assets in interactive combination and their possibly huge covariance components of value. Furthermore they co-vary with many intangible assets and liabilities that cannot be valued even in Mosso's formulation of change. Covariance components can be defined in hypothetical models, but their measurement in reality is next to impossible --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Fair Value Re-measurement Problems in a Nutshell:  (1) Covariances and (2) Hypothetical Transactions and (3) Estimation Cost
    It's All Phantasmagoric Accounting in Terms of Value in Use

    In an excellent plenary session presentation in Anaheim on August 5, 2008 Zoe-Vanna Palmrose mentioned how advocates of fair value accounting for both financial and non-financial assets and liabilities should heed the cautions of George O. May about how fair value accounting contributed to the great stock market crash of 1929 and the ensuing Great Depression. Afterwards Don Edwards and I lamented that accounting doctoral students and younger accounting faculty today have little interest in and knowledge of accounting history and the great accounting scholars of the past like George O. May --- http://en.wikipedia.org/wiki/George_O._May
    Don mentioned how the works of George O. May should be revisited in light of the present movement by standard setters to shift from historical cost allocation accounting to fair value re-measurement (some say fantasy land or phantasmagoric) accounting --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue
    The point is that if fair value re-measurement is required in the main financial statements, the impact upon investors and the economy is not neutral. It may be very real like it was in the Roaring 1920s.

    In the 21st Century, accounting standard setters such as the FASB in the U.S. and the IASB internationally are dead set on replacing traditional historical cost accounting for both financial (e.g., stocks and bonds) and non-financial (e.g., patents, goodwill, real estate, vehicles, and equipment) with fair values. Whereas historical costs are transactions based and additive across all assets and liabilities, fair value adjustments are not transactions based, are almost impossible to estimate, and are not likely to be additive.

    If Asset A is purchased for $100 and Asset B is purchased for $200 and have depreciated book values of $50 and $80 on a given date, the book values may be added to a sum of $130. This is a basis adjusted cost allocation valuation that has well-known limitations in terms of information needed for investment and operating decisions.

    If Asset A now has an exit (disposal) value of $20 and Asset B has an exit value of $90, the exit values can be added to a sum of $110 that has meaning only if each asset will be liquidated piecemeal. Exit value accounting is required for personal estates and for companies deemed by auditors to be non-going concerns that are likely to be liquidated piecemeal after debts are paid off.

    But accounting standard setters are moving toward standards that suggest that neither historical cost valuation nor exit value re-measurement are acceptable for going concerns such as viable and growing companies. Historical cost valuation is in reality a cost allocation process that provides misleading surrogates for "value in use." Exit values violate rules that re-measured fair values should be estimated in terms of the "best possible use" of the items in question. Exit values are generally the "worst possible uses" of the items in a going concern. For example, a printing press having a book value of $1 million and an exit value of $100,000 are likely to both differ greatly from "value in use."

    The "value in use" theoretically is the present value of all discounted cash flows attributed to the printing press. But this entails wild estimates of future cash flows, discount rates, and terminal salvage values that no two valuation experts are likely to agree upon. Furthermore, it is generally impossible to isolate the future cash flows of a printing press from the interactive cash flows of other assets such as a company's copyrights, patents, human capital, and goodwill.

    What standard setters really want is re-measurement of assets and liabilities in terms of "value in use." Suppose that on a given date the "value in use" is estimated as $180 for Asset A and $300 for Asset B. The problem is that we cannot ipso facto add these two values to $480 for a combined "value in use" of Asset A plus Asset B. Dangling off in phantasmagoria fantasy land is the covariance of the values in use:

    Value in Use of Assets A+B = $180 + $300 + Covariance of Assets A and B

    For example is Asset A is a high speed printing press and Asset B is a high speed envelope stuffing machine, the covariance term may be very high when computing value in use in a firm that advertises by mailing out a thousands of letters per day. Without both machines operating simultaneously, the value in use of any one machine is greatly reduced.

    I once observed high speed printing presses and envelope stuffing machines in action in Reverend Billy Graham's "factory" in Minneapolis. Suppose to printing presses and envelope stuffing machines we add other assets such as the value of the Billy Graham name/logo that might be termed Asset C. Now we have a more complicated covariance system:

                Value in Use of Assets A+B+C = (Values of A+B+C) + (Higher Order Covariances of A+B+C)

    And when hundreds of assets and liabilities are combined, the two-variate, three-variate, and n-variate higher order covariances for combined ""value in use" becomes truly phantasmagoric accounting. Any simplistic surrogate such as those suggested in the FAS 157 framework are absurdly simplistic and misleading as estimates of the values of Assets A, B, C, D, etc.

    Furthermore, if the "value of the firm" is somehow estimated, it is virtually impossible to disaggregate that value down to "values in use" of the various component assets and liabilities that are not truly independent of one another in a going concern. Financial analysts are interested in operations details and components of value and would be disappointed if all that a firm reported is a single estimate of its total value every quarter.

    Of course there are exceptions where a given asset or liability is independent of other assets and liabilities. Covariances in such instances are zero. For example, passive investments in financial assets generally can be estimated at exit values in the spirit of FAS 157. An investment in 1,000 shares of Microsoft Corporation is independent of ownership of 5,000 shares of Exxon. A strong case can be made for exit value accounting of these passive investments. Similarly a strong case can be made for exit value accounting of such derivative financial instruments as interest rate swaps and forward contracts since the historical cost in most instances is zero at the inception of many derivative contracts.

    The problem with fair value re-measurement of passive investments in financial assets lies in the computation of earnings in relation to cash flows. If the value of 1,000 shares of Microsoft decreases by -$40,000 and the value of 5000 shares of Exxon increases by +$140,000, the combined change in earnings is $100,000 assuming zero covariance. But if the Microsoft shares were sold and the Exxon shares were held, we've combined a realized loss with an unrealized gain as if they were equivalents. This gives rise to the "hypothetical transaction" problem of fair value re-measurements. If the Exxon shares are held for a very long time, fair value accounting may give rise to years and years of "fiction" in terms of variations in value that are never realized. Companies hate earnings volatility caused by fair value "fictions" that are never realized in cash over decades of time.

    Continued at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Mosso's vague about measuring fair value of non-financial assets. Presumably entry value might be used instead of exit value, but entry value is not really valuation. It is a re-definition of historical cost and is subject to all the arbitrariness of historical cost such as depreciation and amortization assumptions.

    Fair value might be discounted cash flows for some assets and liabilities, but if the asset in question is a single particle amidst an entire conglomeration of heterogeneous particles, how do we allocate the present value into the whole down to its myriad of particles?

    Hi Pat,

    In Theory, Exit Values Often Should not be Disaggregated from "In Use" Factors
    Although there are many flaws in the present mixed attributes conglomeration of valuations of assets and liabilities, I just do not see that valuation of non-financial assets at their worst possible exit value usages for the sake of consistency makes any sense. Especially troublesome are non-financial fixed assets that have high "in use" values and low exit values. For example, ERP information systems, factory robots, computers, etc. may lose most of their exit values the moment they are put to use even though their expected lives may be ten or more years. Maybe I'm just an old has been who clings to the importance of the income statement vis-a-vis the balance sheet.

    Exit value changes are pure fiction for held-to-maturity items, especially debt, where transactions costs of often preclude cashing in before maturity preclude taking advantage of changes in exit values. For example, a company that has $100 million of collateralized debt outstanding cannot t usually take advantage of short-term reductions in interest rates due to the transactions costs of paying off or calling in that debt prematurely and paying the transactions cost of issuing new collateralized debt. I was really sorry to see the IASB and the FASB abandon the concept of held-to-maturity since in many instances the HTM classification in FAS 115 prevented a lot of fiction movements in earnings that will never be realized.

    I don't view "in use" net present value accounting necessarily more subjective than exit value estimations for items that have very unique values such as valuations of each of the Days Inns hotels where appraisers may differ greatly as the valuation of each and every hotel. I would in fact probably consider estimations of discounted net cash flows of a given hotel as probably being as reliable or even more reliable than real estate appraiser estimates of exit value (due largely to reasons mentioned below for in-use factors).

    For nearly a century accounting theorists have advocated that "in use" valuation is preferable to exit valuation that ignores usage. One reason is that appraised values of items like real estate may move up and down with market movements that are will never be realized by a going concern that intends to keep using its assets like factory buildings irrespective of transitory shifts in local markets affecting exit values but not operating profits of the firm. Also there's a possibility that exit values of things factory buildings remain relatively constant while the economic values of the firm fluctuate up and down. Reporting stationary exit values in the presence of wildly changing "in use" economic values can be misleading for going concerns.

    In Practice, Exit Values Often Cannot be Disaggregated from "In Use" Factors
    The IASB naively assumes that exit values can be estimated apart from "in use" factors. This is very, very often just not the case and this greatly complicates estimation of exit values. Let me begin with a real-world case that took place in Littleton, NH around the turn of the century. I will treat this as a hypothetical case simply because I'm not familiar with the actual numbers. But the case actually transpired.

    For decades Market B (a medium-sized super market) pretty much had a monopoly for Littleton-area residents. It operated out of an old but functional building. Suppose the 1999 and 2000financial statements read as follows:

      Market B
    1999
    Net Book Value
    Market B
    1999
    Exit Value
    Market B
    2000
    Net Book Value
    Market B
    2000
    Exit Value
    Land $100,000 $1,000,000 $100,000 $1,000,000
    Building $210,000 $2,000,000 $200,000 $0

    In use factors affected the 1999 exit value estimation of $2 million because, if the land and building were put on the market, bidders for this real estate would be other supermarket investors taking advantage of the monopoly status of Market B. They could buy this real estate before year 2000 and immediately set up shop as a monopoly supermarket.

    Note that "in use" factors affected the real estate appraisal values since the buyers all had the same use in mind for the building. And there were quite a few potential buyers since Market B was very profitable as a monopolist.

    In Year 2,000 Market S built a $10 million building literally adjacent to Market B. Potential supermarket buyers lost all interest in buying the Market B's building. The land still had serious value, but the old building was worth virtually zero (or negative) in alternate uses because of its age, condition, and costs of remodeling for alternate uses.

    In 2001 Market S buys the Market B real estate for $1,000,000 and pays to tear down the Market B building that in 1999 was valued at $2,000,000 by independent real estate appraisers who had a pretty good idea of what the building was worth as long as there were outside buyers of the building to be put "in use" as a monopoly supermarket in the Littleton vicinity.

    In 1999, would the new IASB exit value standard require a valuation of $0 since there was no alternate value of the building other than the value in use as a supermarket monopoly? In fact, if Market B had built a new building elsewhere it probably would have torn down the old building in 1999.

    Actually this is very close but not identical to what happened when Buxtons had a supermarket monopoly in the Littleton vicinity. Then the giant Shaws supermarket chain built a huge supermarket literally next door to Buxtons. Buxtons quickly went out of business, and there were zero buyers interested in buying the building as a supermarket to compete with Shaws next door. Shaws bought the Buxton real estate and now leases about 10% of the building space to a drive-in bank. The remaining 90% of the building has been vacant for a decade.

    In use factors repeatedly affect real estate values. One of my closest friends down the road owns rental properties scattered about northern New England. A few years back he competed with a number of other bidders willing to pay in the range of $1 million for a small office building in the mill town of Rumford, Maine. My friend acquired the building with a high bid of $1.2 million. Virtually all the buyers intended to keep leasing the building to the Veterans Administration that had an "in use" office operation in that building since World War 2 ended.

    My friend invested more in the building to keep the VA happy as a tenant, including the cost of a new elevator. In 2002 my friend seriously considered an offer of $1.5 million to sell the building and mistakenly refused the offer. This was affected by "in use" factors since at the time nobody expected the VA to move out of the building.

    But the paper mill towns in northern New England were hit hard times in the past decade. The Rumford economy took a nose dive, and one of its shopping malls became totally vacant. In 2009, the VA announced its intentions to move to the vacant mall. Now my friend has a building with negative economic value in a struggling mill town having great excess capacity for office space. My friend at the moment is seriously considering letting his investment go for taxes since the prospects of getting rental income in excess of property taxes appear to be nil for the foreseeable future.

    Interestingly, real estate appraisers still estimate the building to be worth $800,000, but there are zero buyers for a building at its appraised value.

    How does the new IASB standard deal with situations where appraised values of real estate are relatively high when there are no buyers willing to take on the property taxes?

    Sometimes real estate has to be taken over by towns for taxes before those towns will lower the property taxes enough to attract buyers. This greatly complicates exit value estimations of real estate.

    It's not hard to find millions of more examples where "in use" factors affect appraised values, especially in real estate.

     

     

    Furthermore, re-valuation can be a very costly process such as paying to re-value a hotel chain's hundreds of pieces of real estate scattered about the world ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Sack concludes his book review by asserting that the "academic community ought to seize on the opportunity for a larger place at the table." Be that as it may, the academic community has be debating these issues since the days of MacNeal, Canning, Paton, Scott, Chambers, Sterling, Edwards, Bell, and on and on through tens of thousands of pages of books, journal articles, and transcripts of speeches and course notes. Woodrow Wilson was correct when he said that moving a professors is harder than moving a cemetery.

    Standard setters have already commenced the Mosso express train.

    Let me off as it approaches the "Non-Financial Asset Depot."

    June 13, 2010 reply from Robert Bruce Walker [walkerrb@ACTRIX.CO.NZ]

    I must confess that the writings of Mr Mosso are not particularly interesting to me – the ideas are not new and simply reflect a distillation of current debates. Far more significant is the writing of RA Bryer, the latest iteration of which I stumbled upon as a draft on Bob’s website (Ideology and reality in accounting: a Marxist history of US accounting theory debate from the late 19th century to FASB’s conceptual framework).

    This essay works at two levels. At the first level is a brilliant narrative showing the evolution of corporate accounting and the debate about historic cost versus fair value. This was happening in the first part of the 20th century. It shows, if nothing else, that nothing is new.

    The second level is, as the title suggests, an ideological analysis. Bryer suggests that one of the prime considerations in corporate accounting emerged from the fight to the death between labour and capital such as prevailed in the early 20th century in America. This fight was indeed vicious, culminating in what we would call terrorism. For example, there was a bombing at a newspaper premises in LA. Clarence Darrow no less was the defending attorney for the workers and was caught, or very close to it, in the process of jury tampering. He did, and it is almost certain he did, this because he knew that a capitalist finger was on the judicial scales. It might even be the case that the capitalist (whose name escapes me) may have been the author of the bombing himself!

    In any event Bryer uses the Marxist labour theory of value (LTV) and its related theories of money and exchange to show the weird parallels between it and historic cost accounting (HCA). He seems to suggest that the notion of future value (present value) accounting is an ideological attempt to deny the validity of LTV. Conversely HCA is an affirmation of LTV, based as it is on past exchange rather than the prospect of exchange.

    It is well worth looking at Marx’s analysis because it does shed light on the enterprise that is accounting – the role of commodities, the pricing mechanism and the idea of purely monetary exchange. Yet I cannot believe that there is this ideological element to accounting. I believe the impulse to HCA is an impulse concerned with the centrality and integrity of double entry bookkeeping. Bryer turns my long held view on its head.

    I know he is wrong but I have to summon all my knowledge, experience and cogitation powers to prove it. All accountants academic or otherwise, especially American accountants, should read what he writes. It is one of the most important things that has ever been written about the subject of accounting.

    You can read more about Bryer’s excellent paper at http://faculty.trinity.edu/rjensen/Theory01.htm#Paton

     


    The Financial Accounting Standards Board and the International Accounting Standards Board tentatively decided to define fair value as an exit price during a three-day joint meeting this week.
    Web CPA. January 20, 2010 --- http://www.webcpa.com/news/Accounting-Boards-Define-Fair-Value-53050-1.html

    The Financial Accounting Standards Board and the International Accounting Standards Board tentatively decided to define fair value as an exit price during a three-day joint meeting this week.

    Fair value measurement is one of the thornier issues the two standards-setters are trying to come to an agreement on as they seek to converge U.S. GAAP with International Financial Reporting Standards by June 2011. Fair value, or mark-to-market, accounting has been blamed in some quarters for helping exacerbate the financial crisis. Standard-setters have come under pressure to revise the standards to give financial institutions more flexibility in valuing assets such as mortgage-backed securities that became difficult to trade during the crisis. The two boards have decided to meet on a monthly basis, both in person and by video conference, to resolve outstanding issues in areas such as fair value, revenue recognition, leases and consolidation.

    When markets become less active, the two boards tentatively decided that an entity should consider observable transaction prices unless there is evidence that the transaction is not orderly. If an entity does not have enough information to determine whether the transaction is orderly, it should perform further analysis to measure the fair value.

    The boards also tentatively decided that the transaction price might not represent the fair value of an asset or liability at initial recognition if, for example, the transaction is between related parties, the transaction takes place under duress or the seller is forced to accept the price in the transaction, the unit of account represented by the transaction is different from the unit of account for the asset or liability measured at fair value, or the market in which the transaction takes place is different from the market in which the entity would sell the asset or transfer the liability.

    The boards also tentatively decided to confirm that a fair value measurement is market based and reflects the assumptions that market participants would use in pricing the asset or liability. Market participants should be assumed to have a reasonable understanding about the asset or liability and the transaction based on all the available information, including information that might be obtained through due diligence efforts that are usual and customary. A price in a related-party transaction may be used as an input to a fair value measurement if the transaction was entered into at market terms.

    Jensen Comment
    Of course the debate will center on the details. To what degree must buyers and sellers be under pressures to sell such as in forced liquidations? To what extend can interactions (covariances, value in use) be ignored? Interactions are usually less of a problem when valuing financial items than non-financial items where value is use often varies greatly from piecemeal liquidation value. The FASB, of course, has considered the exit value hierarchy stumbling blocks such as broken markets in FAS 157 and FSP 157 (4).

    A huge problem is earnings volatility created by unrealized value changes on earnings, particularly value changes on held-to-maturity items like fixed rate debt instruments that management may not even have the option of liquidating before maturity. There also is a huge problem that changes in credit ratings may have misleading impacts on earnings when debt is revalued. What do you do with the unrealized gains caused by lowered credit rating scores on your debt or unrealized losses from increased credit ratings on your debt?

    These complications are discussed in greater detail below.


    In answer to Neal’s original question about the impact of accountics research on standards, I would have to say that the best example in the past two decades has been in the march of both the FASB and the IASB toward fair value accounting. The push came not so much directly from accountics research studies (that were probably never read by most of the standard setters) as it did indirectly from the two leading accountics researchers who successfully argued their case with the other standard setters.

    The push is hard to trace to accountics studies per se, but we have to point to leading accountics researchers who ended up on the IASB (read that Mary Barth for a long time) and FASB (read that Katherine Schipper for a short time). There are no better advocates of fair value accounting than Professor Barth and Professor Schipper.

     An Unlikely Debate Between Leading Accountics Researchers

    Having said this, one of the weirdest (in terms of being the most unlikely) debates between leading accountics researchers  in the history of accounting took place at the 2008 AAA Meetings in Anaheim. The debate was one of the highlights of my career (as an audience member with a camcorder) because it became a pitched (lest I say heated?) debate between leading accountics researchers (who normally do not succumb to a “vocational virus”) who took up different sides on fair value accounting in theory and in practice. My video of this debate is available in the National Library of the Accounting Profession at the University of Mississippi --- http://www.olemiss.edu/depts/accountancy/libraries.html

    In that most impressive debate Katherine Schipper was the very articulate advocate of fair value accounting standards. On the negative side were the equally articulate accountics researchers Zoe-Vanna Palmrose and Ross Watts. This was in fact the most articulate speech I ever heard our leading accountics researcher, Ross Watts, deliver. Zoe-Vanna was just returning to USC after her stint at the SEC (where she no doubt provided accountics findings to practical accountants).

    My video of the great 2008 Fair Value Accounting Debate is available in the National Library of the Accounting Profession at the University of Mississippi --- http://www.olemiss.edu/depts/accountancy/libraries.html

    You might enjoy a recent paper in which Zoe-Vanna is a co-author. This touches on the assumptions (usually unstated) that separate accountics research harvests from truth.
    "CAN SCIENCE HELP SOLVE THE ECONOMIC CRISIS? By Mike Brown, Stuart Kauffman, Zoe-Vonna Palmrose and Lee Smolin,  Edge,  --- http://www.edge.org/3rd_culture/brown08/brown08_index.html


    There are various instances where fair value accounting is required for non-financial as well as financial items under current standards. These include the following:

    Under international accounting standards, it is possible to update fixed assets like real estate to fair values on occasion such as every five or ten years. This is not as acceptable under FASB standards.

    Hi again Tom,

    I know Walter very well and have argued this point with him before, especially in the context of FAS 123. --- http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    If General Electric buys a factory robot for $10 million and pays another $10 million for installation in a plant producing wind turbines, suppose the following:

    Historical Cost:  $20 million (early in 2008) with an estimated productive life of 15 years
    Replacement Cost:  $30 million (with the increase attributed in large measure to increased robot demand due to environmental and energy legislation in 2009)
    Exit Value:  $0 with the loss caused mainly by immense transaction costs of dismantling, transporting, and re-assembly that make buying a new robot cheaper than moving a used robot.
    Value in Use:  Unknown because of unknown discount rates, covariances with other tangible and intangible items, and inseparability of future cash flows attributable to one robot in one factory. In terms of covariance, if wind turbines have the GE boiler plate, the value in use of the robot is much higher than if wind turbines have the Yugo boiler plate.

    From what I know of Walter’s position, Walter will place $0 exit value on the balance sheet for this robot. Unless this wind turbine plant is deemed a non-going concern, the $0 exit value is the worst possible valuation in terms of error in estimating value in use and earnings. Under a double entry system, growth company earnings will nearly always get clobbered by exit values relative to stagnant companies. In a sense Replacement (Current) Cost companies also get clobbered for non-financial assets that can be used effectively and efficiently for many years of production without replacement. Of course Replacement Cost accounting conforms to Capital Maintenance Theory --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    I‘ve never agreed with Walter on exit valuation except in the case of financial instruments and derivative financial instruments and non-going concerns.

     Some might argue that all partionings of balance sheet item values into components are arbitrary. We should only generate aggregated line items such as Factory 1 value, Factory 2, value, etc. Or perhaps we cannot partition value any further than one line item called Value of General Electric. Of course this cannot be reliably measured from thin trades of a miniscule proportion of marginal trades day-to-day on the stock market (called the blockage valuation problem). Nor can it be reliably estimated via economic models due to unknown future cash flows, unknown discount rates, unknown and unstable values of intangibles, unknown environmental and labor legislation, and the thinnest possible market for the purchase of the entire conglomerate of General Electric as a whole.

    For a time Baruch Lev strongly advocated using market share prices for valuing intangibles, but his models proved be particularly unstable and lacked robustness --- http://faculty.trinity.edu/rjensen/Theory01.htm#TheoryDisputes
    Furthermore they put the cart before the horse. Accounting reports are supposed to help decision makers make market decisions. Lev’s approach works backwards by using market values to make accounting decisions.

    The FASB and IASB both want financial reporting in terms of value in use. The trouble is that for most non-financial balance sheet items the only person with a valuation estimate worth considering is the Wizard of Oz. Witness how badly Bank America overvalued Merrill Lynch when the toxic Merrill Lynch was purchased by B of A in 2008. CEO Lewis should've consulted the Wizard of Oz before agreeing to an outrageous purchase price. The point here is that experts in huge corporations make huge mistakes when valuing companies to buy and sell. The markets are just too thin at this level of aggregation.

    The FASB and IASB both want financial reporting in terms of value in use. The trouble is that for most non-financial balance sheet items the only person with a valuation estimate worth considering is the Wizard of Oz.

     Bob Jensen

    Of course, historical cost as we know it is highly corrupted. On Page 1166, Mary Barth states:

    Second, few financial statement amounts are stated at historical cost. Assets and liabilities are typically initially measured at the value established by an exchange, which is their cost. But, some type of remeasurement is pervasive. The only amounts in financial statements today that are always historical costs are those for cash and land in the transaction currency. Essentially all other amounts reflect changes in time, events, or circumstances since the transaction date. Amounts for short-term assets and liabilities, e.g., inventory, receivables, and accounts payable, are historical costs if they have not been impaired. However, once an entity recognizes an impairment of inventory or an allowance for uncollectible accounts receivable, the amounts are no longer historical costs. Also, entities depreciate or amortize long-term assets and revalue them or write them down when they are impaired, and amortize issue premium or discount on long-term debt. They also remeasure many financial instruments at fair value. Impaired, amortized, revalued, or otherwise remeasured amounts are not historical costs. Thus, framing the measurement debate in financial reporting as historical cost versus fair value misleads and obfuscates the issues.
    "Global Financial Reporting: Implications for U.S.," by Mary Barth, The Accounting Review, Vol. 83, No. 5, September 2008 ---
     Not free at http://www.atypon-link.com/AAA/doi/pdfplus/10.2308/accr.2008.83.5.1159

     

    A working paper on fair value accounting from Columbia University --- http://www4.gsb.columbia.edu/publicoffering/post/731291/Behind+the+Mark-to-Market+Change#


    KPMG’s “Unusual Twist”
    While KPMG's strategy isn't uncommon among corporations with lots of units in different states, the accounting firm offered an unusual twist: Under KPMG's direction, WorldCom treated "foresight of top management" as an intangible asset akin to patents or trademarks.
     
    See  http://faculty.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud

    Punch Line
    This "foresight of top management" led to a 25-year prison sentence for Worldcom's CEO, five years for the CFO (which in his case was much to lenient) and one year plus a day for the controller (who ended up having to be in prison for only ten months.) Yes all that reported goodwill in the balance sheet of Worldcom was an unusual twist.


    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.

     


  •  

  • Selected works of FRANK PARTNOY
    Bob Jensen at Trinity University

    1.  Who is Frank Partnoy?

    Cheryl Dunn requested that I do a review of my favorites among the “books that have influenced [my] work.”   Immediately the succession of FIASCO books by Frank Partnoy came to mind.  These particular books are not the best among related books by Wall Street whistle blowers such as Liar's Poker: Playing the Money Markets by Michael Lewis in 1999 and Monkey Business: Swinging Through the Wall Street Jungle by John Rolfe and Peter Troob in 2002.  But in1997.  Frank Partnoy was the first writer to open my eyes to the enormous gap between our assumed efficient and fair capital markets versus the “infectious greed” (Alan Greenspan’s term) that had overtaken these markets.

    Partnoy’s succession of FIASCO books, like those of Lewis and Rolfe/Troob are reality books written from the perspective of inside whistle blowers.  They are somewhat repetitive and anecdotal mainly from the perspective of what each author saw and interpreted. 

    My favorite among the capital market fraud books is Frank Partnoy’s latest book Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0- 477 pages).  This is the most scholarly of the books available on business and gatekeeper degeneracy.  Rather than relying mostly upon his own experiences, this book drawn from Partnoy’s interviews of over 150 capital markets insiders of one type or another.  It is more scholarly because it demonstrates Partnoy’s evolution of learning about extremely complex structured financing packages that were the instruments of crime by banks, investment banks, brokers, and securities dealers in the most venerable firms in the U.S. and other parts of the world.  The book is brilliant and has a detailed and helpful index.

     

    What did I learn most from Partnoy?

    I learned about the failures and complicity of what he terms “gatekeepers” whose fiduciary responsibility was to inoculate against “infectious greed.”  These gatekeepers instead manipulated their professions and their governments to aid and abet the criminals.  On Page 173 of Infectious Greed, he writes the following: 

    Page #173

    When Republicans captured the House of Representatives in November 1994--for the first time since the Eisenhower era--securities-litigation reform was assured.  In a January 1995 speech, Levitt outlined the limits on securities regulation that Congress later would support: limiting the statute-of-limitations period for filing lawsuits, restricting legal fees paid to lead plaintiffs, eliminating punitive-damages provisions from securities lawsuits, requiring plaintiffs to allege more clearly that a defendant acted with reckless intent, and exempting "forward looking statements"--essentially, projections about a company's future--from legal liability.

    The Private Securities Litigation Reform Act of 1995 passed easily, and Congress even overrode the veto of President Clinton, who either had a fleeting change of heart about financial markets or decided that trial lawyers were an even more important constituency than Wall Street.  In any event, Clinton and Levitt disagreed about the issue, although it wasn't fatal to Levitt, who would remain SEC chair for another five years.

     

    He later introduces Chapter 7 of Infectious Greed as follows:

    Pages 187-188

    The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

    Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

    Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

    Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

    But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.

     

    The book Infectious Greed has chapters on other capital markets and corporate scandals.  It is the best account that I’ve ever read about Bankers Trust the Bankers Trust scandals, including how one trader named Andy Krieger almost destroyed the entire money supply of New Zealand.  Chapter 10 is devoted to Enron and follows up on Frank Partnoy’s invited testimony before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

    The controversial writings of Frank Partnoy have had an enormous impact on my teaching and my research.  Although subsequent writers wrote somewhat more entertaining exposes, he was the one who first opened my eyes to what goes on behind the scenes in capital markets and investment banking.  Through his early writings, I discovered that there is an enormous gap between the efficient financial world that we assume in agency theory worshipped in academe versus the dark side of modern reality where you find the cleverest crooks out to steal money from widows and orphans in sophisticated ways where it is virtually impossible to get caught.  Because I read his 1997  book early on, the ensuing succession of enormous scandals in finance, accounting, and corporate governance weren’t really much of a surprise to me.

    From his insider perspective he reveals a world where our most respected firms in banking, market exchanges, and related financial institutions no longer care anything about fiduciary responsibility and professionalism in disgusting contrast to the honorable founders of those same firms motivated to serve rather than steal.

    Young men and women from top universities of the world abandoned almost all ethical principles while working in investment banks and other financial institutions in order to become not only rich but filthy rich at the expense of countless pension holders and small investors.  Partnoy opened my eyes to how easy it is to get around auditors and corporate boards by creating structured financial contracts that are incomprehensible and serve virtually no purpose other than to steal billions upon billions of dollars.

     

    Most importantly, Frank Partnoy opened my eyes to the psychology of greed.  Greed is rooted in opportunity and cultural relativism.  He graduated from college with a high sense of right and wrong.  But his standards and values sank to the criminal level of those when he entered the criminal world of investment banking.  The only difference between him and the crooks he worked with is that he could not quell his conscience while stealing from widows and orphans.

     

    Frank Partnoy has a rare combination of scholarship and experience in law, investment banking, and accounting.  He is sometimes criticized for not really understanding the complexities of some of the deals he described, but he rather freely admits that he was new to the game of complex deceptions in international structured financing crime.

    2.  What really happened at Enron? --- http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony 

     

    3.  What are some of Frank Partnoy’s best-known works?

    Frank Partnoy, FIASCO: Blood in the Water on Wall Street (W. W. Norton & Company, 1997, ISBN 0393046222, 252 pages). 

    This is the first of a somewhat repetitive succession of Partnoy’s “FIASCO” books that influenced my life.  The most important revelation from his insider’s perspective is that the most trusted firms on Wall Street and financial centers in other major cities in the U.S., that were once highly professional and trustworthy, excoriated the guts of integrity leaving a façade behind which crooks less violent than the Mafia but far more greedy took control in the roaring 1990s. 

    After selling a succession of phony derivatives deals while at Morgan Stanley, Partnoy blew the whistle in this book about a number of his employer’s shady and outright fraudulent deals sold in rigged markets using bait and switch tactics.  Customers, many of them pension fund investors for schools and municipal employees, were duped into complex and enormously risky deals that were billed as safe as the U.S. Treasury.

    His books have received mixed reviews, but I question some of the integrity of the reviewers from the investment banking industry who in some instances tried to whitewash some of the deals described by Partnoy.  His books have received a bit less praise than the book Liars Poker by Michael Lewis, but critics of Partnoy fail to give credit that Partnoy’s exposes preceded those of Lewis. 

    Frank Partnoy, FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance (Profile Books, 1998, 305 Pages)

    Like his earlier books, some investment bankers and literary dilettantes who reviewed this book were critical of Partnoy and claimed that he misrepresented some legitimate structured financings.  However, my reading of the reviewers is that they were trying to lend credence to highly questionable offshore deals documented by Partnoy.  Be that as it may, it would have helped if Partnoy had been a bit more explicit in some of his illustrations.

    Frank Partnoy, FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages). 

    This is a blistering indictment of the unregulated OTC market for derivative financial instruments and the million and billion dollar deals conceived in investment banking.  Among other things, Partnoy describes Morgan Stanley’s annual drunken skeet-shooting competition organized by a “gun-toting strip-joint connoisseur” former combat officer (fanatic) who loved the motto:  “When derivatives are outlawed only outlaws will have derivatives.”  At that event, derivatives salesmen were forced to shoot entrapped bunnies between the eyes on the pretense that the bunnies were just like “defenseless animals” that were Morgan Stanley’s customers to be shot down even if they might eventually “lose a billion dollars on derivatives.”
     
    This book has one of the best accounts of the “fiasco” caused almost entirely by the duping of Orange County ’s Treasurer (Robert Citron) by the unscrupulous Merrill Lynch derivatives salesman named Michael Stamenson. Orange County eventually lost over a billion dollars and was forced into bankruptcy.  Much of this was later recovered in court from Merrill Lynch.  Partnoy calls Citron and Stamenson “The Odd Couple,” which is also the title of Chapter 8 in the book.Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)

    Partnoy shows how corporations gradually increased financial risk and lost control over overly complex structured financing deals that obscured the losses and disguised frauds  pushed corporate officers and their boards into successive and ingenious deceptions." Major corporations such as Enron, Global Crossing, and WorldCom entered into enormous illegal corporate finance and accounting.  Partnoy documents the spread of this epidemic stage and provides some suggestions for restraining the disease.

    "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" by Frank Partnoy, Washington University Law Quarterly, Volume 77, No. 3, 1999 --- http://ls.wustl.edu/WULQ/ 
     

    4.  What are examples of related books that are somewhat more entertaining than Partnoy’s early books?

    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.

    John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)

    This is a hilarious tongue-in-cheek account by Wharton and Harvard MBAs who thought they were starting out as stock brokers for $200,000 a year until they realized that they were on the phones in a bucket shop selling sleazy IPOs to unsuspecting institutional investors who in turn passed them along to widows and orphans.  They write. "It took us another six months after that to realize that we were, in fact, selling crappy public offerings to investors."

    There are other books along a similar vein that may be more revealing and entertaining than the early books of Frank Partnoy, but he was one of the first, if not the first, in the roaring 1990s to reveal the high crime taking place behind the concrete and glass of Wall Street.  He was the first to anticipate many of the scandals that soon followed.  And his testimony before the U.S. Senate is the best concise account of the crime that transpired at Enron.  He lays the blame clearly at the feet of government officials (read that Wendy Gramm) who sold the farm when they deregulated the energy markets and opened the doors to unregulated OTC derivatives trading in energy.  That is when Enron really began bilking the public.

    Some of the many, many lawsuits settled by auditing firms can be found at http://faculty.trinity.edu/rjensen/Fraud001.htm
     

     

     

     

    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

    Bob Jensen's threads on the Lehman Examiner's Report ---
    http://faculty.trinity.edu/rjensen/fraud001.htm#Ernst


    Do Investors Overvalue Firms With Bloated Balance Sheets?
    David A. Hirshleifer University of California, Irvine - Paul Merage School of Business
    Kewei Hou Ohio State University - Department of Finance
    Siew Hong Teoh University of California - Paul Merage School of Business
    Yinglei Zhang Chinese University of Hong Kong (CUHK) - School of Accountancy
    SSRN, February 2004
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=404120

    Abstract:
    If investors have limited attention, then accounting outcomes that saliently highlight positive aspects of a firm's performance will promote high market valuations. When cumulative accounting value added (net operating income) over time outstrips cumulative cash value added (free cash flow), it becomes hard for the firm to sustain further earnings growth. When the balance sheet is 'bloated' in this fashion, we argue that investors with limited attention will overvalue the firm, because naïve earnings-based valuation disregards the firm's relative lack of success in generating cash flows in excess of investment needs. The level of net operating assets, the difference between cumulative earnings and cumulative free cash flow over time, is therefore a measure of the extent to which operating/reporting outcomes provoke excessive investor optimism. Therefore, if investor attention is limited, net operating assets will negatively predict subsequent stock returns. In our 1964-2002 sample, net operating assets scaled by beginning total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

    Bob Jensen's threads on valuation are at
    http://faculty.trinity.edu/rjensen/roi.htm

     


    Updates on Venture Capital, Environmental Accounting, Green Accounting: Two Teaching Cases

    Venture Capital --- http://en.wikipedia.org/wiki/Venture_capital

    From The Wall Street Journal Accounting Weekly Review on March 12, 2010

    Venture-Capital firms Caught in a Shakeout
    by: Pui-Wing Tam
    Mar 09, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Mergers and Acquisitions, Valuations

    SUMMARY: "Venture firms are struggling to raise new cash, hampered by poor investment returns and a difficult economy...There were 794 active venture-capital firms in the U.S. at the end of 2009, meaning they have raised money in the last eight years, down from a peak of 1,023 in 2005....Many venture-capital firms...profited handsomely in the boom years in the late 1990s and early 2000....[as well,] their funds typically are set up as long-term, 10-year investment vehicles that don't quickly close down. But in the past decade, many start-ups have flopped or have struggled to go public amid an unwelcoming market for initial public offerings. The tough environment has been exacerbated by the credit crunch...." The related article assesses top promising start up companies by assessing management teams and change in equity valuation over a recent 12-month period.

    CLASSROOM APPLICATION: The article may be used in entrepreneurship, financial accounting, MBA, or management accounting classes.

    QUESTIONS: 
    1. (Introductory) What is a venture capitalist? How does a venture capital firm make profits?

    2. (Advanced) How does the article identify the reduction in returns to venture capitalists in 2009 relative to 2008?

    3. (Introductory) In the related article ranking "the top 50 venture capital-backed firms," how does the WSJ assess these firms, implying likely success? Specifically identify the four criteria used in the analysis.

    4. (Advanced) Given that the firms are not yet publicly traded, does any of the information in the article help to assess profitability of these firms in the past year? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    Sizing Up Promising Young Firms
    by Colleen DeBaise and Scott Austin
    Mar 09, 2010
    Page: B6


    Where the Smart Money Is
    by: Alan Murray
    Mar 08, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Accounting, Entrepreneurship, Environmental Cleanup Costs, Investments

    SUMMARY: The article is part of a special section on "Eco:nomics-Creating Environmental Capital and is based on interviews of venture capitalists John Doerr, a partner at Kleiner Perkins Caufield & Byers; Vinod Khosla, founder and managing partner of Khosla Ventures; and Paul Holland, general partner of Foundation Capital. They comment on their "bets" on clean technology and respond to a question on what has so far been "a dud" of their investments in this area.

    CLASSROOM APPLICATION: The article may be used in financial reporting, MBA, entrepreneurship, or management accounting classes.

    QUESTIONS: 
    1. (Introductory) What is a venture capitalist? How does a venture capital firm make profits?

    2. (Introductory) What do these three venture capitalists see as an area of opportunity for investment now in the environmental arena?

    3. (Advanced) What does the interviewer mean when he speaks about a "price on carbon"?

    4. (Advanced) Mr. Doerr says that none of their investments they expect to make an outstanding rate of return depend on putting a price on carbon. Define expected rate of return. How could a "price on carbon" make an investment economically viable which otherwise may not be viable without this "price"? What is the significance of Mr. Doerr's statement?

    5. (Advanced) What benefit does Mr. Doerr think will come from our government putting in place a system that will price carbon emissions?

    6. (Advanced) In the related article, start up firms in the solar energy area are assessed and ranked. What factors does The Journal use to rank these firms? In particular, given that they are not public and so financial statements are not available, does The Journal assess profitability over a recent year? Explain.

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    And the Top Clean-Tech Companies Are...
    by Colleen DeBaise
    Mar 08, 2010
    Page: R7

    Bob Jensen's threads on Return on Investment and Valuation ---
    http://faculty.trinity.edu/rjensen/roi.htm


    Through the Banking Glass Darkly
     "FASB to Propose More Flexible Accounting Rules for Banks," by Floyd Norris, The New York Times, December 7, 2009 ---
    http://www.nytimes.com/2009/12/08/business/08account.html?_r=2&ref=business

    Facing political pressure to abandon “fair value” accounting for banks, the chairman of the board that sets American accounting standards will call Tuesday for the “decoupling” of bank capital rules from normal accounting standards.

    His proposal would encourage bank regulators to make adjustments as they determine whether banks have adequate capital while still allowing investors to see the current fair value — often the market value — of bank loans and other assets.

    In the prepared text of a speech planned for a conference in Washington, Robert H. Herz, the chairman of the Financial Accounting Standards Board, called on bank regulators to use their own judgment in allowing banks to move away from Generally Accepted Accounting Principles, or GAAP, which his board sets.

    “Handcuffing regulators to GAAP or distorting GAAP to always fit the needs of regulators is inconsistent with the different purposes of financial reporting and prudential regulation,” Mr. Herz said in the prepared text.

    “Regulators should have the authority and appropriate flexibility they need to effectively regulate the banking system,” he added. “And, conversely, in instances in which the needs of regulators deviate from the informational requirements of investors, the reporting to investors should not be subordinated to the needs of regulators. To do so could degrade the financial information available to investors and reduce public trust and confidence in the capital markets.”

    Mr. Herz said that Congress, after the savings and loan crisis, had required bank regulators in 1991 to use GAAP as the basis for capital rules, but said the regulators could depart from such rules.

    Banks have argued that accounting rules should be changed, saying that current rules are “pro-cyclical” — making banks seem richer when times are good, and poorer when times are bad and bank loans may be most needed in the economy.

    Mr. Herz conceded the accounting rules can be pro-cyclical, but questioned how far critics would go. Consumer spending, he said, depends in part on how wealthy people feel. Should mutual fund statements be phased in, he asked, so investors would not feel poor — and cut back on spending — after markets fell?

    The House Financial Services Committee has approved a proposal that would direct bank regulators to comment to the S.E.C. on accounting rules, something they already can do. But it stopped short of adopting a proposal to allow the banking regulators to overrule the S.E.C., which supervises the accounting board, on accounting rules.

    “I support the goal of financial stability and do not believe that accounting standards and financial reporting should be purposefully designed to create instability or pro-cyclical effects,” Mr. Herz said.

    He paraphrased Barney Frank, the chairman of the House committee, as saying that “accounting principles should not be viewed to be so immutable that their impact on policy should not be considered. I agree with that, and I think the chairman would also agree that accounting standards should not be so malleable that they fail to meet their objective of helping to properly inform investors and markets or that they should be purposefully designed to try to dampen business, market, and economic cycles. That’s not their role.”

    Banks have argued that accounting rules made the financial crisis worse by forcing them to acknowledge losses based on market values that may never be realized, if market values recover.

    Mr. Herz said the accounting board had sought middle ground by requiring some unrealized losses to be recognized on bank balance sheets but not to be reflected on income statements.

    Banking regulators already have capital rules that differ from accounting rules, but have not been eager to expand those differences. One area where a difference may soon be made is in the treatment of off-balance sheet items that the accounting board is forcing banks to bring back onto their balance sheets. The banks have asked regulators to phase in that change over several years, to slow the impact on their capital needs.

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    Please don't blame the accountants for the banking meltdown ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValue

    Bob Jensen's threads on banking frauds ---
    http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

    Reply from FASB Chairman Bob Herz on December 8, 2009 --- Click Here
    http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156571228


    "Accounting for Banks' Value Gaps," by Michael Rapoport, The Wall Street Journal, December 30, 2009 ---
    http://online.wsj.com/article/SB10001424052748703278604574624463134498976.html

    Can investors count on consistency when it comes to bank accounting? As many banks struggle with piles of bad loans, it appears some auditors are being stricter than others when assessing their true value.

    Banks using Ernst & Young and Deloitte in particular are showing much sharper declines in the fair value of their loans than those using other accounting firms, a Wall Street Journal analysis shows. Of course, it is quite possible Ernst and Deloitte simply have a less-healthy group of bank clients than other firms. But if it instead reflects different audit policies when it comes to assessing loans, it could have consequences on the strength of banks' regulatory capital.

    Banks carry most loans on their balance sheet at their original cost. But they must also disclose the loans' fair value, or current market value, in financial-statement footnotes. At most banks, despite the carnage of recent years, fair value is only below cost by a small amount. Some banks, however, show much steeper declines. At Regions Financial, fair value was 19.3% lower than cost as of Sept. 30. The difference was 13.4% at Huntington Bancshares, 12% at KeyCorp, 9% at SunTrust Banks and 8.6% at Marshall & Ilsley. Regions, Key and SunTrust are all audit clients of Ernst; Huntington and M&I are Deloitte clients.

    Among the top-25 U.S.-owned commercial banks, those five Ernst and Deloitte clients accounted for five of the six biggest gaps between fair value and cost as of Sept. 30. The average gap among Ernst and Deloitte clients in the 25-bank group was about 6%; among clients of PriceWaterhouseCoopers and KPMG, it was about 2%.

    Those differences can affect how investors view a bank's loan portfolio, and could have a concrete effect on regulatory capital in the future. The Financial Accounting Standards Board is considering changes in banks' accounting for loans and may require them to carry loans on the balance sheet at fair value instead of cost.

    If that happened, the current fair-value declines could reduce shareholder equity and regulatory capital—in some cases, to levels regulators would find troublesome. At Regions, the $16.9 billion gap between its loans' fair value and carrying value would wipe out its $13 billion in Tier 1 capital using a fair-value balance-sheet standard. Huntington, Key and M&I would see Tier 1 capital slashed to low levels. SunTrust would see a major Tier 1 reduction also.

    A move by the FASB to require banks to use fair value as the balance-sheet standard doesn't have to hurt the banks' regulatory capital. Bank regulators could adjust the capital measures they use so that they wouldn't be affected by a fair-value change.

    But big hits to the fair value of loans still matter to investors. Who audits a bank's books may have importance beyond whose name goes on the letter blessing the financial statements once a year.

    Bob Jensen's threads on the bank bailout are at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm


    "GE's $19 Billion (And Increasing) Toxic Asset Sink Hole," by Tyler Durden, Zero Hedge, November 3, 2009 ---
    http://www.zerohedge.com/article/ges-19-billion-and-increasing-toxic-asset-sink-hole

    One, and maybe the only, of the recent benefits of the FASB's meager attempts at providing balance sheet transparency has been the requirement for banks and financial companies to disclose the difference between the Fair Market Value and the Carrying (Book) value of their assets, especially as pertains to loans held on the balance sheet. And while even the FMV calculation leaves much to be desired, it does demonstrate which companies take abnormal liberties with their balance sheets, instead of performing needed asset write-downs as more and more loans turn toxic. A good example of just such optimism appears when one evaluates the disclosure by "banking" company General Electric. On page 38 of the firm's just released 10-Q, the firm indicates that the delta between its loan portfolio FMV and Book Value continues increasing, and as of September 30, hit an all time (disclosed) high of $18.8 billion. In other words, General Electric, whose market cap is about $150 billion at last check, is likely impaired by at least $19 billion if it were forced to access the market today and sell off its loans. The $19 billion is 13% of its entire market cap. And the real number is likely much, much worse.

    The delta between the Carrying and Fair Market Value of GECC's loans can be seen on the chart below:

    A reminder of how GE calculates loan FMV is taken from the company's 10-K:

    Based on quoted market prices, recent transactions and/or discounted future cash flows, using rates we would charge to similar borrowers with similar maturities.

    In other words FMV uses the traditional Level III evaluation methodology. And even when using DCF (we assume that was used as it will always give the firm the "best", most palatable value reading), GE is still seeing a nearly $20 billion balance sheet shortfall?

    What is more troubling, is that even as GECC has been collapsing its balance sheet, with book value of loans dropping from $305 billion to $292 billion from FYE 2009 to Q3 2008, the FMV-Book delta has increased from $12.6 to $18.8 billion. And this is occurring in a time when the credit market is presumably surging? Is there something wrong with this picture? As we pointed out, the $18.8 billion is likely a gross underestimation of the real valuation shortfall, if one were to really mark all of GE's myriads of illiquid loans to market.

    Yet if nothing else, this shortfall should explain GE's urgent desire to sell NBCU and to use the ~$30 billion in proceeds to plug what is becoming an ever growing hole.


    More on the greatest swindles of the world
    General Electric, the world's largest industrial company, has quietly become the biggest beneficiary of one of the government's key rescue programs for banks. At the same time, GE has avoided many of the restrictions facing other financial giants getting help from the government. The company did not initially qualify for the program, under which the government sought to unfreeze credit markets by guaranteeing debt sold by banking firms. But regulators soon loosened the eligibility requirements, in part because of behind-the-scenes appeals from GE. As a result, GE has joined major banks collectively saving billions of dollars by raising money for...

    Jeff Gerth and Brady Dennis, "How a Loophole Benefits GE in Bank Rescue Industrial Giant Becomes Top Recipient in Debt-Guarantee Program," The Washington Post, June 29, 2009 ---
    http://www.washingtonpost.com/wp-dyn/content/article/2009/06/28/AR2009062802955.html?hpid=topnews
     

    Jensen Comment
    GE thus becomes the biggest winner under both the TARP and the Cap-and-Trade give away legislation. It is a major producer of wind turbines and other machinery for generating electricity under alternative forms of energy. The government will pay GE billions for this equipment. GE Capital is also "Top Recipient in Debt-Guarantee Program." Sort of makes you wonder why GE's NBC network never criticizes liberal spending in Congress.
     

    Jensen's threads on the bank rescue swindle are at http://faculty.trinity.edu/rjensen/2008Bailout.htm z
    Bob Jensen's fraud updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    A Case on Mergers, Acquisitions, and Valuation

    From The Wall Street Journal Accounting Weekly Review on September 17, 2009

    Adobe to Buy Web-Tracking Firm Omniture
    by Don Clark and Suzanne Vranica
    Sep 16, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Advanced Financial Accounting, Mergers and Acquisitions, Revenue Forecast, Revenue Recognition

    SUMMARY: "Adobe Systems Inc. agreed to buy software company Omniture Inc. for $1.8 billion....Adobe said it will pay $21.50 a share in cash for Omniture, a 24% premium to Tuesday's 4 p.m. price....Omniture offers advertisers data that show how much time each visitor spends on a site, the number of pages visited, the number of elements downloaded and what makes people leave a Web page. The company also has technology that allows marketers to automatically change their ad mix based on the computer analysis of the data....Adobe...said it hopes to combine its content-creation technology with Omniture's services, which will help its customers create Web site that are more effective and generate more revenue....Adobe CEO Shantanu Narayen called the Omniture deal a 'game changer.'"

    CLASSROOM APPLICATION: The article is useful to introduce business combinations and to introduce revenue generation from internet web pages.

    QUESTIONS: 
    1. (Introductory) How do companies such as Adobe and even Dow Jones, whose WSJ pages you read on the web to answer these questions, generate revenue from their web pages?

    2. (Introductory) How can Adobe "content" and Omniture technology combine to improve these revenues from web pages?

    3. (Advanced) Why is Adobe willing to pay 24% more than the closing price for Omniture stock two days before the announcement of this acquisition agreement? In your answer, describe analytical tools that might be used to decide on an appropriate price to pay. Also, include in your answer the impact of factors you discussed in answers to questions 1 and 2 above.

    4. (Advanced) What is the impact of the fact that "Omniture...has a mixed record in meeting Wall Street estimates" on your answer to question 1 above?

    5. (Introductory) How did Omniture and Adobe shareholders react to announcement of this deal? What other factors may be part of the stock price reaction to this announcement?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Adobe to Acquire Omniture in $1.8 Billion Deal," by Don Clark and Suzanne Vranica, The Wall Street Journal, September 16, 2009 --- http://online.wsj.com/article/SB125304615573813275.html?mod=djem_jiewr_AC

    Adobe Systems Inc. agreed to buy software company Omniture Inc. for $1.8 billion, a deal designed to help customers track and make money from Web sites that were created with Adobe's programs.

    Adobe said it will pay $21.50 a share in cash for Omniture, a 24% premium to Tuesday's 4 p.m. price. Omniture shares surged 25% in after-hours trading on the news, while Adobe shares declined 4.2%.

    The announcement came as Adobe reported its profit fell 29% and revenue slid 21% in its latest quarter as the continuing downturn in media markets slows demand for its traditional software, such as Photoshop and InDesign.

    Omniture, based in Orem, Utah, specializes in a field known as Web analytics. It provides to advertisers, media companies and other customers information about user activity, such as what Web pages they visit, how much time they spend there and what ads they click on. Customers may change their ads or Web sites based on such data, including data about the effectiveness of ads based on terms users type into search engines.

    Deal Journal Omniture Deal May Not Bring Change Adobe Wants Companies such as Ford Motor Co., Ameritrade Holding Corp. and Xerox Corp. pay monthly fees to access Omniture's services. The amount they pay typically reflects the Web traffic occurring on their sites.

    Adobe, San Jose, Calif., said it plans to build code into its content-creation programs to help them exchange data with Omniture services, eliminating time-consuming programming by customers and helping more of them make money on their Web sites. "We really think that we can actually tranform how digital content is created," said Shantanu Narayen, Adobe's chief executive officer.

    Web analytics generates about $600 million in world-wide annual revenue now, but the industry is expected to grow to $2.2 billion by 2011, according to a June 2008 estimate by J.P. Morgan.

    Companies that compete with Omniture include Webtrends Inc. and Coremetrics. Google Inc., the search giant, also offers some analytic services.

    Scott Kessler, an analyst at Standard & Poor's who tracks Omniture, said it has grown by buying smaller players in the market. But Omniture's business has been squeezed by the recession and the company has a mixed record of meeting Wall Street estimates, he said. It reported a loss of $44.8 million last year even as its revenue nearly doubled to $295.6 million. Partly for those reasons, Mr. Kessler remains skeptical about how quickly Adobe could benefit from the deal.

    Suresh Vittal, an analyst at market researcher Forrester Research, was more optimistic. He said many aspects of Web sites aren't reliably measured now, and Adobe's ability to include such capabilities with its software could give site creators valuable new information.

    Adobe said Omniture will become a new business unit. Omniture CEO Josh James will join Adobe as senior vice president of the new unit, reporting to Mr. Narayan.

    The deal is expected to close in the fourth quarter of Adobe's 2009 fiscal year, which ends in November.

    For the quarter ended Aug. 28, Adobe reported a profit of $136 million, down from $191.6 million a year earlier. Revenue was $697.5 million.

    Bob Jensen's threads on valuation:


    Banks using Deloitte and Ernst & Young show sharper declines in the fair value of their loans than those using other accounting firms, a Wall Street Journal analysis shows.

    "Accounting for Banks' Value Gaps," by Michael Rapoport, The Wall Street Journal, December 29, 2009 ---
    http://online.wsj.com/article/SB20001424052748703278604574624463134498976.html#mod=todays_us_money_and_investing

    Can investors count on consistency when it comes to bank accounting? As many banks struggle with piles of bad loans, some auditors appear stricter than others when assessing their true value.

    Banks using Deloitte and Ernst & Young show sharper declines in the fair value of their loans than those using other accounting firms, a Wall Street Journal analysis shows.

    Of course, it is quite possible Ernst and Deloitte simply have a less-healthy group of bank clients. But if it instead reflects different audit policies when it comes to assessing loans, it could have consequences on the strength of banks' regulatory capital.

    Banks carry most loans on balance sheet at their original cost. But they must also disclose the loans' fair value, or current market value, in footnotes. At most banks, despite the carnage of recent years, fair value is only slightly below cost. Some banks, however, show much steeper declines.

    At Regions Financial, fair value was 19.3% lower than cost as of Sept. 30. The difference was 13.4% at Huntington Bancshares, 12% at KeyCorp, 9% at SunTrust Banks and 8.6% at Marshall & Ilsley. Regions, Key and SunTrust are audit clients of Ernst; Huntington and M&I are Deloitte clients.

    Among the top-25 U.S. commercial banks, those five Ernst and Deloitte clients accounted for five of the six biggest gaps between fair value and cost as of Sept. 30. The average gap among Ernst and Deloitte clients in the 25-bank group was about 6%; among clients of PricewaterhouseCoopers and KPMG it was about 2%.

    Those differences can affect how investors view a bank's loan portfolio, and could have an effect on regulatory capital in the future.

    The Financial Accounting Standards Board is considering changes in banks' accounting for loans and may require them to carry loans on the balance sheet at fair value instead of cost. If that happened, the fair-value declines could reduce shareholder equity and regulatory capital—in some cases, to levels regulators would find troublesome. At Regions, for example, the $16.9 billion gap between its loans' fair value and carrying value would wipe out its $13 billion in Tier 1 capital using a fair-value balance-sheet standard.

    A move by the FASB to require banks to use fair value as the balance-sheet standard doesn't have to hurt the banks' regulatory capital. Bank regulators could adjust the capital measures they use.

    But big hits to the fair value of loans still matter to investors. Who audits a bank's books may have importance beyond whose name goes on the letter blessing the financial statements once a year.

    Where were the auditors? ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms 


    Foreign Currency Complications in Valuation Analysis

    Big Mac Index of Purchasing Power Parity --- http://en.wikipedia.org/wiki/Big_Mac_Index

    "CHART OF THE DAY: The iPod And Big Mac Indexes Just Don't Work," by John Carney and Kamelia Angelova, Business Insider, October 20, 2009 ---
    http://www.businessinsider.com/chart-of-the-day-ipod-vs-big-mac-2009-10

    The Economist's Big Mac Index and the new iPod Nano Index from CommSec are both cute ways of getting attention for the organizations that produce them. But do they really measure anything economically significant?
     
    The idea is that the indexes are supposed to expose the relative under- or over-valuation of various currencies. In theory, the same good should trade at broadly the same price across the globe if
    exchange rates are adjusting properly. When goods wind up priced very differently in different locations, it suggests something is out of whack.

    But a side-by-side comparison of the Big Mac Index and the iPod Nano Index suggests that these might not really be good metrics for measuring
    currency valuations. As you can see, the two indexes result in wildly uncorrelated results. If it were really a matter of currency valuation, you’d expect both to show similar valuation problems. Instead, the pattern just seems random.

     


    August 20, 2009 message from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    Here's another interesting post by Jonathan Weil: From:
    http://www.bloomberg.com/apps/news?pid=20601039&sid=a8itsmbfm9qc

    Commentary by Jonathan Weil

    Aug. 20 (Bloomberg) -- How many legs would a calf have if we called its tail a leg?

    Four, of course. Calling a tail a leg wouldn’t make it a leg, as Abraham Lincoln famously said.

    Nor does calling an expense an asset make it an asset. This brings us to the odd accounting rules for the insurance industry, including Lincoln National Corp., which uses Honest Abe as its corporate mascot.

    Look at the asset side of Lincoln National’s balance sheet, and you’ll see a $10.5 billion item called deferred acquisition costs,” without which the company’s shareholder equity of $9.1 billion would disappear. The figure also is larger than the company’s stock-market value, now at $7 billion.

    These costs are just that -- costs. They include sales commissions and other expenses related to acquiring and renewing customers’ insurance-policy contracts. At most companies, such costs would have to be recorded as expenses when they are incurred, hitting earnings immediately.

    Because it’s an insurance company selling policies that may last a long time, however, Lincoln is allowed to put them on its books as an asset and write them down slowly -- over periods as long as 30 years in some cases -- under a decades-old set of accounting rules written exclusively for the industry.

    Rule Overhaul

    Those days may be numbered, under a unanimous decision in May by the U.S. Financial Accounting Standards Board that has received little attention in the press. The board is scheduled to release a proposal during the fourth quarter to overhaul its rules for insurance contracts. If all goes according to plan, insurers no longer would be allowed to defer policy-acquisition costs and treat them as assets.

    One question the board hasn’t addressed yet is what to do with the deferred acquisition costs, or DAC, already on companies’ books. While there’s been no decision on that point, it stands to reason that insurers probably would have to write them off, reducing shareholder equity. The board already has decided such costs aren’t an asset and should be expensed. If that holds, it wouldn’t make sense to let companies keep their existing DAC intact.

    The impact of such a change would be huge. A few examples: As of June 30, Hartford Financial Services Group Inc. showed DAC of $11.8 billion, which represented 88 percent of its shareholder equity, or assets minus liabilities. By comparison, the company’s stock-market value is just $7.3 billion.

    MetLife, Prudential

    MetLife Inc. showed $20.3 billion of DAC, equivalent to 74 percent of its equity. Prudential Financial Inc.’s DAC was $14.5 billion, or 78 percent of equity. Aflac Inc. said its DAC was worth $8.1 billion as of June 30, which was more than its $6.4 billion of equity. Genworth Financial Inc. listed its DAC at $7.6 billion, or 76 percent of net assets. That was more than double the company’s $3.4 billion stock-market value.

    The rules on insurance companies’ sales costs are a holdover from the days when the so-called matching principle was more widely accepted among accountants and investors.

    At life insurers, for example, it’s common to pay upfront commissions equivalent to a year’s worth of policy premiums. By stretching the recognition of expenses over the policy’s life, the idea is that companies should match their revenues and the expenses it took to generate them in the same time period.

    The problem with this approach is that deferred acquisition costs do not meet the board’s standard definition of an asset. That’s because companies don’t control them once they have paid them. The money is already out the door. There’s no guarantee that customers will keep renewing their policies.

    No Recognition

    Even the industry’s normally friendly state regulators don’t recognize DAC as an asset for the purpose of measuring capital, under statutory accounting principles adopted by the National Association of Insurance Commissioners.

    To be sure, the FASB’s decisions to date are preliminary. How to treat acquisition costs is one of many issues the board is tackling as part of its broader insurance project. Others include the question of how to measure insurers’ liabilities for obligations to policy holders.

    Meanwhile, the London-based International Accounting Standards Board is working on its own insurance project and has said it would take a more accommodating approach to policy- acquisition costs.

    Insurers would be required to expense them immediately. However, the IASB has said it would let companies record enough premium revenue upfront to offset the costs. That way, they wouldn’t have to recognize any losses at the outset. So far, the U.S. board has rejected the IASB’s method.

    Congress Wild Card

    The wild card in all this is Congress. Last spring, the insurance industry joined banks and credit unions in getting U.S. House members to pressure the FASB to change its rules on debt securities, including those backed by toxic subprime mortgages, so that companies could keep large writedowns out of their earnings. Because the FASB caved before, it’s a safe bet the industry would go that route again.

    With so much riding on the outcome, we should expect nothing less. What’s at stake isn’t the real value of the industry’s assets, but investors’ perceptions of how much they’re worth.

    Honest Abe wouldn’t be fooled.

    August 20, 2009 reply from Bob Jensen

    ·  The current conflict about rules for insurance company accounting brings to light once again the conflict between income statement versus balance sheet priorities accounting standard setting.

    The matching concept based on historical cost accrual accounting was always favored the income statement in place of the balance sheet, because deferred costs were considered obsolete and often arbitrary on the balance sheet. Paton and Littleton provide one of the best theoretical arguments in favor of the matching concept where revenues deemed realized are matched with expenses (or price-level adjusted expenses) used in generating those revenues --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue
    Also see mention of Paton and Littleton in
    "Research on Accounting Should Learn From the Past," by Michael H. Granof and Stephen A. Zeff, Chronicle of Higher Education, March 21, 2008

    In the 1970s, the matching concept lost favor in accounting when the FASB decided the balance sheet was to be the primary financial instrument of concern in standard setting. This was heavily influenced at the time by when the FASB declared war on off-balance sheet financing that companies were using to hide financial risk. The FASB subsequently became concerned with earnings management, but the priority of the balance sheet was never questioned by the FASB.

    Today the thrust of the FASB and the IASB into fair value accounting is primarily in the interest of making balance sheets more informative to investors. In the process, fair value accounting greatly confuses the income statement by mixing realized versus unrealized earnings components in the bottom line. This has led some powerful accounting leaders like the current Director of the FASB (Bob Herz) to argue that perhaps income statement components should not be aggregated by companies or auditors into bottom line net income ---
    http://faculty.trinity.edu/rjensen/theory01.htm#ChangesOnTheWay
    This is analogous for pharmacies to declare that certain drugs are too dangerous to sell in one pill, but they will sell 100 ingredient pills that you can pick and choose from to get a combined effect.

    The current heated debate on what unrealized earnings can be diverted to Comprehensive Income (OCI) instead of being posted to current earnings is rooted in the unresolved problem of what types of unrealized income to keep out of current earnings. This is the black hole of fair value accounting apart from the even more serious problem of how to make fair value estimates cost effective (e.g., having real estate formally appraised every year would not be cost effective for large international hotel or restaurant chains).

    The current conflict about rules for insurance company accounting brings to light once again the conflict between income statement versus balance sheet priorities accounting standard setting.

    There are accounting theorists (today it's Tom Selling) who argue that historical cost accounting should be replaced by entry value (replacement cost) accounting. Note, however, that replacement cost accounting is not fair value accounting in the sense that it still entails the hated arbitrary cost allocation assumptions of historical cost accounting. When a farmer buys a tractor for $500,000 and puts it on a 15-year double declining balance (DDB) depreciation schedule, the cost allocation is quite arbitrary but still in the spirit of the matching concept. At the end of five years, the replacement cost may now be $800,000, but the farmer cannot book his old tractor at the price of a new tractor. Under replacement cost accounting he must bring the $800,000 on the books net of five years of (arbitrary) depreciation.

    Thus replacement cost accounting is not "valuation" accounting. It’s still cost allocation accounting based largely on capital maintenance theory to prevent greedy managers or ignorant farmers from declaring dividends that destroy the farm.

    There are even more theorists (Chambers, Sterling, Schuetz, Edwards, Bell, etc.) that favor exit value accounting. This is truly valuation accounting. But exit values sometimes have little to do with value in use. For example, the exit value of that $500,000 tractor may only be $100,000 in the used market but still have a value in use to the farmer far in excess of $400,000. Exit values are particularly problematic for valuable assets in place (like custom factory robots) that are practically worthless in the used equipment market because of the immense cost of tearing them down and re-installing them at a new location.

    Hence the main problem of exit value accounting for operating assets in use is that it nearly always values them in their worst possible use (unloading them in a used-asset market) when in fact their best possible use is to continue using them as part of a profitable operation where they have synergy and valuable covariances with other operating assets and skilled employees.

    Hence there are no silver bullets in putting numbers on balance sheet items. All have some advantages and disadvantages in terms of potential to mislead passive investors --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    Bob Jensen’s summary of the fair value accounting controversies (including a Days Inn illustration from the past) are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    Bob Jensen's threads on accounting history ---
    http://faculty.trinity.edu/rjensen/theory01.htm#AccountingHistory

    Bob Jensen

    One of the early contributors to value theory in accounting was Theodore Limperg from Holland.

    The social responsibility of the auditor: A basic theory on the auditor's function  by Theodore Limpberg ((Hard to Find, but no doubt Steve Zeff has a copy. Steve is an expert on accounting in The Netherlands)


    I had an inquiry about the origins of scholarship on fair value accounting in the USA and France. My initial reply is shown below. Since the person that asked this question is on the AECM, perhaps some of you can provide more help than me.

    Hi XXXXX,

          It's interesting how a paper (in this case a chapter of a book) gets served up in all sorts of places where the author and publisher are not aware of various places where it is being served up free to the world. When seeking an answer to your question, Google led me to one of my own book chapters being served up free from a link that I discovered using Google ---
    [PDF] Fair value accounting in the USA
    http://citeseerx.ist.psu.edu/viewdoc/download;jsessionid=04208F53BD8335ADA0F30DD2ED91BE81?doi=10.1.1.161.3740&rep=rep1&type=pdf

    Be that as it may, the above book chapter does not really delve into the origins of fair value accounting scholarship in the USA or France. My guess is that exit value scholarship in most nations originated by borrowing from writings in The Netherlands, although use of this exit value in settlements of estates probably has a history than cannot be traced to the first-time invention of the practice.
    http://som.eldoc.ub.rug.nl/FILES/reports/1995-1999/themeE/1999/99E43/99e43.pdf
    I would begin be examining some of the writings of Theodore Limpberg.

    It would be far better to see if Dale Flesher has some ideas on this ---- acdlf@olemiss.edu

    Dale has access to an outstanding accounting history library (most things not yet in digital form) ---
    http://www.olemiss.edu/depts/accountancy/libraries.html

    Back issues (from 1974) of the Accounting Historians Journal are now free at
    http://www.olemiss.edu/depts/general_library/dac/files/ahj.html
    My keyword searches for exit value, fair value, and value were somewhat disappointing in this database. However, that does not mean that a whole lot more cannot be uncovered with a more diligent search of AHJ articles.

    I had a bit better luck with word searches of the MAAW database ---
    http://maaw.info/
    The MAAW leads to some excellent bibliographies to pursue.

    Steve Zeff (Rice) and Gary Previts (Case Western) may also be of help.

    For entry value accounting, I would go back to John Canning’s classic thesis to see if he traces the history of replacement cost accounting.
    Also see http://maaw.info/ReplacementCostArticles.htm

    Texas A&M has an interesting accounting history site maintained by Gary Giroux ---
    http://acct.tamu.edu/giroux/history.html
    It would be a tremendous help if the Aggies added a search box.
    I don’t think this site delves into the origins of fair value accounting.

    Sorry I can’t be of more help. I suspect what you really would like to find is the first published account of fair value accounting that, like double entry bookkeeping, had origins hundreds of years prior to when somebody decided to write about it in a scholarly manner.

    An interesting history of discounted cash flow appears at
    http://esvc000040.wic056u.server-web.com/grad/gradarum.pdf

    As an aside you might also look at
    http://www.capitalideasonline.com/articles/index.php?id=2339

    Bob Jensen

     

     

     


    August 25, 2009 message from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    In theory, mortgage loans should be natural hedges if the entity rationally got a loan matched to the cash flows of the asset.

    Marking only one to fair value would mess that up.

    One alternative is to leave the loan at amortized cost. The other is to measure the asset at fair value which could be the present value of future cash flows.

    Fully admitting to not having any time to read Tom's blog posts....yet.

    Reading AECM emails are my "break".

    Pat

    August 26, 2009 reply from Bob Jensen

    Hi Pat,

    Many loans are not used for assets, such as loans to pay off other debt and loans to pay expenses.. In Modigliani and Miller theory we should not even try to map assets with financing ---
    http://en.wikipedia.org/wiki/Modigliani-Miller_theorem

    I assume what you really meant by "natural hedging" is the possibility that borrowers can sometimes buy back their debt below book (payoff) value and therefore capture a gain on debt. This is often the case with unsecured debt. But there are problems since all investors in the debt may not be willing to sell at market value below book value. To avoid buy back and call back complications, some fixed-rate borrowers like Exxon resort to defeasance to capture gains on long-term debt. However, defeasance was somewhat deterred by

    In-substance defeasance used to be a ploy to take debt off the balance sheet. It was invented by Exxon in 1982 as a means of capturing the millions in a gain on debt (bonds) that had gone up significantly in value due to rising interest rates. The debt itself was permanently "parked" with an independent trustee as if it had been cancelled by risk free government bonds also placed with the trustee in a manner that the risk free assets would be sufficient to pay off the parked debt at maturity. The defeased (parked) $515 million in debt was taken off of Exxon's balance sheet and the $132 million gain of the debt was booked into current earnings --- http://www.bsu.edu/majb/resource/pdf/vol04num2.pdf

    Defeasance was thus looked upon as an alternative to outright extinguishment of debt until the FASB passed FAS 125 that ended the ability of companies to use in-substance defeasance to remove debt from the balance sheet. Prior to FAS 125, defeasance became enormously popular as an OBSF ploy.

    It is very difficult to buy back secured debt for less than book value. The reason is than in most cases the loan collateral value exceeds the loan's book (payoff) value plus foreclosure costs. In 2009 in some parts of the country, the collateral value markets are broken. And we still have a problem that some real estate appraisers place fraudulent values on collateral. But for the most part, collateral value exceed book value.

    The common way to hedge or speculate in debt since the 1980s is with interest rate swaps. A great example of this is Example 2 in Appendix B of FAS 133, for which I have an Excel workbook 133ex02a.xls file at http://www.cs.trinity.edu/~rjensen/
    The above 133ex02a.xls file shows how the FASB screwed up the example slightly.
    This illustrates where the ABC Company having fixed-rate debt with no cash flow risk (and accordingly fair value risk) swaps to hedge fair value, thereby creating cash flow risk on the hunch that interest rates will decline.

    Summary of Cash Transactions          
    Debt Interest Rate Note Note Without a  With a  Net Impact of
    Interest Swap Payoff Proceeds FV Hedge FV Hedge FV Hedge
    Sources of Cash:              
    07/01/x1       1,000,000 $1,000,000 $1,000,000 $0
                 
    Applications of Cash:              
    09/30/x1 (16,025) 0     (16,025) (16,025) 0
    12/31/x1 (16,025) (175)     (16,025) (16,200) (175)
    03/31/x2 (16,025) 0     (16,025) (16,025) 0
    06/30/x2 (16,025) 225     (16,025) (15,800) 225
    09/30/x2 (16,025) (2,975)     (16,025) (19,000) (2,975)
    12/31/x2 (16,025) (3,250)     (16,025) (19,275) (3,250)
    03/31/x3 (16,025) (3,525)     (16,025) (19,550) (3,525)
    06/30/x3 (16,025) (2,525) (1,000,000)   (1,016,025) (1,018,550) (2,525)
      (128,200) (12,225) (1,000,000) (1,140,425)      
                  Net decrease in cash =    ($140,425) ($128,200) ($140,425) ($12,225)

     

    Example 5 in Appendix B illustrates the opposite situation where a swap is used to hedge cash flow risk. That Excel workbook is the 133ex05a.xls file at http://www.cs.trinity.edu/~rjensen/
    The video is the 133ex05a.wmv file at http://www.cs.trinity.edu/~rjensen/video/acct5341/

     

    Tom Selling also uses the term "natural hedge" is a somewhat confusing manner in the context of a forecasted transaction (not booked) to buy copper. In countless instances, manufacturers engage in cash flow hedges of unbooked forecasted transactions with derivatives. FAS 133 and IAS 39 allow hedge accounting for those derivatives such that fair value changes in the derivative that are offset economically by the hedged item cannot be offset in current earnings because the hedged item is not booked.

    Tom stated the following at one point in time:

    Let me try state it in terms of a manufacturer of a commodity product that contains a significant amount of copper. Changes in market prices of the end product can be expected to be highly correlated with changes in the price of copper. Therefore, a natural hedge is already in place for the risk that copper prices will rise in the future. If you add a forward contract to purchase copper to the firm's investment portfolio, then you are actually adding to economic volatility instead of subtracting from it. (I trust you don't need a numerical example, but I could provide one if you want it.) If you add an at-the-money option to purchase copper, you are destroying value by paying a premium for what is essentially an insurance contract on a long run risk that doesn't exist.

    His argument is misleading. The purpose of the cash flow hedge is simply to lock in the price of copper for a future purchase rather than speculate in copper prices. It's tantamount to buying the copper now without having to incur the inventory storage costs. If the cash flow hedge is perfect the only volatility of earnings during the hedging period would arise if hedge accounting was not allowed and changes in the fair value of the hedging contract was carried to current earnings.

    If the firm does not hedge on the forecasted transaction, it runs the risk of having to pay a much higher spot price when the copper is eventually purchased. Purchasing a long (call option) as a price hedge simply eliminated that risk. The fact that the price of the company's end product is correlated with copper prices is irrelevant. The company is not hedging profit with the option hedging contract. It is hedging the purchase price of copper. If ultimate (unknown) spot price of copper exceeds the strike price, the company earns more profit than if it had not hedged. If the spot price goes down, it loses some opportunity value profit (which I guess is Tom's point).

    However, the whole purpose of the economic price hedging take the price risk out of buying future inventory. Of course there's a chance of losing opportunity value in copper price speculation (the loss in the case of a purchased call option is limited to the price paid for the option). But some manufacturers do not want speculate on price of forecasted transactions. They prefer to sleep nights and make their profits without speculating on price.

    Under current rules in FAS 133 and IAS 39, the value changes in the hedging contract that are not offset by booked value changes in the hedged item receive hedge accounting status and are posted to AOCI. This is illustrated in Examples 1 and 4 of Appendix B of FAS 133. My Excel workbook file is the 133ex01a.xls file at http://www.cs.trinity.edu/~rjensen/

    I also have a real-world copper price swap illustration in the 133spans.xls workbook at http://www.cs.trinity.edu/~rjensen/
    I wrote the above case because of a challenge years ago made by Rashad Abdel-Khalik.

    Bob Jensen


    From The Wall Street Journal Accounting Review on October 8, 2009

    Borrowing for Dividends Raises Worries
    by Liz Rappaport
    Oct 05, 2009
    Click here to view the full article on WSJ.com

    TOPICS: Bonds, Debt, Dividends, Financial Accounting, Financial Analysis, Financial Statement Analysis, Mergers and Acquisitions

    SUMMARY: "Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds...to pay out special dividends, buy back stock, or finance acquisitions.... [In contrast,] most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash."

    CLASSROOM APPLICATION: The article can be used in covering bond issuances, ratio analysis particularly of debt-to-equity and interest versus earnings, dividend payments, and corporate acquisitions.

    QUESTIONS: 
    1. (Introductory) What was the effective interest rate for corporations with high credit ratings who issued bonds in September 2009? How does that rate compare to one year ago?

    2. (Introductory) What reasons for that change are given in the article? Do they have anything to do with changing creditworthiness of the borrowers?

    3. (Introductory) Compare the actions of Intel Corporation and TransDigm Group, Inc., with their debt issuance. How are they similar? How are they different?

    4. (Advanced) What is the impact on a corporate balance sheet of issuing debt? Describe the impact ignoring use of the proceeds, in essence assuming the company will "stockpile" the cash.

    5. (Introductory) Define the financial statement ratios of debt-to-equity and times interest earned.

    6. (Advanced) Describe the change in impact of debt issuance on a balance sheet equation and the two financial ratios if the proceeds are used to pay dividends to shareholders.

    7. (Advanced) Can a company issue bonds in order to "reduce debt" as the author says was done in during the recession and credit crisis? Explain, proposing a better term for such a transaction.

    8. (Introductory) The author uses two benchmarks to make clear the impact of TransDigm Group's debt issuance and dividend payment. What are these benchmarks? How does using them increase clarity about the size of the $425 million bond offering and the $7.50 to $7.70 per share special dividend?

    9. (Advanced) The author also includes use of bond proceed to finance acquisitions as a risky action. How have debt analysts reacted to Kraft's offer to buy Cadbury?

    10. (Advanced) Describe the impact of a business combination financed by debt on the total combined balance sheets of the firms entering into the business combination. How does this impact compare to using bond proceeds to pay dividends to shareholders? How does it differ?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Borrowing for Dividends Raises Worries," by Liz Rappaport, October 5, 2009 ---
    http://online.wsj.com/article/SB125470107157763085.html?mod=djem_jiewr_AC

    Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds to go on the offensive, even if that means rewarding shareholders at the expense of bondholders.

    The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.

    Eric Felder, global head of credit trading at Barclays Capital, says the lure of low rates and companies' stables of cash increases "the risk of non-bondholder friendly events."

    Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company.

    The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service.

    Moody's said the dividend "illustrates the company's aggressive financial policy." Moody's gave the new debt a junk rating of B3, even though the ratings firm said TransDigm's "strong operating performance will enable the company to service the increased debt level."

    Sean Maroney, director of investor relations at TransDigm, says the "stability of our business, high profit margins and consistent cash flow" give the company "the ability to support this level of leverage."

    Borrowing from bondholders to pay shareholder dividends is "a hallmark of an earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year.

    Companies like Dex Media Inc. took on debt to pay dividends to its private-equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe, before taking the companies public. Dex Media filed for bankruptcy earlier this year under a mountain of debt.

    With the federal-funds rate at 0% for nine months now and confidence returning to the stock and debt markets, investors have been driven to take on more risk. That is flooding the corporate-bond market with cash. Investors poured $43 billion into investment-grade corporate-bond funds in the second quarter and nearly $40 billion in the third quarter -- almost double previous peak quarters, according to Lipper AMG Data Services.

    The wave of buying drove down borrowing costs for the average highly rated corporation to about 5%, according to Merrill, a level not seen since 2005. In the heat of the crisis last October, such rates averaged 9%. Through the end of September, more than 1,000 high-rated companies borrowed a record $860 billion, according to Dealogic.

    In July, Intel Corp. sold $1.75 billion of convertible bonds, planning to use $1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined to comment.

    The computer-chip giant has a strong credit rating of single-A, so it doesn't carry a burdensome debt load. Still, the deal raised eyebrows among some analysts and investors, who say floating debt to buy back stock could become more common as companies regain confidence.

    And as merger-and-acquisition activity revs up, the cheaper cost of debt compared with equity is tempting companies to use bond sales as a deal-making war chest.

    Analysts are watching Kraft Foods Inc. in anticipation that the company would finance its proposed purchase of U.K. chocolate, candy and chewing gum maker Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was then valued at about $16.7 billion, but it could be weeks before Kraft submits a formal offer.

    Three major credit-ratings agencies have warned Kraft that they could slash the company's debt ratings if the company reaches a deal agreement with Cadbury. At the current offering price, Kraft would need to shell out at least $6 billion in cash, much of it likely from the debt markets, according to corporate-bond research firm Gimme Credit.

    "Kraft is committed to maintaining an investment-grade rating," a Kraft spokesman said, declining to comment further.

    So far in 2009, returns to high-grade bond investors are 19%, according to Merrill. "We've seen a feeding frenzy" because of low interest rates, says Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds recently to take profits from the rally. Loomis Sayles wants to have cash on the sidelines in case the Fed raises rates soon or Treasury bonds sell off.

    Jensen Comment
    If you buy into the Modigliani and Miller Theorem of capital structure, how the corporation is financed, including dividend payouts, is as follows:

    The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

    Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

    Miller was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

    Video:  The Greek Economic Crisis Explained --- http://www.simoleonsense.com/video-the-greek-crisis-explained/

    Video Lunch with a Laureate: Famous Financial Researcher Robert Merton ---
    http://www.simoleonsense.com/lunch-with-a-laureate-famous-financial-researcher-robert-merton/

    Of course these days, the assumption of market efficiency is a big stretch ---
    http://faculty.trinity.edu/rjensen/theory01.htm#EMH

    Bob Jensen's threads on debt versus equity and capital structure (including investor earn out contracts) are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FAS150

    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 of the firm are at http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory01.htm 


    September 11, 2009 message from David Albrecht [albrecht@PROFALBRECHT.COM]

    I usually agree with most every word that Floyd Norris, business correspondent at-large for the New York Times and the International Herald Tribune.

    If I understand him correctly, he says that the crash is accounting's fault because the accounting world didn't have better rules.

    In a short concluding paragraph, Norris states some downside if the SEC does not adopt IFRS.  This is pretty significant, as Floyd Norris is widely read and carries influence in Washington.  IFRS proponents have a significant ally if Floyd Norris is on board.

    First Kroeker, then Norris?  IFRS in the U.S. might be getting pretty close.

    David Albrecht

    "Accountants Misled Us Into Crisis," by FLOYD NORRIS, The New York Times, September 11, 2009 ---
    http://www.nytimes.com/2009/09/11/business/economy/11norris.html?_r=1

    The accountants let us down.

    That is one of the clear lessons of the financial crisis that drove the world into a dee
    p recession. We now know the major banks were hiding dubious assets off their balance sheets and stretching rules if not breaking them. We know that their capital was woefully inadequate for the risks they were taking.

    Efforts are now being made to improve the rules, with some success. But banks have persuaded politicians on both sides of the Atlantic that the real problem came not when their financial inadequacies were obscured by bad accounting, but when they were revealed as the losses mounted.

    “There were important aspects of our entire financial system that were operating like a Wild West show, huge unregulated opaque markets,” said the man whose job was to write the accounting rules, Robert H. Herz, the chairman of the
    Financial Accounting Standards Board.

    “The crisis highlighted how important better transparency around that system is,” Mr. Herz added in an interview this week. “I would hope that would be a major lesson learned or relearned.”

    Unfortunately, some seem to have learned exactly the opposite lesson. Accounting rule makers at FASB and its international equivalent, the International Accounting Standards Board, have been lambasted for efforts to improve transparency by forcing banks to disclose what their dodgy assets are actually worth, as opposed to what the banks think they should be worth.

    Both boards have tried to resist, but have been forced by political pressure to back down on some specifics. In the case of FASB, the retreat took a few weeks after Mr. Herz was ordered to act at an extraordinary Congressional hearing. The international board was given a long weekend to retreat, with the
    European Commission threatening to impose its own rules if the board did not cave in. Both boards tried to reduce the damage by forcing more disclosures, but it is unclear how much good that will do. Neither was willing to defy the politicians.

    It is unfortunate that there are significant differences between the American and international rules on how to determine fair values of financial assets. That has enabled banks on both sides of the Atlantic to demand that they get the best of both worlds. Pleas for a level playing field have resonated in Washington and Brussels.

    The banks have argued that market values can be misleading, and that their own estimates of the eventual cash flow from assets are more realistic than what they ­ or others ­ will now pay for those assets. The rules already allowed them to ignore so called “distress sales” in assessing fair value, but the banks pushed to broaden that exemption in the United States, while in Europe they got the regulators to allow them to retroactively stop calculating market value for assets they said they did not intend to sell.

    Behind the scenes, there is a battle pitting securities regulators ­ who instinctively favor disclosure ­ against banking regulators, who fear there are times when disclosure could make a bad situation worse.

    The securities regulators argue that accounting should do its best to report the actual financial condition of a company. If the banking regulators want to allow banks to use different rules in calculating capital ­ rules that would not require marking down assets, for example ­ then they can do so without depriving investors of important information.

    But that information could scare those investors, and set off the kind of panic that brought down
    Lehman Brothers a year ago.

    It is the job of banking regulators to keep their institutions healthy, and that effort can only be helped by accounting that reveals problems early. But if the banks do get into trouble, some regulators would prefer to maintain the appearance of prosperity while efforts are made to fix the problems quietly.

    It can be argued that approach worked nearly 20 years ago, when some banks were allowed to pretend they were solvent after the Latin American debt crisis, and were able to earn their way out of the problem over the ensuing decade.

    Had a different course been chosen in the early 1990s, Citibank might have vanished. Given what has happened to Citi in this crisis, it is not clear if that would have been a good or bad outcome.

    The accounting rules on financial assets were, and are, a confusing mess, with the same loan getting very different accounting based on whether or not it had been packaged as part of a security. In some cases, banks could not take loan losses as early as they should have, even if they wished to do so. As financial complexity increased, rule makers struggled to keep up, and were not always successful.

    // huge snip//

    The fights over bank accounting are taking place against the backdrop of the S.E.C. trying to decide whether and when to move the United States to international accounting standards, and as the two boards seek to converge on one set of accounting rules.

    Mr. Ciesielski fears convergence could lead to acceptance of the weakest standards for banks. But without convergence, the S.E.C. will have no standing to oversee application of international standards, or to act as a counterweight if European politicians try to order even weaker standards to protect their banks.

    Floyd Norris comments on finance and economics in his blog at nytimes.com/norris

    September 11, 2009 reply from Bob Jensen

    Hi David,

    It seems to me that we have two issues here that are being confounded in a confusing manner.

    Issue 1
    When should auditors  insist on FAS 157 Level 1 (fair value adjustments of poisonous loan portfolios) or allow Level 3 (essentially historical cost in the name of a discounted cash flow model) on the grounds that the Level 1 and Level 2 requisite markets are broken. In FSP 157-4 the FASB essentially opened to floodgates to Level 3 by simply stating to auditing firms that:  “Hey, Level 3 is O.K. with us as long as you think the markets are broken.” The issue thus reduces to auditor judgment regarding if and when markets are seriously broken.

    Issue 2
    If banks adopt Level 3 and essentially revert to historical cost balance sheet reporting of loan portfolios that most likely are laced with poison, the real issue reduces to the age-old problem we’ve had with banks throughout the history of historical cost accounting. The fact of the matter is that when loan portfolios have likely increases in future collection losses, banks fight tooth and nail to under-report estimated bad debt loss reserves. Norris appropriately reminds us of the notorious underestimation of the really sick Latin American receivables held by big U.S. banks in the 1980s and how these banks arm twisted their auditors to underestimate bad debt losses on those international loan portfolios.

    It seems to me that the net result could be the same in either way as shown below where the estimated loan loss is $400,000 on a $1 million portfolio (historical cost book value).

    FAS 157 Level 1
    Unrealized fair value loss on loan portfolio           400,000
         Loan portfolio                                                                                400,000

    FAS 157 Level 3
    Estimated bad debt expense on loan portfolio      400,000
         Allowance for doubtful accounts on loan portfolio                           400,000

    If the Allowance for doubtful accounts is a contra account, the net balance in the balance sheet should be roughly the same if the degradation in the loan value is only due to estimated bad debts. Changes in interest rates can complicate this illustration.

    But the banks don’t want either entry to be made when there is serious poison in the loan portfolio.

    What the banks really want is a green light to hide suspected poison in loan portfolios, and they’re willing to take it to the EU in Europe and Washington DC in the U.S. We’ve already seen how thousands of banks forced the EU to carve out portions of IAS 39 compliance because they did not want to adjust all derivatives to fair value.

    Thus we have a power struggle over the authority and independence of the IASB and the FASB to set accounting standards in the face of industries that are willing to take their lobbying efforts to higher authorities. Fortunately, EU legislation and acts of the U.S. Congress are difficult to engineer. A huge effort to override FAS 123R was mounted by technology firms, but even enormous companies like Intel and Cisco found that legislating accounting standard overrides is no piece of cake. In the case of FAS 123R, the override effort failed and Intel and Cisco had to learn to live with expensing of employee stock options when the options vest.

    By the way, Janet Tavakoli in the book Dear Mr. Buffet has a very interesting chapter (The Prairie Princes versus Princes of Darkness) devoted to the evolution of FAS 123R and options backdating scandals. What I did not know is that Milton Friedman, Harry Markowitz, George Shultz, Paul O’Neil, Art Laffer, and Holman Jenkins were Princes of Darkness whereas there was a FAS 123R Prince of the Prairie named Warren Buffett.

    The political problem is different with banks, as opposed to most other corporations, since banks, like lawyers, seem to have exceptional insider-fighting powers when it comes to legislatures and members of parliament.

     Bob Jensen


    Question
    Why the bruha now since FSP 157-4 cleared up doubts that FAS 157 Level 3 leaves everything up to how banks want to define broken markets?

    Answer
    Even if banks carry toxic assets at historical costs well above current market values under FSP 157-4 leniency, both FASB domestic and IASB international standards require realistic estimates of loan loss bad debt reserves. However, CPA auditors have traditionally allowed banks to underestimate bad debt losses, which of course why shareholders of many failed banks are now suing large auditing firms with the Washington Mutual (WaMu) lawsuit against Deloitte being Exhibit A ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

    The current wave of audit firm lawsuits is tending to make auditing firms more conservative about loan loss bad debt reserves. What banks really want is to carry toxic assets at or near cost well above current values and to continue to greatly underestimate loan loss bad debt reserves. They want their cake and sweeteners too.

     

    Three Former Directors of the SEC Weigh In Banker Requests to Get Out from Under Accounting Standards
    "Don't Let Banks Hide Bad Assets:  In times of distress, there's always pressure to change accounting standards," by Roderick M. Hills, Harvey L. Pitt, and David S. Ruder," The Wall Street Journal, November 19, 2009 ---
    http://online.wsj.com/article/SB10001424052748704782304574542134264068424.html

    Independent accounting standards have helped make American capital markets the best in the world. In making financial decisions, investors rely heavily upon the integrity of corporate financial reports prepared in accordance with accounting standards established by the independent Financial Accounting Standards Board (FASB). That board is supervised by the Securities and Exchange Commission (SEC).

    Now, the Obama administration is on the verge of transferring accounting standards responsibility from the SEC to a systemic risk regulator. Such a radical move would have extremely negative consequences for our capital markets.

    Although there may be good reasons for establishing different regulatory capital standards for financial services firms, those reasons cannot justify dispensing with the FASB's accounting standards. Acting in accord with powers given to it by the Sarbanes-Oxley Act, the SEC has formally recognized the FASB as the definitive standard-setting body, capable of "improving the accuracy and effectiveness of financial reporting and the protection of investors."

    The SEC treats accounting standards adopted by the board as authoritative. If the SEC has concerns about, or disagrees with, accounting standards promulgated by the FASB, it can refuse to give them deference.

    Today, the American Bankers Association, on behalf of many commercial banks, is seeking to prevent disclosure of the fair value of the financial instruments they own. It is attempting to persuade Congress that the safety and soundness of the banking system will be protected if a systemic risk regulator can prescribe accounting disclosures for financial companies.

    The government shouldn't follow their advice. This change might well interfere with efforts by financial firms to raise capital. Investors will assume that the accounting standards they employ are designed to mask risks.

    As former chairmen of the Securities and Exchange Commission, we are well aware of the long-held desire of commercial interests to avoid fully disclosing their finances. In the 1990s, business interests opposed publicly disclosing their post-employment pension and health obligations. Similarly, in 2000, efforts were made to prevent the FASB from eliminating distortions that inflated the balance sheet values of newly merged companies, because its elimination might make balance sheets look less favorable to potential investors.

    In 1994, the FASB considered requiring companies to reflect the current value of their outstanding stock options. After intense lobbying from certain business interests and pressure from Congress, the FASB decided not to require use of the fair value method. In 2004, when the FASB finally mandated it for valuing stock options, certain U.S. business opponents continued to lobby Congress to overturn that decision.

    During times of financial distress, there is always pressure to change accounting standards in order to inflate the value of assets. Under certain circumstances, there may be a legitimate need to recognize that stresses on large financial institutions may threaten the stability of the U.S. financial system. Banking regulators can ease such stresses by reducing regulatory capital requirements. But it would be a mistake to adopt legislation that would allow financial-services firms to hide their true financial positions from investors.

    If changes in accounting standards are used to bury significant risks for one purpose, it will not be long before other purposes are asserted to permit further deviations. This is a dangerous path that will only hurt investors and our capital markets.

    Messrs. Hills, Pitt and Ruder are former chairmen of the Securities and Exchange Commission.

     

    Fiction Writer Rosie Scenario Heads Up the Accounting Division of Wells Fargo
    (with the FASB's FSP 157-4 blessing)
    Before reading this note that Wells Fargo took over the toxic-asset laden Wachovia on December 31, 2008.  It was a government-forced sale of Wachovia to prevent the total implosion of the poisoned Wachovia --- http://en.wikipedia.org/wiki/Wachovia
    However, Wells Fargo stood to profit from the poison in the sweet deal offered by Paulson.

    The Motley Fool is a very popular commercial Website about stocks, investing, and personal finance --- http://en.wikipedia.org/wiki/Motley_Fool  
    Did you ever wonder about the “Fool” part of the company’s name?
    The Gardner brothers considered themselves “fools” that were smarter than some foxes. Although at many times the Gardners have shown that fools can fool wannabe foxes, the Gardners brothers have at times also been out foxed.

    My point here, Pat, is that people who buy Wells Fargo Bank shares just because the price went up following an accounting change (accounting change from Level 1 to Level 3 covered up the smell of Wells Fargo’s enormous toxic loan portfolio) may not be ignorant that accounting changes don’t really offset pending toxic deaths in the long run.

    Some “fools” buying Wells Fargo Bank shares just think there are many fools more foolish than themselves.

    Either way you look at it, investing is a bit of a fools game with fools trying to out fool one another. The premise is, however, that sophisticated fools ultimately win. That's most certainly the case with casinos.

    "Time to Call Out Wells Fargo's Balance Sheet," by Michael Shulman, Seeking Alpha, September 22, 2009 ---
    http://seekingalpha.com/article/162681-time-to-call-out-wells-fargo-s-balance-sheet

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     


    AIG Worships at the Alter of new FSP 157-4 rulings
    Selling Hot Air to Investors While Still Begging for Hard TARP Cash

    When should auditors insist on FAS 157 Level 1 (fair value adjustments of poisonous loan portfolios) or allow Level 3 (essentially historical cost in the name of a discounted cash flow model) on the grounds that the Level 1 and Level 2 requisite markets are broken? In FSP 157-4 the FASB essentially opened to floodgates to Level 3 by simply stating to auditing firms that:  “Hey, Level 3 is O.K. with us as long as you think the markets are broken.” The issue thus reduces to auditor judgment regarding if and when markets are seriously broken.

    "Asset Write-Ups Put AIG in Black," by Lavonne Kuykendall and Joan E. Solsman, The Wall Street Journal, November 6, 2009 --- http://online.wsj.com/article/SB125750911722533537.html

    American International GroupInc. posted its second consecutive profit in the third quarter, driven largely by asset write-ups, while its core insurance operations continued to struggle with a weak economy and lingering negative perceptions in the marketplace.

    Despite beating analyst estimates, AIG shares were down Friday. The stock, which has risen nearly sixfold from an all-time low in March, was up 25% for 2009 through Thursday.

    In a news release, AIG Chief Executive Robert H. Benmosche said that AIG's results "reflect continued stabilization in performance and market trends," but said the company expects "continued volatility in reported results in the coming quarters, due in part to charges related to ongoing restructuring activities."

    One coming expense will be an approximately $5 billion charge in the fourth quarter as it closes on the special-purpose vehicles (read that SPEs) connected to its foreign life- insurance businesses AIA and ALICO, to pay off $25 billion of its New York Fed credit line.

    The outstanding balance of AIG's government bailout, including government support of all types, was $120.6 billion at the beginning of September, out of total authorized assistance of $182 billion.

    Financial markets have improved significantly in the year since AIG's bailout and changes in how financial firms can value assets (read that FSP 157-4) have helped AIG recover from the write-downs and charges that brought it near collapse. But analysts say the company, while healthier, remains weak.

    AIG posted a profit of $455 million, or 68 cents a share, compared with a year-earlier loss of $24.47 billion, or $181.02 a share. The latest results included $1.8 billion in capital losses, while the previous year's results included billions in write-downs from credit-default swaps and $15.06 billion in capital losses.

    Excluding capital losses and hedging activities that don't qualify for hedge-accounting treatment, the profit was $2.85 in the latest quarter. A survey of analysts by Thomson Reuters predicted $1.98.

    Operating income at AIG's general-insurance business before capital gains rose more than sixfold, as net premiums written fell 13%. The portion of premiums paid out on claims and expenses climbed to 105.2% from 104.5%.

    Profit at the life-insurance division more than doubled as assets under management rose in an improving market. Premiums, deposits and other considerations dropped 38.6% from last year, to $13.7 billion on lingering negative perceptions of AIG events and lower industry sales generally.

    AIG, which has become more patient in selling off units as it attempts to repay federal aid, last month sold investment company Primus Financial Holdings Ltd. for $2.15 billion, its biggest sale globally so far. The company will book a $1.4 billion fourth-quarter loss on the sale.

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     


    Even though the neutrality-believing FASB is in a state of denial about the impact of FSP 115-4 on decision making in the real world, financial analysts and the Director of Corporate Governance at the Harvard Law School are in no such state of denial,
    "The Fall of the Toxic-Assets Plan," The Wall Street Journal, July 9, 2009 ---
    http://blogs.wsj.com/economics/2009/07/09/guest-contribution-the-fall-of-the-toxic-assets-plan/

    The government announced plans to move forward with its Public-Private Investment Program yesterday. Lucian Bebchuk, professor of law, economics, and finance and director of the corporate governance program at Harvard Law School, says that the program, which has been curtailed significantly, hasn’t made the problem go away.

    The plan for buying troubled assets — which was earlier announced as the central element of the administration’s financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks’ new ability to raise capital through stock sales without having to sell toxic assets. But the program’s inability to take off is in large part due to decisions by banking regulators and accounting officials to allow banks to pretend that toxic assets haven’t declined in value as long as they avoid selling them.

    The toxic assets clogging banks’ balance sheets have long been viewed — by both the Bush and the Obama administrations — as being at the heart of the financial crisis. Secretary Geithner put forward in March a “public-private investment program” (PPIP) to provide up to $1 trillion to investment funds run by private managers and dedicated to purchasing troubled assets. The plan aimed at “cleansing” banks’ books of toxic assets and producing prices that would enable valuing toxic assets still remaining on these books.

    The program naturally attracted much attention, and the Treasury and the FDIC have begun implementing it. Recently, however, one half of the program, focused on buying toxic loans from banks, was shelved. The other half, focused on buying toxic securities from both banks and other financial institutions, is expected to begin operating shortly but on a much more modest scale than initially planned.

    What happened? Banks’ balance sheets do remain clogged with toxic assets, which are still difficult to value. But the willingness of banks to sell toxic assets to investment funds has been killed by decisions of accounting authorities and banking regulators.

    Earlier in the crisis, banks’ reluctance to sell toxic assets could have been attributed to inability to get prices reflecting fair value due to the drying up of liquidity. If the PIPP program began operating on a large scale, however, that would no longer been the case.

    Armed with ample government funding, the private managers running funds set under the program would be expected to offer fair value for banks’ assets. Indeed, because the government’s funding would come in the form of non-recourse financing, many have expressed worries that such fund managers would have incentives to pay even more than fair value for banks’ assets. The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

    A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets. For many toxic assets whose fundamental value fell below face value, banks may avoid recognizing the loss as long as they don’t sell the assets.

    Even if banks can avoid recognizing economic losses on many toxic assets, it remained possible that bank regulators will take such losses into account (as they should) in assessing whether banks are adequately capitalized. In another blow to banks’ potential willingness to sell toxic assets, however, bank supervisors conducting stress tests decided to avoid assessing banks’ economic losses on toxic assets that mature after 2010.

    The stress tests focused on whether, by the end of 2010, the accounting losses that a bank will have to recognize will leave it with sufficient capital on its financial statements. The bank supervisors explicitly didn’t take into account the decline in the economic value of toxic loans and securities that mature after 2010 and that the banks won’t have to recognize in financial statements until then.

    Together, the policies adopted by accounting and banking authorities strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. As long as banks don’t sell, the policies enable them to pretend, and operate as if, their toxic assets maturing after 2010 haven’t fallen in value at all.

    By contrast, selling would require recognizing losses and might result in the regulators’ requiring the bank to raise additional capital; such raising of additional capital would provide depositors (and the government as their guarantor) with an extra cushion but would dilute the value of shareholders’ and executives’ equity. Thus, as long as the above policies are in place, we can expect banks having any choice in the matter to hold on to toxic assets that mature after 2010 and avoid selling them at any price, however fair, that falls below face value.

    While the market for banks’ toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells. In such a case, authorities should reconsider the policies that allow banks to pretend that toxic assets haven’t fallen in value. In the meantime, it must be recognized that the curtailing of the PIPP program doesn’t imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet.

     


    Professor Schiller at Yale asserts housing prices are still overvalued and need to come down to reality
    The median value of a U.S. home in 2000 was $119,600. It peaked at $221,900 in 2006. Historically, home prices have risen annually in line with CPI. If they had followed the long-term trend, they would have increased by 17% to $140,000. Instead, they skyrocketed by 86% due to Alan Greenspan’s irrational lowering of interest rates to 1%, the criminal pushing of loans by lowlife mortgage brokers, the greed and hubris of investment bankers and the foolishness and stupidity of home buyers. It is now 2009 and the median value should be $150,000 based on historical precedent. The median value at the end of 2008 was $180,100. Therefore, home prices are still 20% overvalued. Long-term averages are created by periods of overvaluation followed by periods of undervaluation. Prices need to fall 20% and could fall 30%.....
    Watch the video on Yahoo Finance --- Click Here
    See the chart at http://www.businessinsider.com/the-housing-chart-thats-worth-1000-words-2009-2
    Also see Jim Mahar's blog at http://financeprofessorblog.blogspot.com/2009/02/shiller-house-prices-still-way-too-high.html
    Jensen Comment
    In the worldwide move toward fair value accounting that replaces cost allocation accounting, the above analysis by Professor Schiller is sobering. It suggests how much policy and widespread fraud can generate misleading "fair values" in deep markets with many buyers and sellers, although the housing market is a bit more like the used car market than the stock market. Each house and each used car are unique, non-fungible items that are many times more difficult to update with fair value accounting relative to fungible market securities and new car markets.


    Some Thoughts on Fair Value Accounting

    Our recent AECM regarding why accounting standard setters require mark-to-market (fair value) adjustments of marketable securities (except for HTM securities) and do not generally allow mark-to-market adjustments to inventories (except for precious metals and LCM downward adjustments for permanent impairments).

    Fungible --- http://en.wikipedia.org/wiki/Fungible
    I think this "inconsistency" in the accounting standards hinges on the concept of fungible. Marketable securities are generally fungible. A General Motors share of stock NYC is identical to other GM shares in Bavaria versus Hong Kong versus Sugar Hill, New Hampshire. One advantage of fair value accounting for marketable securities is that these securities are fungible until they become unique such as when companies go bankrupt.

    The classic example for fungible inventories that I always used in class is the difference between new cars in a dealer's lot and used cars in that same lot is that new cars are fungible (there are thousands or tens of thousands in the world exactly like that new car) and used cars are not fungible. There is no other car in the world exactly like any of the used cars in a dealer's parking lot. We have Blue Book pricing of used cars of every make and model, but these are only suggested prices before serious negotiations between buyers and a seller of used models with varying mileage, accident histories, flooding histories such as being trapped while being parked in flood waters, new parts installed such as a new engine or new transmission, etc.

    My point here is that it's almost impossible to accurately value a used car until a buyer and seller have negotiated a purchase price. And the variation from Blue Book suggested prices can be quite material in amount. Thus we can value General Motors common shares before we have a buyer, but we can't value any used car before we have a buyer.

    I used to naively claim that this was not the case of new cars because they were fungible like General Motors common shares. But on second thought I was wrong. New cars are not fungible items. Consider the case of a particular BMW selling for $48,963 in Munich. The same car will sell for varying prices in NYC versus Hong Kong versus Sugar Hill, NH. This variation is due largely to delivery cost differentials.

    Now consider the Car A and Car B BMW models that are exactly alike (including color) in a Chicago dealership lot. After three months, a buyer and the dealer agree on a $67.585 price for Car A. Car B sits in the lot for over 11 months before a buyer and the dealer agree on a price of $58,276. This discount is prompted mostly by the fact that the new models are out making Car B seem like its a year old even though it odometer has less than two miles.

    My point here is that until a dealer finds a buyer for either a new car or a used car, we really don't know what the inventory fair value is for those non-fungible items. Similarly the same grade and quality of corn in Minneapolis has a different price than identical corn in Chicago. Corn and other commodities like oil are not really fungible for inventory valuation purposes.

    There are numerous examples of where inventory product values really can't be known until a sales transaction takes place. We can fairly accurately estimate the replacement costs of some of the new items for sale although FAS 33 found that the cost of generally doing so accurately for inventory valuation purposes probably exceeds the value of such replacement cost adjustments at each financial reporting date.

    There's great moral hazards in allowing owners of non-fungible inventories to estimate fair values before sales transactions actually take place. Creative accounting would be increasingly serious if accounting standards allowed fair value accounting for non-fungible items that vary in value depending upon the buyer and the time and place of sales negotiations.

    Thus we can explain to our students that the reason we report marketable securities at fair value and inventories at transaction or production historical costs is that marketable securities are fungibles and most inventories are not fungible. The main reason is that estimating the value of truly fungible marketable securities is feasible before we have a sales transaction whereas the value of so many non-fungible (unique) items is not known until we have a sales transaction at a unique time and place.


    Should known fiction be added to financial statements?
    There’s a huge controversy as to how much fiction we should allow in financial statements under fair value accounting. In my viewpoint, we should not allow fiction that we’re 99.999999% certain it's fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.

    Some argue that HTM fair value adjustments reflect opportunity gains and losses when evaluating management. But these opportunity gains and losses may be so inaccurate that they remain in the realm of total fiction.

    Bob Jensen

     

    "FASB Could Finally Get Loan Accounting Right – Well, Less Wrong," by Tom Selling, Accounting Onion, August 13, 2009  ---
    Click Here
    http://accountingonion.typepad.com/theaccountingonion/2009/08/fasb-could-finally-get-loan-accounting-right-almost.html

     

    Jensen Comment

    Tom selling wrote:
    I can an think of two responses to the argument. The obvious one is that much has changed since 1993, when the FASB voted 5-2 to adopt FAS 115, and acceded to the held-to-maturity camp, to allow issuers to blissfully disregard readily available market values.

     

    Tom and I will forever disagree on that earnings should be allowed to fluctuate for the fiction of price movements in held-to-maturity (HTM) securities and the asymmetry of fair value movements of hedging contracts that hedge unbooked items (such as forecasted transactions). My differences with Tom on these two issues vary with respect to HTM securities versus unbooked hedged items.

    Suppose a firm borrows $100 million by selling 10-year bonds at 5% with the holding that debt to maturity. Letting earnings fluctuate for 40 quarters for fictional gains and losses of value changes on those bonds is more misleading than helpful investors in my viewpoint. It may be especially fiction if there are cost-profit-volume considerations. Just because a few investors in those bonds are willing to sell at current market (thereby making a market) does not mean that all investors are willing to sell at current market rates. There are issues of blockage costs of trying to by all the bonds back versus buying only $1 million of those bonds back. The fair value of all $100 million bonds is very, very difficult to estimate. Level 1 of FAS 157 can be very misleading in this instance.

    But even if we can accurately measure the value of the $100 million in debt, I still do not think it adds value to actually book repeated gains and losses that automatically wash out over the 10 year life of the bonds. This is especially the case in IFRS where severe penalties are incurred for firms that the IASB imposes on companies that renege on their held-to-maturity pledges.

    Debtors could book debt at current call back values, but these call back values often have penalty clauses that make them poor surrogates of current value, especially when penalties are severe.

    I might ask Tom how he would adjust fair market value of HTM securities for the penalty clauses of the IASB for reneging on HTM pledges.

    There are also hedge accounting considerations.

    Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. AFS securities can get hedge accounting relief.

    Tom could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

    There’s a huge controversy as to how much fiction we should allow in financial statements under fair value accounting. In my viewpoint, we should not allow fiction that we’re 99.999999% certain is fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory01.htm#FairValue


    Is convergence of FASB and IFRS possible bankers ask?
    American Banking Association Critical of FASB and IASB Pace and Divergence between the Two
    The American Bankers Association has released a white paper expressing concern about The Current Pace and Direction of Accounting Standard Setting (PDF 266k). The paper notes that while the IASB and the FASB are working on many similar projects, including financial instruments, they are moving toward 'different solutions and at different speeds, which may make international convergence impossible'.
    IAS Plus, August 14, 2009 --- http://www.iasplus.com/index.htm
    Jensen Comment
    The big issue with bankers is fair value accounting, and the allegations of "different solutions" is probably overstated. What is clear is that bankers are going to put up political stumbling blocks to what standard setters want in the way of fair value accounting for financial instruments. The impact has already been seen in the FASB's fine tuning of FAS 157 --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue
    U.S. banks have used the FASB's staff positions to dress up their financial statements filled with toxic assets and boost reported earnings by coloring book accounting of toxic asset losses.

    The FASB and IASB Won't Care For This Case
    The Moral Hazard of Fair Value Accounting

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

    Wells Fargo, BofA Pay to Settle Claims
    by Jennifer Levitz
    The Wall Street Journal

    Jun 09, 2009
    Click here to view the full article on WSJ.com

    http://online.wsj.com/article/SB124447741263994585.html?mod=djem_jiewr_AC

    TOPICS: Advanced Financial Accounting, Auditing, Fair-Value Accounting Rules, Internal Controls, Investments

    SUMMARY: "One of the nation's largest mutual-fund companies allegedly overvalued its holdings of mortgage securities during the housing bust, making its fund appear to be one of the top performers, and then was forced to take big write-downs, leaving some investors in the supposedly conservative offering with losses approaching 25%....Evergreen began repricing the securities after its valuation committee learned on June 10 that the portfolio managers had known since March about problems with a certain mortgage-backed security but had failed to disclose it to the committee", the SEC said.

    CLASSROOM APPLICATION: The implication of properly establishing fair values in a trading portfolio is the major topic covered in this article. Also touched on are the internal control procedures and related audit steps over this valuation process.

    QUESTIONS: 
    1. (Introductory) What was the implication of not properly valuing certain fund investment for the reported performance of the Evergreen Ultra Fund?

    2. (Introductory) What also was the apparent problem with the type of investment made by portfolio managers of this Evergreen fund? In your answer, comment on the purpose of the fund and the risk of mortgage-backed securities in which it invested.

    3. (Introductory) How should an entity such as the Evergreen Ultra Fund account for its investments? Describe the balance and income implications and state what accounting standard requires this treatment.

    4. (Advanced) What evidence should the Evergreen fund's portfolio managers have taken into account in valuing investments? How did the fund managers allegedly avoid using that evidence?

    5. (Advanced) What internal control procedures were apparently in place at Evergreen to ensure that fund assets were properly valued by portfolio managers? What was the apparent breakdown in internal control?

    6. (Advanced) Based on the description in the article of internal control processes at Evergreen, design audit procedures to assess whether the internal control over investment valuations is functioning properly. What evidence might arise to indicate a failure in internal control?

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Wells Fargo, BofA Pay to Settle Claims," by Jennifer Levitz, The Wall Street Journal, June 10, 2009 ---
    http://online.wsj.com/article/SB124447741263994585.html?mod=djem_jiewr_AC

    Wells Fargo & Co. and Bank of America Corp. agreed Monday to settle claims that employees misled investors about the value and safety of certain securities during the financial crisis.

    Wells's Boston-based mutual fund Evergreen Investment Management Co. agreed along with its brokerage unit to pay $40 million to end civil state and federal securities-fraud allegations that it overvalued the holdings of its Evergreen Ultra Short Opportunities Fund and then, when it was going to lower the value of the securities, informed only select investors -- many of them customers of an Evergeen affiliate -- allowing them to cash out of the fund and lessen their losses.

    Separately, Bank of America agreed to "facilitate" the return of more than $3 billion to California clients who purchased auction rate securities, an investment that went sour last year amid a liquidity freeze. The bank reached the agreement with the California Department of Corporations.

    "We are pleased that the outcome of these negotiations will result in the return of money to many investors who suffered by the freezing of their assets when the auctions failed," said California Department of Corporations Deputy Commissioner Alan Weinger. A bank spokeswoman couldn't be reached for comment.

    The Wells case highlights the valuing of securities as a key issue during the financial crisis as banks, hedge funds and now mutual funds have failed to take losses on their holdings even though there was evidence in the market these securities were trading at lower prices.

    In one case Evergreen, which had $164 billion in assets at the end of the first quarter, was holding a security at nearly full value when another fund at the firm purchased a similar security for 10 cents on the dollar.

    Evergreen didn't admit or deny wrongdoing in a settlement with the Securities and Exchange Commission and the Massachusetts Securities Division. "We are committed to acting in the best interest of shareholders, and continue to move forward with our primary goal of safeguarding your investments," Evergreen stated in a letter to clients on its Web site announcing the settlement.

    Evergreen was a unit of Wachovia Corp. at the time of the alleged overvaluations. Lisa Brown Premo and Robert Rowe, then co-managers of the Ultra fund, have left Evergreen, as have two unidentified senior vice presidents, said Evergreen spokeswoman Laura Fay. Wachovia was acquired last year by Wells Fargo.

    The Evergreen case is similar to an SEC fraud case against Van Wagoner Funds in San Francisco. In 2004, Van Wagoner agreed to pay $800,000 to settle civil charges by the SEC that it mispriced some technology-company securities in its stock funds.

    Regulators allege that Evergreen inflated the value of mortgage-related securities in the Ultra fund -- which the company touted as conservative -- by as much as 17% between February 2007 and June 2008, when it closed and liquidated the fund. The overstatement caused the fund to rank as one of the top five or 10 funds among between 40 and 50 similar funds in 2007 and part of 2008. An accurate valuation would have placed the fund at the bottom of its category, regulators said.

    Regulators said that when Evergreen began to reprice certain inflated holdings in the three weeks before the fund was liquidated on June 18, the company only disclosed the adjustments -- and the reason why -- to select customers, many of them customers of Evergreen affiliate Wachovia Securities LLC. Those customers also were told more pricing adjustments were likely.

    At liquidation, the fund had $403 million in assets, down from $739 million at the end of 2007, regulators said.

    David Bergers, director of the SEC in Boston, said that by law mutual funds must treat all shareholders equally, and that "it's particularly troubling in these difficult times that that did not happen." He said the SEC's "investigation is continuing relating to this matter."

    Ms. Fay declined to comment on Mr. Bergers's statement. Of Monday's settlement, she said it is in "Evergreen's and our clients' best interest to resolve the matter and move forward."

    Regulators say that in pricing Ultra fund securities, Evergreen's portfolio managers didn't factor in readily available information about the decline in mortgage-backed securities. By law, mutual funds are supposed to take all available information into account when valuing securities, and "that's especially true when the market is shifting," Mr. Bergers said.

    Massachusetts regulators cite one case in May 2008 in which the Ultra fund priced a subprime mortgage-backed security for $98.93, even though another Evergreen fund purchased the same security for $9.50.

    After learning of the transaction, state regulators allege, the Ultra fund's portfolio management team contacted the broker who had sold the security to determine whether the sale was distressed and thus could be disregarded for purposes of determining the fair value of the security. The dealer responded that the security wasn't coming from a distressed seller. Nonetheless, the Ultra fund team told Evergreen's valuation committee they believed the sale was distressed and failed to lower the price of the security for several days.

    Evergreen began repricing the securities after its valuation committee learned on June 10 that the portfolio managers had known since March about problems with a certain mortgage-backed security but had failed to disclose it to the committee, the SEC said.

     


    The AICPA's Fair Value Accounting Resources --- http://www.journalofaccountancy.com/Web/FairValueResources.htm
     


    Not for Accounting Amateurs
    Tom's Mea Culpa and Some Good (Critical) Reasoning That Follows

    "SAB 112: Let the New Earnings Game Begin," by Tom Selling, The Accounting Onion, June 21, 2009 ---
    http://accountingonion.typepad.com/theaccountingonion/2009/06/sab-112-let-the-new-earnings-game-begin.html

    In a recent post on business combinations accounting that is related to SAB 112, I criticized the FASB for creating yet another loophole in business combinations accounting that make M&A transactions more attractive than they really should be. To recap, I described how JP Morgan wrote down toxic loans acquired from WaMu so that, going forward, JP Morgan had a built-in stream of future earnings at very high interest rates.

    First, a Mea Culpa

    I was feeling pretty satisfied with myself until reader Michael interrupted my reverie with several interesting and valid comments. With great reluctance, I began to re-think parts of my screed.

    First of all, he found a couple of inaccuracies in my telling, which should be corrected:

    "Tom, I think I'm with you on your conclusion (i.e. mark all financial assets to fair value (replacement cost?)) but the area of GAAP causing the inconsistent measurement is not FAS 141(R). FAS 141(R) was first effective for transactions that closed on or after 1/1/09 for calendar year companies. JPMorgan was subject to FAS 141 (no R) for this transaction and disclosed as such. However, you may be aware that even under FAS 141, certain loans were required to be accounted for at fair value, notwithstanding the SAB [Topic 2A-(5)]...those loans that were purchased at a significant discount are subject to the guidance in SOP 03-3, which requires a fair value measurement [at the acquisition date] for such loans. Given the purely awful composition of WaMu's portfolio, it is not surprising that half their loans fell into that guidance. I think most of the focus should be on the criminal allowance put up by WaMu pre-transaction...$2 billion on $240 billion in loans at 3/31/08, $8 billion on $240 at 6/30/08. Yikes." [italics and bolding supplied]


     

    That's a really interesting last sentence, especially coming from an auditor, and I'm betting that even the PCAOB will not want to go near that one. As important as that may be, it's a digression from the mea culpa I now proffer to all who read that post: I overlooked the fact that SOP 03-3 would be applicable, because I mistakenly thought the acquisition of WaMu was accounted for under FAS 141(R).

    Michael's comment and my mea culpa notwithstanding, the fact remains that henceforth, FAS 141(R) has taken over for SOP 03-3 in the earnings management toolbox when it comes to making sure that a business combination transaction will be accretive to future earnings. (Note: that doesn't mean that SOP 03-3 has become obsolete. Loan acquisitions that are not part of a business combination are also within its scope.)

    Michael also responded to my suggestion that the offending provision of FAS 141(R) should be suspended until loans are fair valued.  He pointed out that should that day ever come, the invitation for earnings management of which I spoke doesn't completely go away:

    " … [L]et's assume that all financial instruments were remeasured each period at fair value. While there will be timing differences with loans that are measured at fair value at acquisition, net income over the life of the same loans will be the same...if JPMorgan had to continue to remark the loans, they'd still recognize that accretion into earnings if the loans ultimately perform. I understand your generally well founded skepticism, but I think this is one of the less offensive areas of FAS 141R.

    Michael is right (again). I could live with an outcome whereby unbiased fair value measurements will provide a stream of accounting earnings to an acquiree. But, I am indeed more than a little skeptical that two versions of fair value will emerge from FAS 141(R)—if they haven't already from other games that executives will play with earnings. The WaMu's will still have strong incentives to overstate market value, and even Michael implies that auditors are not likely to stand in their way. The JP Morgans of the world have incentives to understate the same fair values.

    Enter SAB 112

    That's where SAB 112 comes into the discussion. Among other ministerial changes, it deleted Topic 2A-(5) of the SAB codification, which I described in the earlier post and became unnecessary after FAS 141(R) instituted the fair value requirement for acquired loans. The crux of this post is this: if the SEC thought that manipulation of loan loss reserves during a business combination merited an anti-abuse rule, then more than ministerial adaptations were called for.  How can the SEC be so naïve as to think that fair value will fix the problem of loan value manipulation? Instead of merely deleting Topic 2A-(5), they should have re-written it to put the brakes on what will surely become a new recipe for chicken salad. It would have been really simple for the SEC to make the following rule:

    Irrespective of pre- and post-acquisition bases of measurement, the new carrying amount of every asset recognized may be no less at the date of acquisition than the carrying amount recognized by the acquiree; similarly, the fair value of liabilities assumed may be no greater than amounts recognized by acquirees.

    I know that my suggestion may sound unprinicpled and draconian to some (and I would be prepared to allow for some exceptions), but the reality is that no set of business combination accounting rules will be perfectly 'efficient.' For any accounting rule, it is inevitable that some value-creating transactions will be discouraged, and some value-destroying transactions will occur because the accounting result is too sweet to resist. The key for regulators is to strike an appropriate balance based on broadly acceptable objectives for financial reporting.

    In regard to business combinations, there have been no such objectives ever before.  It is clear that the rules have been completely out of whack since the inception of GAAP in the 1930s. As for the last few decades, the evidence is crystal clear that our economy has been administered a nearly lethal dose of value-destroying business combinations to juice executive compensation while killing share prices and wreaking havoc among rank and file employees. That's why I believe it is time to trying something more radical: an acquiror should not be able to create a stream of reported earnings by writedowns to assets or increases to liabilities. Therefore, post acquisition writedowns of assets and write-ups of liabilities would be charged against the post-combination earnings of the acquiror.

    Let's see if the 'new SEC' is up to the task. We'll know they're doing it right if the EU and IASB have conniptions over it.


    The infamous fair value accounting FASB Staff Positions (FSPs) announced on April 2, 2009.
    This relaxation/reinterpretation of fair value definitions and impairment testing arose largely out of political pressures and accusations that fair value accounting rules played a large role in the banking crisis of 2008 and recovery in 2009.

    On April 9, 2009, the Financial Accounting Standards Board ("FASB") issued the three FSPs: --- http://www.fasb.org/news/nr040909.shtml

    FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly ("FSP FAS 157-4") ---
    http://www.fasb.org/pdf/fsp_fas157-4.pdf

    FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments ("FSP FAS 115-2") ---
    http://www.fasb.org/pdf/fsp_fas115-2andfas124-2.pdf

    FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments ("FSP FAS 107-1") ---
    http://www.fasb.org/pdf/fsp_fas107-1andapb28-1.pdf
    /

    In response the PCAOB issued "Staff Audit Practice Alert No. 4," April 21, 2009 ---
    http://www.pcaobus.org/Standards/Staff_Questions_and_Answers/2009/04-21_APA_4.pdf


    The FASB Probably Won't Care for this Teaching Case
    But it provides good input for student debates on fair value accounting
    In fairness, the FASB contends that the what bankers claim is a major change in FAS 157 really is a cosmetic change that wasn't truly needed but is no big deal if it makes bankers happy. If the banks really wanted to bypass Level 1 and 2 fair value estimation, they could've moved to Level 3 all along without the rule change. Whatever the reasons or excuses, banks with toxic loan portfolios can now report higher earnings that have little to do with higher cash flows (unless the cash is rolled in from TARP bailout loans and gifts is reduced because gullible investors are relying on phony bank earnings reports). Sadly, the European Union is now bringing similar pressures to bear on IFRS fair value accounting.

    Personally, I thought the blaming fair value accounting standards by Bill Isaac and his billionaire friends (Warren Buffet and Steve Forbes) for the bank failures was a pile of crap --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValue
    The banks failed because of dysfunctional mortgage lending policies that encouraged fraud, dysfunctional performance compensation schemes that encouraged bankers to cheat shareholders, and too much reliance on David Li's flawed Gaussian copula function --- http://faculty.trinity.edu/rjensen/2008Bailout.htm

    The frauds were exacerbated by unprofessional CPA auditing firms and credit rating agencies that were anything but independent of the clients that paid their fees --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

    Sadly, the bankers want to blame fair value accounting standards for the the collapse of their system. This is like blaming Hans Brinker for having such a small finger in in a Holland dike.

    From The Wall Street Journal Weekly Accounting Review on June 4, 2009

    Congress Helped Banks Defang Key Rule
    by Susan Pulliam and Tom McGinty
    The Wall Street Journal

    Jun 03, 2009
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB124396078596677535.html?mod=djem_jiewr_AC

    TOPICS: Accounting For Investments, Advanced Financial Accounting, Banking, Fair Value Accounting, Fair-Value Accounting Rules, Financial Accounting Standards Board, Financial Reporting

    SUMMARY: This article reports on a WSJ investigation into lobbying of, and contributions to, members of the House Financial Services subcommittee. "Earlier this year...thirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about [changing the FASB's fair value] rule and other issues, according to a Wall Street Journal analysis of public filings. They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of whom pushed for the rule change, the filings indicate." The FASB ultimately responded to pressure by issuing a staff position on April 9, 2009 allowing financial institutions to use greater judgment in determining market values when markets show evidence of illiquidity and signs of being disorderly than was originally included in Statement 157. "The American Bankers Association (ABA)...acknowledges that it exerted pressure to change the rules. The ABA was the biggest donor to the campaign funds of committee members in the weeks before the hearing. It gave a total of $74,500 to 33 members of the committee in the first quarter, according to the Journal analysis of public filings. An ABA spokesman says that is its normal level of support for lawmakers, and that the initiative was part of a broader effort to change accounting rules....We worked that hearing," says ABA President Edward Yingling. "We told people that the hearing should be used to talk about the big problems with 'mark to market,' and you had 20 straight members of Congress, one after another, turn to FASB and say, 'Fix it.'"

    CLASSROOM APPLICATION: This article shows the political nature of the accounting standards setting process. It also shows how the press can obtain information and conduct analyses to keep interested individuals aware of the process. In this case, the interested individuals include investor groups who feel that the accounting changes watered down the fair value reporting standards.

    QUESTIONS: 
    1. (Introductory) In general, what are the requirements established in FASB Statement No. 157, Fair Value Measurements? Hint: you may access this FASB document on their web site at http://www.fasb.org/st/

    2. (Introductory) What changes were implemented with FASB Staff Position (FSP) 157-4? Again, you may access the document at http://www.fasb.org/st/

    3. (Introductory) In general, what is the usual process for establishing authoritative accounting literature?

    4. (Advanced) How did the U.S. political process influence this change in accounting requirements under fair value reporting? What are the concerns with the usual process for establishing accounting standards?

    5. (Advanced) As reported in this article, who is displeased with this change in financial reporting requirements? Are their concerns limited to whether the appropriate accounting requirements have been set?

    6. (Advanced) What do you think about having our elected officials in Congress, influence the process of establishing accounting standards?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Congress Helped Banks Defang Key Rule," Susan Pulliam and Tom McGinty, The Wall Street Journal, June 3, 2009 --- http://online.wsj.com/article/SB124396078596677535.html?mod=djem_jiewr_AC

    Not long after the bottom fell out of the market for mortgage securities last fall, a group of financial firms took aim at an accounting rule that forced them to report billions of dollars of losses on those assets.

    Marshalling a multimillion-dollar lobbying campaign, these firms persuaded key members of Congress to pressure the accounting industry to change the rule in April. The payoff is likely to be fatter bottom lines in the second quarter.

    The accounting issue lies at the heart of the financial crisis: Are the hardest-to-value securities worth no more than what the market is willing to pay, or did the market grow too dysfunctional to properly set values?

    The rule change angered some investor advocates. "This is political interference on a major issue, and it raises questions about whether accounting standards going forward will have the quality and integrity that the market needs," says Patrick Finnegan, director of financial-reporting policy for CFA Institute Centre for Financial Market Integrity, an investor trade group.

    Backers of the change say it was necessary because existing accounting rules never contemplated the kind of market turmoil that unfolded last year.

    The rules had required banks, securities firms and insurers to use market prices to help assign values to mortgage securities and other assets that don't trade on exchanges -- to "mark to market." But when markets went haywire last fall, financial firms complained that the rules forced them to slash the value of many assets based on fire-sale prices. That contributed to big losses that depleted their capital and left several of the nation's largest firms on the brink of failure.

    Earlier this year, financial-services organizations put their lobbyists on the case. Thirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues, according to a Wall Street Journal analysis of public filings. They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of whom pushed for the rule change, the filings indicate.

    Rep. Paul Kanjorski, a Pennsylvania Democrat who heads the House Financial Services subcommittee that pressed for the accounting change, received $18,500 from coalition members in the first quarter, the second-highest total among committee members, according to Federal Election Commission records. Over the past two years, Mr. Kanjorski received $704,000 in contributions from banking and insurance firms, the third-highest total among members of Congress, according to the FEC and the Center for Responsive Politics.

    A spokeswoman says Rep. Kanjorski believes the accounting industry's rule-making body, the Financial Accounting Standards Board, or FASB, made the right move since neither mark-to-market critics nor advocates are "entirely pleased with the outcome." She says campaign contributions didn't factor into the congressman's thinking.

    Congressional Attention During a March 12 hearing before the House subcommittee, FASB came under intense pressure from committee members. "If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself," Rep. Kanjorski said in his opening remarks.

    "We want you to act," Rep. Kanjorski told Robert Herz, FASB's chief. Mr. Herz waffled about how quickly the standards board could act. Rep. Kanjorski leaned over the dais. "You do understand the message that we're sending?" he said.

    "Yes," Mr. Herz replied. "I absolutely do, sir."

    FASB made speedy revisions to its rules. In an interview, Mr. Herz said FASB merely accelerated the matter on its agenda, and tried to be responsive to input from investors and financial-services firms.

    The change helped turn around investor sentiment on banks. Financial firms had the option of reflecting the accounting change in their first-quarter results; they will be required to do so in the second quarter. Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings. The Federal Home Loan Bank of Boston said the shift boosted its first-quarter earnings by $349 million.

    Robert Willens, a tax and accounting analyst, estimates that the changes will increase bank earnings in the second quarter by an average of 7%.

    Building Pressure The American Bankers Association, a trade group, acknowledges that it exerted pressure to change the rules. The ABA was the biggest donor to the campaign funds of committee members in the weeks before the hearing. It gave a total of $74,500 to 33 members of the committee in the first quarter, according to the Journal analysis of public filings. An ABA spokesman says that is its normal level of support for lawmakers, and that the initiative was part of a broader effort to change accounting rules.

    "We worked that hearing," says ABA President Edward Yingling. "We told people that the hearing should be used to talk about the big problems with 'mark to market,' and you had 20 straight members of Congress, one after another, turn to FASB and say, 'Fix it.'"

    The banking industry's victory stands in contrast to at least one defeat it has been dealt in recent weeks, on new credit-card legislation.

    Changing Environment Mark-to-market accounting has been around for decades. Many banks were content with the rules when the markets were going up. But the rules became a big problem in late 2007. As markets turned down, FASB clarified the rules and established how certain financial instruments, including mortgage securities, should be valued.

    Continued in article

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them. “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said
    "Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New York Times, April 20, 2009 --- http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

    This is starting to feel like amateur hour for aspiring magicians.

    Another day, another attempt by a Wall Street bank to pull a bunny out of the hat, showing off an earnings report that it hopes will elicit oohs and aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of America all tried to wow their audiences with what appeared to be — presto! — better-than-expected numbers.

    But in each case, investors spotted the attempts at sleight of hand, and didn’t buy it for a second.

    With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

    Bank of America sold its shares in China Construction Bank to book a big one-time profit, but Ken Lewis heralded the results as “a testament to the value and breadth of the franchise.”

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

    Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

    Continued in article

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    Bob Jensen's recent slide show on on fair value accounting --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
    Click on the 10FairValueFSU.ppt file


    In my opinion, Bill Isaac is an ignorant advocate of horrible and dangerous bank accounting
    First of all he blamed the subprime collapse of thousands of banks on the FASB requirements for fair value accounting (totally dumb) --- http://faculty.trinity.edu/rjensen/2008bailout.htm#FairValue

    Now he wants the FASB to continued to grossly under estimate loan loss reserves (now that the FASB is finally trying to fix the problem)
    “AccountingWEB Exclusive: Former FDIC Chief says FASB proposal is 'irresponsible'," AccountingWeb, June 3, 2010 ---
    http://www.accountingweb.com/topic/accounting-auditing/aw-exclusive-former-fdic-chief-says-fasb-proposal-irresponsible

    Banks are notorious for underestimating loan loss reserves and auditors are notorious for letting them get away with it ---
    http://faculty.trinity.edu/rjensen/2008bailout.htm#AuditFirms

    On May 26, 2010 the FASB issued an exposure draft that would make it more difficult to enormously underestimate load losses. International standards are expected to be changed accordingly.

    On May 26, 2010, the FASB issued a proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, setting out its proposed comprehensive approach to financial instrument classification and measurement, and impairment, and revisions to hedge accounting. Also, extensive new presentation and disclosure requirements are proposed.

    Here’s a “brief” from PwC on the new May 26 ED from the FASB --- Click Here
    http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=THUG-85UVWW&SecNavCode=MSRA-84YH44&ContentType=Content

    PwC points out some of the major differences between these proposed FASB revisions versus the IASB provisions.

    Click Here to download the ED  http://snipurl.com/fasb5-26-2010  


    Question
    What are the implications of the April 2, 2009 Fair Value Accounting FSPs for international accounting standards?

    April 22. 2009 message from Deloitte to the IASB --- http://www.iasplus.com/index.htm

    ·  Deloitte's IFRS Global Office has submitted to the IASB a Letter of Comment on IASB's Request for Views on Proposed FASB Amendments on Fair Value Measurement and Impairment Requirements. On 19 March 2009, the IASB requested views on what were, then, two proposed FASB Staff Positions. The FASB has since adopted the two proposals as final FSPs, along with a third related FSP dealing with disclosures, as follows:

    • FSP FAS 157-4, which provides guidance on determining fair value when market activity has decreased
    • FSP FAS 115-2 and FAS 124-2, which addresses other-than-temporary impairments for debt securities
    • FSP FAS 107-1 and APB 28-1, which discusses fair value disclosures for financial instruments in interim periods

    The Deloitte letter to the IASB provides our detailed views on each of the final FASB Staff Positions and contrasts them with IFRSs. Here are two excerpts from our letter:

    • Regarding FAS 157-4, the Deloitte letter to the IASB states:
      We believe that the FASB Staff Position FAS 157-4 is broadly consistent with the principles of fair value in IFRSs and the Expert Advisory Panel document and therefore an amendment to IFRSs is not necessary. However, in light of the IASB's imminent release of an exposure draft on Fair Value Measurements, the IASB should consider whether the words used in the FASB Staff Position FAS 157-4 are consistent with the exposure draft and whether the wording of the exposure draft should be aligned with the FASB Staff Position FAS 157-4. In addition, the IASB should seek the views of the Expert Advisory Panel to establish whether differences in the words of the FASB Staff Position FAS 157-4 and the Expert Advisory Panel report are expected to have any practical effect.
       
    • Regarding FAS 115-2 and 124-2, the Deloitte letter to the IASB states:
      As noted in the request for views, the differences between U.S. GAAP and IFRSs with respect to scope, impairment triggers, impairment measurements, and recoveries are numerous and complex. A short term project to fully converge with FASB's amendment would entail substantial changes to IFRSs that would require significant efforts and would create unnecessary complexities (e.g., recognizing impairments of held-to-maturity securities that are not due to credit in other comprehensive income). Instead, we would encourage both Boards to expedite their work on a joint standard that would improve reporting for all financial instruments including impairment issues (e.g., loss recognition triggers, measurement of losses, recognition of recoveries, etc.).

     

    Bob Jensen’s PowerPoint slides (to date) --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/10FairValueFSU.ppt


    Question
    Why did Morgan Stanley lower first quarter earnings because the credit spreads on some of its long-term debt had narrowed?

    Paragraph 15 of FAS 157

    Application to liabilities
    15. A fair value measurement assumes that the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled) and that the nonperformance risk relating to that liability is the same before and after its transfer. Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred.
    Therefore, the fair value of the liability shall reflect the nonperformance risk relating to that liability. Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk. The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. That effect may differ depending on the liability, for example, whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability), and the terms of credit enhancements related to the liability, if any.

    Credit Spread of a Bond --- http://en.wikipedia.org/wiki/Credit_spread_(bond)

    In finance, a credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk. The credit spread of a particular security is often quoted in relation to the yield on a credit risk-free benchmark security or reference rate.

    There are several measures of credit spread, including Z-spread and option-adjusted spread.

    Jensen Note
    Under the April 9, 2009 FSPs issued by the FASB, unrealized mark-to-market gains and losses attributable to changes in credit risk are posted to current earnings whereas non-credit fair value adjustments are posted to AOCI. ---
    (slide show) --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/10FairValueFSU.ppt
     

    Reduced credit spread on a bond investment ceteris paribus increases market value of a bond and, thereby, results higher unrealized earnings due to mark-to-market upward adjustment of an asset. Reduced credit spread on a liability has the opposite impact on earnings for the unrealized loss due to a mark-to-market adjustment that increases the fair value of the liability. This is a bit confusing, since by reducing credit risk on their debt, debtors take an earnings hit when adjusting the debt to fair value.

    "Mark-to-market Madness," by David M. Katz, CFO.com, April 24, 2009 --- http://www.cfo.com/blogs/?f=header

    As if they needed any, the critics of fair value got a fresh new example of the craziness of an oft-decried provision in FAS 157, paragraph 15 of Fair Value Measurements. The provision rewards companies whose credit spreads on their debt liabilities have widened and punishes those who have become more creditworthy.

    On Wednesday, Morgan Stanley reported that it had to cut its first-quarter net revenues $1.5 billion because the credit spreads on some of its long-term debt had narrowed. What happened was that as the investment bank grew more reliable to its creditors over the first part of the year, its debt became more valuable. And under the dictates of mark-to-mark accounting, the firm had to take a writeoff because of this very positive occurrence.

    Sound nuts? It has sounded so to many observers. In the 15th paragraph of 157 FASB says, nevertheless, that "the fair value of [a company's] liability shall reflect the nonperformance risk relating to that liability." Thus, as the nonperformance risk--as reflected by slimmer credit spreads—narrowed, Morgan Stanley had to reflect the decreased value of its debt as a decrease in sales on its income statement.

    Like the alleged evils of mark-to-market accounting in illiquid markets—although to a lesser extent—the irrational practice of forcing improved creditworthiness to be reflected in revenue decreases has become fodder for fair value’s enemies. When FASB made its recent amendments to 157, it neglected to attack the provision. If only to preserve fair-value accounting from more political attacks, it should do so now.


    Hi David,

    I think it’s more apt to be a gain resulting from buying up one’s own debt under traditional accounting. However, if buying up debt causes an improved credit rating, your fair value accountant may have a stroke.

    There’s a fair value accounting problem that arises from raising a credit rating. Becoming more credit worthy can force a hit to the bottom line. Conversely, getting a lower credit rating can boost the bottom line in fair value accounting. This causes fair value accounting advocates to get red in the face and hyperventilate.

    "The Fair-Value Deadbeat Debate Returns: On hiatus while other fair-value questions were debated, the hotly-contested issue of why companies can book a gain when their credit rating sinks has returned to center stage," by  Marie Leone, CFO.com, June 29, 2009 --- http://www.cfo.com/article.cfm/13932186/c_2984368/?f=archives

    A new discussion paper released last week by the staff of the International Accounting Standards Board has revived an old, but still fiery fair-value controversy.

    At issue: the role of credit risk in measuring the fair value of a liability. According to the paper's opening statement: the topic has "arguably ... generated more comment and controversy than any other aspect of fair value measurement."

    At the heated core of the dispute is the question of why accounting rules allow companies to book a gain when their credit rating actually sinks. The accounting convention, which opponents contend is counterintuitive if not ridiculous, has prompted "a visceral response to an intellectual issue," says Wayne Upton, the IASB project principal who authored the discussion paper.

    For all the hubbub around it, the rule is rather simple: When a company chooses to use the fair value method of accounting, it must mark its liabilities as well as its assets to market. As a company's credit rating goes down, so does the price of its debt, which therefore must be re-measured by marking the liability to market. The difference between the debt's carrying value and its so-called fair value is then recorded as a debit to liabilities, and a credit to income.

    Consider an oversimplified example to clarify the accounting treatment. A company records a $100 liability for a bond it has issued. Overnight, the company's credit rating drops from A to BB. That drop causes the price of the bond trading in the market to decrease from $100 to $90. The $10 difference, under current accounting rules, is recorded as a $10 debit to liabilities on the balance sheet and a $10 credit to income on the income statement.

    As the company's credit rating and the price of the bond rise — to, say, $100 again — the accounting is reversed. Income takes a $10 hit, while the liability account is credited.

    That accounting oddity has been a lingering problem since 2000, when the Financial Accounting Standards Board introduced Concept Statement 7, which includes a general theory on credit standing and measuring liabilities. The notion was hotly debated again in 2005, when IASB revised IAS 39, its measurement rule for financial instruments and in 2006 when FASB issued FAS 157, its fair-value measurement standard.

    Addison Everett, the practice leader for global capital markets at PricewaterhouseCoopers, notes that the debate cooled down over the last 18 months as the liquidity crisis bubbled up. The crisis spotlighted more politically charged fair-value topics such as asset valuation in illiquid markets, classification of financial assets, asset impairment, and financial disclosures, he says.

    But the credit risk quandary is back, demanding the attention of investors, regulators, and lawmakers who were carefully watching ailing financial institutions as they posted their first-quarter earnings results. As financial results were disclosed this year, it became clear that IAS 39 and FAS 157 were being used to boost income as banks and insurance companies became less creditworthy. For example, in the first quarter, Citigroup benefited from its credit rating downgrade by posting a $30 million gain on its own bond debt.

    A Credit Suisse report looking back to last year, flagged a similar trend. The bank examined the first-quarter 2008 10-Qs of the 380 members of the S&P 500 with either November or December year-end closes, the first big companies to adopt FAS 157. For the 25 companies with the biggest liabilities on their balance sheets measured at fair value, widening credit spreads-an indication of a lack of creditworthiness-spawned first-quarter earnings gains ranging from $11 million to $3.6 billion.

    Those keen on keeping the rules intact and allowing companies to book a gain when credit ratings worsen give several reasons for their stance. Most are laid out neatly in the IASB discussion paper. Consistency is one argument. "Accountants accept that the initial measurement of a liability incurred in an exchange for cash includes the effect of the borrower's credit risk," according to the paper. There's "no reason why subsequent current measurements should exclude changes."

    There's a practical problem with that argument, however. Not all liabilities are financial in nature. Non-financial liabilities, such as those tied to plant closings (asset removal), product warranties, pensions, insurance claims, and obligations linked to sales contracts, are not as easily marked to market as a clear-cut borrowing. Often non-financial liabilities represent a transaction with an individual counterparty that has already placed a price on the chance of not being repaid. For many of those liabilities, "accounting standards differ in their treatment of credit risk," notes the paper.

    One cure is to use a risk-free discount rate for all liabilities in order to apply a consistent measurement approach. But applying a blanket discount rate to the initial measure of debt leaves accountants with the problem of what to do with the debit. That is, for financial liabilities, should the debit be treated as a borrowing penalty and therefore as a charge against earnings? Or should the debit be subtracted from shareholder's equity and amortized into earnings over the life of the debt? For non-financial debt, should the debit be the recognized warranty or plant-closing expense?

    Continued in article

    Question
    Why did Morgan Stanley lower first quarter earnings because the credit spreads on some of its long-term debt had narrowed?

    Paragraph 15 of FAS 157

    Application to liabilities
    15. A fair value measurement assumes that the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled) and that the nonperformance risk relating to that liability is the same before and after its transfer. Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred.
    Therefore, the fair value of the liability shall reflect the nonperformance risk relating to that liability. Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk. The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. That effect may differ depending on the liability, for example, whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability), and the terms of credit enhancements related to the liability, if any.

    Credit Spread of a Bond --- http://en.wikipedia.org/wiki/Credit_spread_(bond)

    In finance, a credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk. The credit spread of a particular security is often quoted in relation to the yield on a credit risk-free benchmark security or reference rate.

    There are several measures of credit spread, including Z-spread and option-adjusted spread.

    Jensen Note
    Under the April 9, 2009 FSPs issued by the FASB, unrealized mark-to-market gains and losses attributable to changes in credit risk are posted to current earnings whereas non-credit fair value adjustments are posted to AOCI. ---
    (slide show) --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/10FairValueFSU.ppt
     

    Reduced credit spread on a bond investment ceteris paribus increases market value of a bond and, thereby, results higher unrealized earnings due to mark-to-market upward adjustment of an asset. Reduced credit spread on a liability has the opposite impact on earnings for the unrealized loss due to a mark-to-market adjustment that increases the fair value of the liability. This is a bit confusing, since by reducing credit risk on their debt, debtors take an earnings hit when adjusting the debt to fair value.

    "Mark-to-market Madness," by David M. Katz, CFO.com, April 24, 2009 --- http://www.cfo.com/blogs/?f=header

    As if they needed any, the critics of fair value got a fresh new example of the craziness of an oft-decried provision in FAS 157, paragraph 15 of Fair Value Measurements. The provision rewards companies whose credit spreads on their debt liabilities have widened and punishes those who have become more creditworthy.

    On Wednesday, Morgan Stanley reported that it had to cut its first-quarter net revenues $1.5 billion because the credit spreads on some of its long-term debt had narrowed. What happened was that as the investment bank grew more reliable to its creditors over the first part of the year, its debt became more valuable. And under the dictates of mark-to-mark accounting, the firm had to take a writeoff because of this very positive occurrence.

    Sound nuts? It has sounded so to many observers. In the 15th paragraph of 157 FASB says, nevertheless, that "the fair value of [a company's] liability shall reflect the nonperformance risk relating to that liability." Thus, as the nonperformance risk--as reflected by slimmer credit spreads—narrowed, Morgan Stanley had to reflect the decreased value of its debt as a decrease in sales on its income statement.

    Like the alleged evils of mark-to-market accounting in illiquid markets—although to a lesser extent—the irrational practice of forcing improved creditworthiness to be reflected in revenue decreases has become fodder for fair value’s enemies. When FASB made its recent amendments to 157, it neglected to attack the provision. If only to preserve fair-value accounting from more political attacks, it should do so now.

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    June 26, 2009 reply from walkerrb@ACTRIX.CO.NZ

    This issue arose at the time of FASB's (brilliant) special report on using cash flow information in 1996. Between the time of the issue of the special report and the conceptual statement emanating from it, the position had changed. In the report, from memory, the position was the actuarially pure one in which both sides of the balance sheet were discounted at the same, risk free rate.

    When the CS was issued in draft it had changed to the, arguably, actuarially invalid position that the balance sheet was discounted at different rates - assets would be at the risk free rate and liabilities at a rate reflecting the credit risk of the accounting entity.

    At the time I found this to be bizarre. I have slowly changed my mind over the last decade. The apparent maintenance of actuarial purity across the balance sheet is actually an illusion. To apply the risk free rate to assets necessitates a significant degree of mathematical calculation prior to its application (see IAS 36 para 30). No such computation is necessary for liabilities.

    Ultimately, it is best to look at the practical effects of which two are illustrative.

    Firstly, the value of a liability should be the same as the value of the asset in the counter-party's records, being the creditor. The creditor would apply a process which would compute the credit risk premium from a probability analysis, being the spread, and then apply the risk free rate. All that is happening in debtor's accounting records is the mirror of this process. Intuitively this must be correct.

    Second, I do recall many years ago being sent a case by a man named William (?) Hackney, a lawyer from Pittsburgh I think who wrote academic articles about the determination of corporate solvency and GAAP. (I have lost touch with him, does anybody know him?). The case involved TWA and its solvency. One side argued that the correct value of its liabilities for solvency purposes was its market value. Its debt traded at 50 cents in the dollar so its liabilities were 50% of its face value.

    Dr Liability Cr Equity

    with 50% of the value.

    The other contestant in the matter claimed the liability should be face value.

    I have lost my copy of the case but I think the discounter won. This makes a kind of perverse sense. One of the essential characteristics of a liability is that it results in an outflow of funds. A company with an asset costing $100 fully funded by a liability where that asset fetches only $25 will only cause an outflow of funds to $25. That must be the value of the liability therefore.

    Where this becomes perverse is that a company is never insolvent because as it falls into the abyss its liabilities erode in the same proportion to the erosion of its assets. In insolvency law this becomes extremely problematic as insolvency is the determinant of civil or criminal sanction or penalty.

     


    Questions
    Did the FASB's amended fair value guidelines give the players (banks), umpires (regulators), and fans (notably shareholders like Steve Forbes and Warren Buffett seeking a new stock market bubble) the overvalued wine they were seeking? Will the new guidelines mostly increase client pressures on auditors to sign off on fantasy financial statements?


    Although the new FASB Guidelines for estimating fair value under FAS 157 and FAS 115 in "broken markets" expands client/auditor discretion for some types of assets having long-term value such as real estate, it's asking a lot to have auditors agree once again to rosy valuation of sorry-looking toxic investments such as the value of a mortgage that's about to wither on the vine. You can't squeeze sweet grape juice from shriveled homeowners, let alone fine wine. It may, however, be that higher value on foreclosed properties in bank inventories will lead to some partying over banks' financial statements.

    The wonderful December 30, 2008 research report of the SEC shows that fair value accounting is neither the cause nor the cure for the banking crisis. The liquidity problem of the holders of the toxic investments is caused by trillions of dollars invested in underperforming (often zero performing) of bad investments mortgages or mortgaged-backed bonds that have to be written down unless auditors agree to simply lie about values. That is not likely to happen, but client pressures on auditors to value on the high side for many properties will be heavy handed.
    The wonderful full SEC report that bankers and regulators do not want to read can be freely downloaded at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

    The FASB probably did its best to maintain integrity in the face of massive political pressures. I hope the IASB is able to resist the same pressures in the international arena. To me the new FASB Guidelines are mostly old wine in new bottles since FAS 157 previously gave considerable discretion in valuing items in broken markets.

    "Expedited fair value guidance may ease pressure on banks," AccountingWeb, March 17, 2009 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=107232

    Following a hearing at a House Financial Services subcommittee last week, the Financial Accounting Standards Board (FASB) agreed to expedite release of their proposed guidance for the application of FAS 157 "Fair Value Measurement." The proposed guidance was published for public comment on March 17th and will be voted on by the Board on April 2. If approved, the FASB recommends that the guidance be effective for interim and annual periods ending after March 15, 2009. According to CFO.com, FASB chairman, Robert H. Herz, chairman of the Financial Accounting Standards Board (FASB), told legislators, "We can have the guidance in three weeks, but whether that will fix everything is another [issue]."

    SB's proposal give more detailed guidance for valuing assets that would be classified as Level 3 under FAS 157, where values are assigned in the absence of an active market or where a sale has occurred in distressed circumstances when prices are temporarily weighed down. The new guidance allows companies to use their own models and estimates and exercise "significant judgment" to determine whether a market exists or whether the input is from a distressed sale. Under FAS 157, financial instruments' fair values cannot be based on distressed sales.

    FASB had planned to issue the proposed guidance by the end of the second quarter. A study on mark-to-market accounting standards conducted by the Securities and Exchange Commission (SEC), which was mandated by the Emergency Economic Stabilization Act of 2008, concluded that more application guidance to determine fair values was needed in current market conditions. On February 18, Herz announced that FASB agreed with the SEC study and would develop additional guidance.

    Thomas Linsmeier, FASB board member, said that they hoped that the new guidance could lead to more accurate and possibly higher values, CFO.com reports. "What we are voting on will hopefully elevate fair values to a more reasonable price so investors are more comfortable investing in the banking system," he said.

    Edward Yingling, president of the American Bankers Association, said in a statement he welcomed the proposal but expressed caution about the ways it might be used by auditors, MarketWatch says. "While we welcome today's news, it will be important to look at the details of the written proposal to see how fully it improves the guidance. It will also be imperative to examine the practical effect the proposal will have based on the various ways it is interpreted."

    The FASB proposal recommends that companies take two steps to determine whether there an active market exists and whether a recent sale is distressed before applying their own models and judgment:

    Step 1: Determine whether there are factors present that indicate that the market for the asset is not active at the measurement date. Factors include:

    If after evaluating all the factors the sum of the evidence indicates that the market is not active, the reporting entity shall apply step 2.

    Step 2: Evaluate the quoted price (that is, a recent transaction or broker price quotation) to determine whether the quoted price is not associated with a distressed transaction. The reporting entity shall presume that the quoted price is associated with a distressed transaction unless the reporting entity has evidence that indicates that both of the following factors are present for a given quoted price:

    The proposed guidance also provides examples of measurement approaches in the event that the observable input is from a distressed sale.

    At Monday's meeting, Herz deflated any beliefs that FASB's new guidance will be a panacea for the many ills of the U.S. economy. "There's not much accounting can do other than help people get the facts and use their best judgment," he said.

    The International Accounting Standards Board, which sets accounting rules followed by more than 100 countries, plans to publish a draft rule to replace and simplify fair-value accounting rules. Critics say the rules have exacerbated the credit crunch by forcing write-downs. "We plan to replace it, the whole thing. We want to stop patching up the standard and we want to write a new one. We are aware that the current model is too complex. We need to simplify.... We will move to exposure draft hopefully within the next six months," said Philippe Danjou, a member of the IASB board.

    FASB's FSP Decisions: Bigger than Basketball?" Seeking Alpha, April 2, 2009 ---
    http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

    Finally, the FASB held its long-anticipated meeting on the two FSPs that would have gutted fair value reporting as it exists. There's been more hoopla (and hope-la) about these two amendments than in all of March Madness.

    Briefly, here's what transpired, as best as I could tell from the webcast of the meeting:

    1. FSP 157-e, the proposal which would have provided a direct route to Level 3 modeling of fair values whenever there was a problem with quoted prices, will be quite different from the original plan. There will be indicators of inactive markets in the final FSP, but they'll only be indicators for a preparer to consider - and more importantly, their presence WILL NOT create a presumption of a distressed price for securities in question. That part of the proposal would have greased the skids for Level 3 modeling. Not now.

    There will be added required disclosures, which were not in the exposure draft. One that I caught: quarterly "aging" disclosures of the securities that are in a continuous loss position for more than 12 months and less than 12 months. As discussed in last week's report on the proposals, these now-annual disclosures are useful for assessing riskiness of assets that could become a firm's next other-than-temporary impairment charge.

    Bottom line: investors didn't lose here.

    2. FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens the blow of recognizing other-than-temporary impairments, was essentially unchanged from the original proposal. It remains a chancre on the body of accounting literature. The credit portion of an other-than-impairment loss will be recognized in earnings, with all other attributed loss being recorded in "other comprehensive income," to be amortized into earnings over the life of the associated security. That's assuming the other-than-temporary impairment is recognized at all, because the determination will still be largely driven by the intent of the reporting entity and whether it's more likely than not that it will have to sell the security before recovery. This is a huge mulligan for banks with junky securities.

    If OTT charges are taken, the full amount of the impairment will be disclosed on the income statement with the amount being shunted into other comprehensive income shown as a reduction of the loss, leaving only the credit portion to be recognized in current period earnings.

    Bottom line: Investors lost on this vote, and they will have to pay more attention to OCI in the future, as it becomes a more frequently-used receptacle for unwanted debits. When investors note these "detoured charges" in earnings, they should skip the detour and factor the full charge into their evaluation of earnings. A small victory for investors: the original proposal would have included other-than-temporary impairments on equity securities. The final decision will affect only debt securities.

    There was a third, much less-heralded FSP voted upon at the meeting:

    3. FSP FAS 107-a and APB 28-a, which will make the now-annual fair value disclosures for all financial instruments required on a quarterly basis. This will be required beginning in the second quarter, with early implementation allowed in the first quarter.

    All three FSPs will become effective in the second quarter, with early implementation allowed in the first quarter. Note: any firm electing early adoption of the impairment FSP cannot wait until later to adopt the FSP 157-e fair value amendment. If they change the way they recognize impairments, they also have to change how they consider the calculation of fair values.

    Some board members expressed hope that this was the last of the "emergency amendments" to take place at the end of a reporting period. It seems too much to hope for; there could more ahead, depending on how meddlesome the G-20 would like to be. Remember when IFRS in the United States was a hot topic? To a very large degree, that sprouted from a trans-Atlantic summit meeting between the EU and the White House. The same thing could happen again if the G-20 gang decides they know accounting better than the standard-setters.

    "FASB Approves New Mark-to-Market Guidance," by Matthew G. Lamoreaux, Journal of Accountancy, April 2, 2009 ---
    http://www.journalofaccountancy.com/Web/20091601.htm 

    Exactly three weeks after FASB Chairman Robert Herz’s March 12 testimony before a rancorous House Financial Services subcommittee, the independent standard-setting board voted Thursday to release three new pieces of guidance to address concerns over the application of fair value accounting standards in current market conditions.

    All three new pronouncements will be published in the form of FASB Staff Positions (FSPs). FASB Technical Director Russell Golden said in a press conference following the meeting that the final FSPs would not be available until next week.

    FASB Staff Position no. FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed, establishes a process to determine whether a market is not active and a transaction is not distressed. The FSP says companies should look at several factors and use judgment to ascertain if a formerly active market has become inactive. Once a market is determined to be inactive, more work will be required. The company must see if observed prices or broker quotes obtained represent “distressed transactions.” Other techniques such as a discounted cash flow analysis might also be appropriate in that circumstance, as long as it meets the objective of estimating the orderly selling price of the asset in the current market.

    The AICPA’s Accounting Standards Executive Committee (AcSEC) submitted a comment letter to FASB recommending against adoption of FSP FAS 157-e based on concerns that it could be interpreted in a way that would contradict the exit price model of FASB Statement no. 157, Fair Value Measurements.

    But following the meeting, AcSEC Chairman Jay Hanson said he was pleased that FASB clarified during its deliberations on Thursday that the FSP is not intended to change the measurement objective of Statement no. 157.

    The second FASB document—FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments—deals with other-than-temporary impairment (OTTI). This FSP was passed by a 3-2 vote. Under the new rules, once an OTTI is determined for a debt security, the portion of an asset write down attributed to credit losses may flow through earnings and the remaining portion may flow through other comprehensive income, depending on the situation and facts involved. There will be several new required disclosures about how the charges are split.

    Initial reaction from financial institutions regarding the new OTTI rules was positive. “I am pleased to see the changes being made and believe they will provide more accurate financial information,” said Security Financial Bank CFO Mark C. Oldenberg, CPA. “I expect there will be substantial discussion on how to determine ‘credit losses’ versus ‘market losses’ and whether to allow recovery of OTTI losses.”

    But at least some investors did not appear to be quite so enthusiastic. “The new guidance seems to be a result of government pressure,” said Jason S. Inman, CPA, of McDonnell Investment Management LLC. “The fair value concept before the change allowed for greater transparency in the market and for an investor to make a decision as to whether or not the company had the ability to hold those assets until recovery.”

    “Investors lost on this vote,” wrote former FASB Emerging Issues Task Force member Jack Ciesielski, CPA, on the AAO Weblog regarding the new OTTI rules. “And they will have to pay more attention to other comprehensive income in the future, as it becomes a more frequently-used receptacle for unwanted debits. When investors note these ‘detoured charges’ in earnings, they should skip the detour and factor the full charge into their evaluation of earnings.”

    The third piece of guidance—FSP FAS 107-B and APB 28-A, Interim Disclosures About Fair Value of Financial Instruments—will increase the frequency from annually to quarterly of disclosures providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value.

    All three FSPs will be effective for periods ending after June 15, 2009. Early adoption is permitted for periods ending after March 15, 2009. However, if a company wants to adopt the FSP FAS 115-a, FAS 124-a, and EITF 99-20-b in the first quarter, it must also adopt the FSP FAS 157-e at the same time.

    April 3 message from Bob Jensen

    Hi David,

    I think I can correctly surmise what IASB Board members who eventually dissent on easing fair value accounting rules, and I think it will be for the same reasons why two of five FASB Board members voted against the FASB fair value changes announced at http://www.fasb.org/action/sbd040209.shtml

    Yes Robert Herz
    Yes Leslie Seidman
    Yes Lawrence Smith
     No Thomas Linsmeier
     No Marc Siegel

    Reasons for the No votes have not been announced, but they probably will be published soon by the FASB.

    The same 3-2 voting outcome happened on FSP EITF 99-20-1

    "FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head," by Tom Selling, The Accounting Onion, January 14, 2009 --- http://accountingonion.typepad.com/theaccountingonion/2009/01/fsp-eitf-99-20.html

    Is there a pattern here in FASB voting on Fair Value Accounting? Maybe not if we accept the rationale give to us by Denny Beresford. My own opinion is that this is not really a fundamental change in FAS 157 since Level 3 always allowed valuation based on models. What has changed is that clients and auditors will no longer be so hesitant to move down to Level 3 after this official re-affirmation of Level 3 taken by the FASB on April 2 ---
    http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

    There are three United States IASB Board Members Mary Barth, John Smith, and Jim Leisenring. My guess is that two of the  three (maybe all three) will strongly dissent if the IASB follows the April 2 lead on easing fair value accounting rules set by the FASB on April 2.

    Mary Barth and John Smith strongly dissented when the IASB voted to allow entities a free choice between the partial and full fair value alternatives to goodwill and NCI measurement. Jim Leisingring went along with the majority of the IASB on that issue, but I think he has stronger feelings about easing fair value accounting rules. I don’t anticipate strong objections from the majority of the IASB voting members.

    If I’m correct the dissent is a straw man if you buy into the Level 3 of the original FAS 157. However, it is a real tiger now that banks will once again be underestimating bad debt reserves and overstating income with less worry about investor class action lawsuits. This so-called change in accounting rules certainly is consistent with “principled-based” accounting standards and will lead to inconsistencies on how virtually identical financial instruments are accounted for in practice.

    Bob Jensen


    April 2, 2009—
     Audio of Today's Press Conference with Robert Herz, Teresa Polley, and Russell Golden on Fair Value and OTTI Actions
    (Posted: 04/02/09)

    April 3, 2009 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU

    One of the IASB board members is on my campus today and he fully expects the IASB to follow the FASB's lead, which he strongly disagrees with. For the record, I think the FASB's action was much needed clarification of the intent of SFAS 157 and I applaud its efforts. This was not at all a situation of "bowing to pressure" but rather one of realizing that earlier guidance hadn't been applied in the intended manner. The FASB clearly accelerated its work in response to Congressional concerns but moving too slowly has been a fault of the FASB from the beginning, including the 10 1/2 years I was there.

    Bob Jensen

    "Herz Should Resign," by: J. Edward Ketz, SmartPros, April 2009 --- http://accounting.smartpros.com/x66142.xml

    April 2, 2009 is a day of accounting infamy. It is a day in which the Financial Accounting Standards Board (FASB) bowed to the pressures of the banking community and Congress to allow distortions, massagings, and manipulations of the U.S. financial reports. Because of these cowardly acts, I think it time for Robert Herz to resign from the FASB.

    Robert Herz is the chairman of the FASB, appointed on July 1, 2002 and reappointed on July 1, 2007. Before this he was a senior partner with PricewaterhouseCoopers. I have read many of his papers and I have heard some of his speeches. I have found Mr. Herz quite intelligent, filled with much knowledge about accounting and finance, well-mannered, articulate, and an avid defender of the accounting profession.

    Unfortunately, I also find Herz lacking in courage and moral fortitude. Whenever some bully comes on the scene and challenges him and the FASB to a fight, he runs away. When accounting truth is at stake, he compromises and enables corporate managers to use methods and vehicles by which they can cook the books. Shame!

    The first thing the FASB did at its April 2 meeting concerns whether a market is not active and a transaction is not distressed. In this FSP FAS 157-e, the board allows business enterprises to weigh the evidence whether the a transaction involved an orderly market; in reality it will permit managers to ignore distressed conditions, some of which they themselves created, and to pretend some “value” based on normalcy. Clearly, this will buoy asset prices on the balance sheet and reduce losses or create gains on the income statement. Too bad this is fiction.

    In the second matter the FASB addressed other-than-temporary impairments. In this FSP the FASB permits managers to overlook other-than-temporary impairments if management believes that it does not have the intent to sell the security and it is more likely than not it will not have to sell the security before recovery of its cost basis. Of course, that will be just about everybody so this is a vacuous recognition condition.

    The FSP goes on to state that gains or losses due to credit risk will go into the income statement, while noncredit gains and losses will bypass the income statement and go directly into comprehensive income. This distinction appears academic as in practice it is hard to distinguish credit losses from noncredit losses. Clearly, this decision will give managers ample room to manipulate the income statement.

    The FASB got pushed into this decision and Robert Herz caved in. This isn’t the first time either. Herz became chairman after Enron’s special purpose entities exploded on Wall Street and has yet to do anything about them. These special purpose entities have also played a part in the current banking crisis. Herz also presided over the new rules on business combinations. While I applaud the elimination of the pooling option, which enabled many corporate frauds, I remain skeptical of the treatment of goodwill, which is another loophole. And Robert Herz keeps preaching against complexity and for simplicity and principles-based accounting, which are keywords to allow corporate executives the power to do as they wish with the recognition and measurement of revenues and other elements. (Bob, if these FSPs are based on any legitimate principles, pray tell us which ones.)

    Writing about these items when originally proposed, Jonathan Weil referred to the FASB as the Fraudulent Accounting Standards Board. I am sympathetic with his f-word, but I think it may be too harsh. After all, the board is “merely” allowing managers to commit fraud without facing any disincentives. But I think there are other f-words that we could employ, such as fearful, feckless, and futile.

    Mr. Herz, please resign. You are making the board ineffective as a standard bearer for accounting truth. While I think you have a sense of right and wrong, you are not willing to hold bankers accountable for their mistakes and you are not willing to stand up against politicians who favor lies.

    This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

    Jensen Comment
    Jonathon Weil was a prominent WSJ reporter during the Enron scandal
    "GLASS LEWIS NAMED JONATHAN WEIL MANAGING DIRECTOR AND EDITOR OF FINANCIAL RESEARCH in 2006 ---
    http://www.glasslewis.com/downloads/354-38.pdf

    Bob Jensen's threads on how the bankers bull crapped their troubles on the FASB's former fair value accounting rules ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting


    "A Fair Value Prescription for "Share Lending:"  If it's probable that the deal's investment bank will default, the issuing company must recognize an expense equal to the fair value of the unreturned shares, says FASB," by Robert Willens, CFO.com, July 6, 2009 --- http://www.cfo.com/article.cfm/13979193/c_2984368/?f=archives

    There are times when a company finds that the cost of borrowing its own shares is "prohibitive." When that happens, a company may, and frequently will, enter into a share lending arrangement in connection with a convertible debt offering. The accounting treatment for such a transaction has been clarified by the Emerging Issues Task Force of the Financial Accounting Standards Board, which recently reached consensus on the manner in which certain specialized share lending arrangements are to be accounted for.1

    The share lending arrangement ordinarily entails an agreement between the issuing entity and an investment bank and is intended to facilitate the ability of investors (primarily hedge funds and other sophisticated investors) to hedge the conversion feature with respect to the convertible debt.

    Typically, the terms of the share lending arrangement require the company to issue shares to the investment bank in exchange for a nominal "loan processing fee." Upon the maturity or conversion of the convertible debt, the investment bank is required to return the loaned shares to the issuing entity for no additional consideration. Moreover, the investment bank is generally required to reimburse the issuing entity for any dividends paid on the loaned shares and is prohibited from exercising the voting rights associated with the loaned shares.

    The new guidance, EITF Issue No. 09-1, says that at the date of issuance, a share lending arrangement is required to be measured at fair value and recognized as a "debt issuance cost" in the financial statements of the issuing entity. No guidance is provided regarding how the fair value is to be ascertained. The debt issuance cost is then amortized, under the "effective interest method," over the life of the financing arrangement, as interest cost.

    If it becomes probable that the counterparty (the investment bank) will default, the issuer shall recognize an expense equal to the then fair value of the unreturned shares — net of the fair value of any probable recoveries — with an offset to the issuer's additional paid-in capital (APIC) account.

    The loaned shares are excluded from both the basic and diluted earnings per share computation unless default is found to be probable. When default is probable, the loaned shares would be included in the earnings per share calculation. Moreover, if dividends on the loaned shares do not revert back to the issuing entity, all amounts (including contractual dividends) attributable to the loaned shares shall be deducted in computing "income available to common shareholders," which is consistent with the "two-class method" of computing earnings per share.2

    This EITF Issue will be effective for fiscal years which begin after December 15, 2009, and for interim periods within those fiscal years.


    The other big news items were the the infamous fair value accounting FASB Staff Positions (FSPs) announced on April 2, 2009. This relaxation/reinterpretation of fair value definitions and impairment testing arose largely out of political pressures and accusations that fair value accounting rules played a large role in the banking crisis of 2008 and recovery in 2009.

    On April 9, 2009, the Financial Accounting Standards Board ("FASB") issued the three FSPs: --- http://www.fasb.org/news/nr040909.shtml

    FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly ("FSP FAS 157-4") ---
    http://www.fasb.org/pdf/fsp_fas157-4.pdf

    FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments ("FSP FAS 115-2") ---
    http://www.fasb.org/pdf/fsp_fas115-2andfas124-2.pdf

    FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments ("FSP FAS 107-1") ---
    http://www.fasb.org/pdf/fsp_fas107-1andapb28-1.pdf
    /

    In response the PCAOB issued "Staff Audit Practice Alert No. 4," April 21, 2009 ---
    http://www.pcaobus.org/Standards/Staff_Questions_and_Answers/2009/04-21_APA_4.pdf

    Question
    What are the implications of the April 2, 2009 Fair Value Accounting FSPs for international accounting standards?

    April 22. 2009 message from Deloitte to the IASB --- http://www.iasplus.com/index.htm

    ·  Deloitte's IFRS Global Office has submitted to the IASB a Letter of Comment on IASB's Request for Views on Proposed FASB Amendments on Fair Value Measurement and Impairment Requirements. On 19 March 2009, the IASB requested views on what were, then, two proposed FASB Staff Positions. The FASB has since adopted the two proposals as final FSPs, along with a third related FSP dealing with disclosures, as follows:

    • FSP FAS 157-4, which provides guidance on determining fair value when market activity has decreased
    • FSP FAS 115-2 and FAS 124-2, which addresses other-than-temporary impairments for debt securities
    • FSP FAS 107-1 and APB 28-1, which discusses fair value disclosures for financial instruments in interim periods

    The Deloitte letter to the IASB provides our detailed views on each of the final FASB Staff Positions and contrasts them with IFRSs. Here are two excerpts from our letter:

    • Regarding FAS 157-4, the Deloitte letter to the IASB states:
      We believe that the FASB Staff Position FAS 157-4 is broadly consistent with the principles of fair value in IFRSs and the Expert Advisory Panel document and therefore an amendment to IFRSs is not necessary. However, in light of the IASB's imminent release of an exposure draft on Fair Value Measurements, the IASB should consider whether the words used in the FASB Staff Position FAS 157-4 are consistent with the exposure draft and whether the wording of the exposure draft should be aligned with the FASB Staff Position FAS 157-4. In addition, the IASB should seek the views of the Expert Advisory Panel to establish whether differences in the words of the FASB Staff Position FAS 157-4 and the Expert Advisory Panel report are expected to have any practical effect.
       
    • Regarding FAS 115-2 and 124-2, the Deloitte letter to the IASB states:
      As noted in the request for views, the differences between U.S. GAAP and IFRSs with respect to scope, impairment triggers, impairment measurements, and recoveries are numerous and complex. A short term project to fully converge with FASB's amendment would entail substantial changes to IFRSs that would require significant efforts and would create unnecessary complexities (e.g., recognizing impairments of held-to-maturity securities that are not due to credit in other comprehensive income). Instead, we would encourage both Boards to expedite their work on a joint standard that would improve reporting for all financial instruments including impairment issues (e.g., loss recognition triggers, measurement of losses, recognition of recoveries, etc.).

     


    Looking for blue sky above polluted bank accounting hot air
    Bank Profits Appear Out of Thin Air in 2009

    Question
    What direction did the price of shares of Bank of America move when BofA announced higher than expected earnings for the first quarter of 2009?

    Answer
    Down, because investors suspect that such earnings were not sustainable while BofA holds billions of dollars of Countrywide and Merrill Lynch toxic paper that will drive down future earnings due to non-performance of home owners and business owners who will not fully perform on loans.

    The magic accounting tricks in 2009 are hurting rather than helping to restore faith in accounting and auditing after the 2008 banking crash.

    Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them. “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said
    "Bank Profits Appear Out of Thin Air ," by Andrew Ross Sorkin, The New York Times, April 20, 2009 --- http://www.nytimes.com/2009/04/21/business/21sorkin.html?_r=1&dbk

  • This is starting to feel like amateur hour for aspiring magicians.

  • Another day, another attempt by a Wall Street bank to pull a bunny out of the hat, showing off an earnings report that it hopes will elicit oohs and aahs from the market. Goldman Sachs, JPMorgan Chase, Citigroup and, on Monday, Bank of America all tried to wow their audiences with what appeared to be — presto! — better-than-expected numbers.

  • But in each case, investors spotted the attempts at sleight of hand, and didn’t buy it for a second.

  • With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JPMorgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

  • Bank of America sold its shares in China Construction Bank to book a big one-time profit, but Ken Lewis heralded the results as “a testament to the value and breadth of the franchise.”

  • Sydney Finkelstein, the Steven Roth professor of management at the Tuck School of Business at Dartmouth College, also pointed out that Bank of America booked a $2.2 billion gain by increasing the value of Merrill Lynch’s assets it acquired last quarter to prices that were higher than Merrill kept them.

  • “Although perfectly legal, this move is also perfectly delusional, because some day soon these assets will be written down to their fair value, and it won’t be pretty,” he said.

  • Investors reacted by throwing tomatoes. Bank of America’s stock plunged 24 percent, as did other bank stocks. They’ve had enough.

  • Why can’t anybody read the room here? After all the financial wizardry that got the country — actually, the world — into trouble, why don’t these bankers give their audience what it seems to crave? Perhaps a bit of simple math that could fit on the back of an envelope, with no asterisks and no fine print, might win cheers instead of jeers from the market.

  • What’s particularly puzzling is why the banks don’t just try to make some money the old-fashioned way. After all, earning it, if you could call it that, has never been easier with a business model sponsored by the federal government. That’s the one in which Uncle Sam and we taxpayers are offering the banks dirt-cheap money, which they can turn around and lend at much higher rates.

  • “If the federal government let me borrow money at zero percent interest, and then lend it out at 4 to 12 percent interest, even I could make a profit,” said Professor Finkelstein of the Tuck School. “And if a college professor can make money in banking in 2009, what should we expect from the highly paid C.E.O.’s that populate corner offices?”

  • But maybe now the banks are simply following the lead of Washington, which keeps trotting out the latest idea for shoring up the financial system.

  • The latest big idea is the so-called stress test that is being applied to the banks, with results expected at the end of this month.

  • This is playing to a tough crowd that long ago decided to stop suspending disbelief. If the stress test is done honestly, it is impossible to believe that some banks won’t fail. If no bank fails, then what’s the value of the stress test? To tell us everything is fine, when people know it’s not?

  • “I can’t think of a single, positive thing to say about the stress test concept — the process by which it will be carried out, or outcome it will produce, no matter what the outcome is,” Thomas K. Brown, an analyst at Bankstocks.com, wrote. “Nothing good can come of this and, under certain, non-far-fetched scenarios, it might end up making the banking system’s problems worse.”

  • The results of the stress test could lead to calls for capital for some of the banks. Citi is mentioned most often as a candidate for more help, but there could be others.

  • The expectation, before Monday at least, was that the government would pump new money into the banks that needed it most.

  • But that was before the government reached into its bag of tricks again. Now Treasury, instead of putting up new money, is considering swapping its preferred shares in these banks for common shares.

  • The benefit to the bank is that it will have more capital to meet its ratio requirements, and therefore won’t have to pay a 5 percent dividend to the government. In the case of Citi, that would save the bank hundreds of millions of dollars a year.

  • And — ta da! — it will miraculously stretch taxpayer dollars without spending a penny more.

    Bob Jensen's threads on fair value accounting or lack thereof are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue


    Last weekend, Harvard University sponsored a conference called (I am not making this up) "The Free Market Mindset: History, Psychology, and Consequences." Its purpose was to try to figure out why, since everyone knows the current crisis amounts to a failure of the market economy, the stupid rubes continue to believe in it. The promotional literature for the conference opened with That Quotation from Alan Greenspan — the one in which he suggested that there was, after all, a "flaw" in the free market he hadn't noticed before.
    Thomas E. Wood, Jr., "Supporters of Capitalism Are Crazy, Says Harvard," Ludwig von Mises, Institute, March 17, 2009 --- http://mises.org/story/3379
    Jensen Comment
    Conservatism's hero Bill Buckley once commented, after the implosion of the Soviet Union and the tearing down of the Iron Curtain, that the only communists left in the world worked along the banks of the Charles River (read that Cambridge, Mass.). Communists can take heart that the person virtually in charge of the U.S. economy, Lawrence Summers, is a Harvard Professor.

    Aides say that Obama was drawn to Summers in part because the former Harvard president shares the president-elect’s passion for a more equitable distribution of economic benefits. Obama was impressed during campaign policy discussions that Summers would often pull the conversation away from general talk about economic growth to a concern with the living standards of families with average incomes.” There’s an irony here . . . As Dem-oriented economists go, Summers used to be known as among the more laissez-faire oriented. As Dan Froomkin recently wrote at the Washington Post, citing the Nation’s Christopher Hayes, “It’s hard to imagine the Larry Summers of 1993 saying that income inequality is the ‘defining issue of our time,’ as he recently did.” But a couple years ago, perhaps sensing the changing political sands, Summers became a born-again redistributionist. And that made him attractive to Barack Obama.
    Mark Finkelstein, "Obama Dug Summers’ Redistributionist Rap," Finkel Blog, March 19, 2009 ---
    http://finkelblog.com/index.php/2009/03/19/obama-dug-summers-redistributionist-rap/
    Mark got the quote from E.J. Dionne’s Washington Post column ---  http://www.washingtonpost.com/wp-dyn/content/article/2008/11/24/AR2008112402116_pf.html


    "Now Is No Time to Give Up on Markets (or fair value accounting)," by Anastasia O'Grady, The Wall Street Journal, March 21, 2009 --- http://online.wsj.com/article/SB123759849467801485.html?mod=djemEditorialPage

    Gary Becker, the winner of the 1992 Nobel Prize in Economic Sciences, is in New York to speak to a special meeting of the Mont Pelerin Society on the global meltdown. He has agreed to sit down to chat with me on the subject of his lecture.

    Slumped in a soft chair in a noisy hotel coffee lounge, the 78-year-old University of Chicago professor is relaxed and remarkably humble for a guy who has achieved so much. As I pepper him with the economic and financial riddles of our time, I am impressed by how many times his answers, delivered in a pronounced Brooklyn accent, include an "I think" and sometimes even an "I don't know the answer to that." It is a reminder of why he is so highly valued. In contrast to a number of other big-name practitioners of the dismal science, he is a solid empiricist genuinely in search of answers -- not the job as the next chairman of the Federal Reserve. What he sees is what you get.

    . . .

    Mr. Becker sees the finger prints of big government all over today's economic woes. When I ask him about the sources of the mania in housing prices, the first culprit he names is the Fed. Low interest rates, he says, were "partly, maybe mainly, due to the Fed's policy of keeping [its] interest rates very low during 2002-2004." A second reason rates were low was the "high savings rates primarily from Asia and also from the rest of the world."

    "People debate the relative importance of the two and I don't think we know exactly," Mr. Becker admits. But what is clear is that "when you have low interest rates, any long-lived assets tend to go up in price because they are based upon returns accruing over many years. When interest rates are low you don't discount these returns very much and you get high asset prices."

    On top of that, Mr. Becker says, there were government policies aimed at "extending the scope of homeownership in the United States to low-credit, low-income families." This was done through "the Community Reinvestment Act in the '70s and then Fannie Mae and Freddie Mac later on" and it put many unqualified borrowers into the mix.

    . . .

    How about getting rid of the mark-to-market pricing of bank assets [that is, pricing assets at the current market price] that some say has destroyed bank capital? Mr. Becker says he prefers mark-to-market over "pricing by cost because costs are often completely out of whack with what the real prices are." Then he adds this qualifier: "But when you have a very thin market, you have to be very careful about what it means to mark-to-market. . . . It's a big problem if you literally take mark-to-market in terms of prices continuously based on transactions when there are very few transactions in that market. I am a mark-to-market person but I think you have to do it in a sensible way."

    However that issue is resolved in the short run, there will remain the problem of institutions growing so big that a collapse risks taking down the whole system. To deal with the "too big to fail" problem in the long run, Mr. Becker suggests increasing capital requirements for financial institutions, as the size of the institution increases, "so they can't have [so] much leverage." This, he says, "will discourage banks from getting so big" and "that's fine. That's what we want to do."

    Mr. Becker is underwhelmed by the stimulus package: "Much of it doesn't have any short-term stimulus. If you raise research and development, I don't see how it's going to short-run stimulate the economy. You don't have excess unemployed labor in the scientific community, in the research community, or in the wind power creation community, or in the health sector. So I don't see that this will stimulate the economy, but it will raise the debt and lead to inefficient spending and a lot of problems."

    There is also the more fundamental question of whether one dollar of government spending can produce one and a half dollars of economic output, as the administration claims. Mr. Becker is more than skeptical. "Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way."

    As the interview winds down, I'm thinking more about how people can make pretty crazy decisions with the right incentives from government. Does this explain what seems to be a decreasing amount of personal responsibility in our culture? "When you get a larger government, when you have the government taking over Social Security, government taking over health care and with further proposals now for the government to take over more activities, more entitlements, the rational response is to have less responsibility. You don't have to worry about things and plan on your own as much."

    That suggests that there is a risk to the U.S. system with more people relying on entitlements. "Well, they become an interest group," Mr. Becker says. "The more you have dependence on the government, the stronger the interest group of people who want to maintain it. That's one reason why it is so hard to get any major reform in reducing government spending in Scandinavia and it is increasingly so in the United States. The government is spending -- at the federal, state and local level -- a third of GDP, and that share will go up now. The higher it is the more people who are directly or indirectly dependent on the government. I am worried about that. The basic theory of interest-group politics says that they will have more influence and their influence will be to try to maintain this, and it will be hard to go back."

    Still, there remain many good reasons to continue the struggle against the current trend, Mr. Becker says. "When the market economy is compared to alternatives, nothing is better at raising productivity, reducing poverty, improving health and integrating the people of the world."

    Bob Jensen's threads on the attacks on fair value accounting by bankers, regulators, and billionaires Steve Forbes and Warren Buffett are at http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    Video Lecture:  John Maynard Keynes and Hayek: Bruce Caldwell ---
    http://www.youtube.com/watch?v=t4a_SkJzoIg

    Video Rap:  Keynes and Hayek Rap from PBS  ---
    http://www.pbs.org/newshour/bb/business/july-dec09/keynes_12-16.html
    Also see http://financeprofessorblog.blogspot.com/2009/12/keynes-and-hayek-rap-from-pbs.html

     

    Bob Jensen's arguments for not extending fair value accounting to non-financial items --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's threads on entitlements --- http://faculty.trinity.edu/rjensen/Entitlements.htm


    "SEC ISSUES DETAILED STUDY ON MARK-TO-MARKET ACCOUNTING," by Gia Chevis, Accounting Education.com, February 19, 2009 ---
    http://accountingeducation.com/index.cfm?page=newsdetails&id=148980
    The report was issued on December 31, 2008

    At the direction of the U.S. Congress, the SEC prepared and released on 30 December 2008 a study on mark-to-market accounting and its role in the recent financial crises. Though it concluded that mark-to-market accounting was not responsible for the crisis, it did make eight recommendations.

    The 259-page document, a result of the Emergency Economic Stabilization Act of 2008, details an in-depth study of six issues identified by the Act: effects of fair value accounting standards on financial institutions' balance sheets; impact of fair value accounting on bank failures in 2008; impact of fair value accounting on the quality of financial information available to investors; process used by the FASB in developing accounting standards; alternatives to fair value accounting standards; and advisability and feasibility of modifications to fair value accounting standards. Its eight recommendations are:

    1) SFAS No. 157 should be improved, but not suspended.

    2) Existing fair value and mark-to-market requirements should not be suspended.

    3) While the Staff does not recommend a suspension of existing fair value standards, additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates).

    4) The accounting for financial asset impairments should be readdressed.

    5) Implement further guidance to foster the use of sound judgment.

    6) Accounting standards should continue to be established to meet the needs of investors.

    7) Additional formal measures to address the operation of existing accounting standards in practice should be established.

    8) Address the need to simplify the accounting for investments in financial assets.

    On February 18, the FASB announced the addition of two short-timetable projects to its agenda concerning fair value measurement and disclosure. The first project aims to improve application guidance for measurement of fair value, with issuance projected for the second quarter. The second will address issues related to input sensitivity analysis and changes in levels; the FASB anticipates completing that project in time for calendar-year-end filing deadlines. Both projects were undertaken in response to the SEC's recent study on mark-to-market accounting and input from the FASB's Valuation Resource Group.

    The full report can be freely downloaded at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf
     

    SFAS No. 157’s fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to unadjusted quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3). With respect to IFRS, the report states the following on Page 33:

    Currently, under IFRS, “guidance on measuring fair value is dispersed throughout [IFRS] and is not always consistent.”52 However, as discussed in Section VII.B, the IASB is developing an exposure draft on fair value measurement guidance.

    IFRS generally defines fair value as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction” (with some slight variations in wording in different standards).53 While this definition is generallyconsistent with SFAS No. 157, it is not fully converged in the following respects:

    The definition in SFAS No. 157 is explicitly an exit price, whereas the definition in IFRS is neither explicitly an exit price nor an entry price.

    SFAS No. 157 explicitly refers to market participants, which is defined by the standard, whereas IFRS simply refers to knowledgeable, willing parties in an arm’s length transaction.

    For liabilities, the definition of fair value in SFAS No. 157 rests on the notion that the liability is transferred (the liability to the counterparty continues), whereas the definition in IFRS refers to the amount at which a liability could be settled.

     

    Related Items
      The Relationship between Fair Value, Market Value, and Efficient Markets
      IAASB PRACTICE ALERT HELPS AUDITORS AND MANAGEMENT ASSESS IMPACT OF CREDIT CRISIS ON GOING CONCERN A...
      Accounting in and for the Subprime Crisis
      Inco Ltd.: Market Value, Fair Value, and Management Discretion
      INTERNATIONAL STANDARDS ARE THE WAY AHEAD SAYS ACCA
      SEC ISSUES DETAILED STUDY ON MARK-TO-MARKET ACCOUNTING
  • "SEC Advises No Break in 'Mark' (Fair Value Accounting) Rules," by Michael R. Crittenden, The Wall Street Journal, December 31, 2008 --- http://online.wsj.com/article_email/SB123067591247143735-lMyQjAxMDI4MzMwMDYzNzA1Wj.html 

    The Securities and Exchange Commission recommended against suspending fair-value accounting rules, instead suggesting improvements to deal with illiquid markets and reducing the number of models used to measure impaired assets.

    In a 211-page report to U.S. lawmakers, as expected, the agency's staff Tuesday definitely recommended that fair-value and mark-to-market not be eliminated or suspended. "The abrupt elimination of fair value and market-to-market requirements would erode investor confidence," the report said.

    The banking lobby has argued that financial institutions have been forced to write off as losses still-valuable assets because the market for them had dried up, creating a spiral of write-downs and asset sales.

    The report said that staff found no evidence to suggest that the accounting rules had played a significant role in the collapse of U.S. financial institutions. "While the application of fair value varies among these banks...in each case studied it does not appear that the application of fair value can be considered to have been a proximate cause of the failure," the report said.

    Additionally, the SEC suggests that the Financial Accounting Standards Board narrow the number of accounting models firms can use to assess the impairment for financial instruments.

    "Robert H. Herz, Chairman of the Financial Accounting Standards Board, today announced the addition of new FASB agenda projects intended to improve
    (1) the application guidance used to determine fair values and
    (2) disclosure of fair value estimates.
    "FASB Initiates Projects to Improve Measurement and Disclosure of Fair Value Estimates," SmartPros, February 18, 2009 --- http://accounting.smartpros.com/x65563.xml


  • The projects were added in response to recommendations contained in the Securities and Exchange Commission's (SEC) recent study on mark-to-market accounting, as well as input provided by the FASB's Valuation Resource Group, a group of valuation and accounting professionals who provide the FASB staff and Board with information on implementation issues surrounding fair value measurements used for financial statement reporting purposes.

    "The SEC expressed continued support of fair value accounting in its study, but recommended consideration of potential improvements in the guidance surrounding the application of fair value principles," stated Chairman Herz. "We agree with the SEC and with our Valuation Resource Group that more application guidance to determine fair values is needed in current market conditions. Additionally, investors have asked for more information and disclosure about fair value estimates. Therefore, the FASB is immediately embarking on projects that directly address areas that constituents have told us are challenging in the current environment, and which will improve disclosures in financial reports."

    The fair value projects address both application and disclosure guidance:

    -- The projects on application guidance will address determining when a market for an asset or a liability is active or inactive; determining when a transaction is distressed; and applying fair value to interests in alternative investments, such as hedge funds and private equity funds.

    -- The project on improving disclosures about fair value measurements will consider requiring additional disclosures on such matters as sensitivities of measurements to key inputs and transfers of securities between categories.

    The FASB anticipates completing projects on application guidance by the end of the second quarter of 2009, and the project on improving disclosures in time for year-end financial reporting. The FASB has also recently proposed enhanced disclosures in interim reports relating to the fair values of financial instruments. (Proposed FASB Staff Position (FSP) FAS 107-b and APB 28-a is available at http://www.fasb.org/fasb_staff_positions/prop_fsp_fas107-b&apb28-a.pdf ).

    As previously announced, the FASB has also commenced work with the International Accounting Standards Board (IASB) on a more comprehensive project to improve, simplify, and converge the accounting for financial instruments. The Boards are obtaining input on that project from a number of sources, including the senior-level Financial Crisis Advisory Group that has been formed to assist the FASB and the IASB in evaluating financial reporting issues emanating from the global financial crisis.

    The SEC study, entitled Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting,, was issued to Congress by the SEC's Office of the Chief Accountant and Division of Corporate Finance on December 30, 2008, as mandated by the Emergency Economic Stabilization Act of 2008. The 211-page report recommended against suspension of fair value accounting standards, and instead recommended specific improvements to existing practice. The report reaffirms that investors generally believe fair value accounting increases financial reporting transparency, and that the information it provides helps result in better investment decision-making. (The report is available at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf .)

    The FASB Valuation Resource Group met on February 5, 2009 to provide input on fair value issues to the Board. The group was formed in June 2007, as a result of feedback received from constituents calling for the Board to address issues relating to valuation for financial reporting. More information about the VRG and its members is available at http://www.fasb.org/project/valuation_resource_group.shtml#background

    Continued in article



     

    Forbes serves up barf --- No worse than barf!
    It's clear that Forbes never read the excellent December 2008 SEC research report on this topic.
    "Obama Repeats Bush's Worst Market Mistakes:  Bad accounting rules are the cause of the banking crisis," by Steve Forbes, The Wall Street Journal, March 6, 2009 --- http://online.wsj.com/article/SB123630304198047321.html?mod=djemEditorialPage

    What is most astounding about President Barack Obama's radical economic recovery program isn't its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama's hero.

    The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.

    That works when you have very liquid securities, such as Treasurys, or the common stock of IBM or GE. But when the credit crisis hit in 2007, there was no market for subprime securities and other suspect assets. Yet regulators and auditors kept pressing banks and other financial firms to knock down the book value of this paper, even in cases where these obligations were being fully serviced in the payment of principal and interest. Thus, under mark-to-market, even non-suspect assets are being artificially knocked down in value for regulatory capital (the amount of capital required by regulators for industries like banks and life insurance).

    Banks and life insurance companies that have positive cash flows now find themselves in a death spiral. Of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not actual cash losses. When banks or insurers write down the value of their assets they have to get new capital. And the need for new capital is a signal to ratings agencies that these outfits might deserve a credit-rating reduction.

    So although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions that would warm Tony Soprano's heart. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired.

    If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression.

    But put aside for a moment the absurdity of trying to price assets in a disrupted or non-existent market, of not distinguishing between distress prices and "normal" prices. Regulatory capital by its definition should take the long view when it comes to valuation; day-to-day fluctuations shouldn't matter. Assets should be kept on the books at the price they were obtained, as long as the assets haven't actually been impaired.

    Continued in article

    Jensen Comment
    By now investors know which large banks are stuck with trillions of dollars in non-performing loans. Wrapping them gold ribbons by reporting them way above market value is hardly going to induce investors to go out an buy enormous amounts of common shares of CitiBank, Bank of America, Wells Fargo, and JP Morgan. This artificial gilding of capital ratios does nothing to solve the problem of detoxifying the poison of non-performing loans and poisonous collateralized bonds.

    This type of naive and dangerous reasoning was started on September 19, 2008 by former FDIC director Bill Isaac --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    "Former FDIC Chief: Fair Value Caused the Crisis:  Things were fine before the accounting standards-setters barged in and "destroyed hundreds of billions of dollars of capital," he contends," by David M. Katz, CFO.com, October 29, 2008 --- http://www.cfo.com/article.cfm/12502908 

  • In perhaps the most sweeping indictment of fair-value accounting to date, the chairman of the Federal Deposit Insurance Corporation during the 1980s savings-and-loan debacle told the Securities and Exchange Commission today that mark-to-market accounting rules caused the current financial meltdown.

    Speaking at an SEC panel on mark-to-market accounting and the recent period of market turmoil, William Isaac, FDIC chairman from 1978 to 1985 and now the chairman of a consulting firm that advises banks, said that before FAS 157, the controversial accounting standard issued in 2006 that spells out how companies should measure assets and liabilities that have been marked to market, took hold, subprime losses were "a little biddy problem."

    Isaac rhetorically asked the participants how the financial system could have come upon such hard times in under two years. "I gotta tell you that I can't come up with any other answer than that the accounting system is destroying too much capital, and therefore diminishing bank lending capacity by some $5 trillion," he asserted. "It's due to the accounting system, and I can't come up with any other explanation."

    As of late 2006, Isaac, now chairman of The Secura Group, a financial institutions consulting firm, argued, "inflation was under control, economic growth was good, unemployment was low, and there were no major credit problems in the banking system." There were $1.2 trillion worth of U.S. subprime mortgages, with about $300 billion provided by FDIC-insured banks and the rest held by investors world-wide.

    Since subprime losses were estimated to be about 20 percent in 2006, federally insured U.S. banks had lost about $60 billion in that market, according to Isaac. But those banks had recorded about $150 billion in after-tax earnings and had $1.4 trillion of capital.

    The devastation that followed stemmed largely from the tendency of accounting standards-setters and regulators to force banks, by means of their litigation-shy auditors, to mark their illiquid assets down to "unrealistic fire-sale prices," the former FDIC chief asserted. The fair-value rules "have destroyed hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by ten times that amount," he said in his prepared remarks.

    Noting that 157 was issued in 2006, Isaac noted that he wasn't "asking that we change the whole system of accounting that has been developed for centuries." Instead, he said, "I'm asking for a very bad rule to be suspended until we can think about this more and stop destroying so much capital in our financial system. I think that's a basic step that needs to be taken immediately."

    Isaac added that it's his "fervent hope that the SEC will recommend in its report to Congress that we abandon mark-to-market accounting altogether." The panel was held as part of the commission's effort to comply with a requirement in the Emergency Economic Stabilization Act signed earlier this month that the SEC complete a study of mark-to-market's role in the current crisis by Jan. 2, 2009.

    Isaac's remarks seemed to underline the highly polarized current state of the fair-value debate, with the banking industry pitted in fierce opposition to mark-to-market against the strong defense of investors and auditors. The latter point of view was represented by Ray Ball, a professor of accounting at the University of Chicago's graduate school of business. Noting that fair value has been a subject of accounting debate for five decades, he declared, "I think it would be a terrible shame if we shoot the messenger and ignore the message" mark-to-market accounting conveys about the current condition of banks.

    Similarly, Vincent Colman, a partner at PricewaterhouseCoopers, encouraged the SEC to look at the "root causes" of the crisis, "including those that go beyond accounting and financial reporting." In particular, regulators should refine current capital guidelines and enforce "an independent standards- setting process" that's free of political influence, he said.

    The auditor urged the commission to keep the current fair-value rules intact during the credit crisis. "Any fundamental change to fair value runs the risk of reducing confidence among investors," he said, "which tends to restrict the flow of capital."

    Espousing a middle position in the debate, Damon Silvers, associate general counsel for the AFL-CIO, asserted that there were errors on both sides. Countering fair value's critics on the banking side, he said that the opacity in the reporting of mortgage securitizations is a root cause of the credit freeze.

    Further, even if fair-value accounting were eliminated, the trillions of dollars of distressed mortgage-backed assets on bank balance sheets "are never going to be worth their full value," he said. "Assuming that those people who are thrown out of their homes will return with a pile of cash is deeply deluded."

    On the other hand, 157's provision that companies holding assets and liabilities in inactive markets need to use models to value them runs the risk of "making a complete hash of financial statements," according to Silvers.

    The provision causes companies to move "further and further away from the stated mark-to-market regime," he observed. "If we don't have that market [on which to base valuations], we move to a more baroque series of arrangements."

    Jensen Comment
    In calling for the suspension of FAS 157, Isaac was joined by most other bankers, Congressional representatives, and billionaires Steve Forbes and Warren Buffet

  • Congress Ordered the SEC to Conduct a Hurried Research Study into Fair Value Accounting in the Context of the Banking Crisis
    The wonderful December 30, 2008 research report of the SEC shows that fair value accounting is neither the cause nor the cure for the banking crisis. The liquidity problem of the holders of the toxic investments is caused by trillions of dollars invested in underperforming (often zero performing) of bad investments mortgages or mortgaged-backed bonds that have to be written down unless auditors agree to simply lie about values. That is not likely to happen, but client pressures on auditors to value on the high side for many properties will be heavy handed.
    The wonderful full SEC report that bankers and regulators do not want to read can be freely downloaded at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

    But political pressures mounted in spite of the SEC research findings. On April 2, 2009 in a 3-2 vote the FASB reached a highly controversial decision to ease fair value accounting in such a way that banks will be able to report higher earnings due to changes in accounting rules.

    "Expedited fair value guidance may ease pressure on banks," AccountingWeb, March 17, 2009 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=107232

    Following a hearing at a House Financial Services subcommittee last week, the Financial Accounting Standards Board (FASB) agreed to expedite release of their proposed guidance for the application of FAS 157 "Fair Value Measurement." The proposed guidance was published for public comment on March 17th and will be voted on by the Board on April 2. If approved, the FASB recommends that the guidance be effective for interim and annual periods ending after March 15, 2009. According to CFO.com, FASB chairman, Robert H. Herz, chairman of the Financial Accounting Standards Board (FASB), told legislators, "We can have the guidance in three weeks, but whether that will fix everything is another [issue]."

    SB's proposal give more detailed guidance for valuing assets that would be classified as Level 3 under FAS 157, where values are assigned in the absence of an active market or where a sale has occurred in distressed circumstances when prices are temporarily weighed down. The new guidance allows companies to use their own models and estimates and exercise "significant judgment" to determine whether a market exists or whether the input is from a distressed sale. Under FAS 157, financial instruments' fair values cannot be based on distressed sales.

    FASB had planned to issue the proposed guidance by the end of the second quarter. A study on mark-to-market accounting standards conducted by the Securities and Exchange Commission (SEC), which was mandated by the Emergency Economic Stabilization Act of 2008, concluded that more application guidance to determine fair values was needed in current market conditions. On February 18, Herz announced that FASB agreed with the SEC study and would develop additional guidance.

    Thomas Linsmeier, FASB board member, said that they hoped that the new guidance could lead to more accurate and possibly higher values, CFO.com reports. "What we are voting on will hopefully elevate fair values to a more reasonable price so investors are more comfortable investing in the banking system," he said.

    Edward Yingling, president of the American Bankers Association, said in a statement he welcomed the proposal but expressed caution about the ways it might be used by auditors, MarketWatch says. "While we welcome today's news, it will be important to look at the details of the written proposal to see how fully it improves the guidance. It will also be imperative to examine the practical effect the proposal will have based on the various ways it is interpreted."

    The FASB proposal recommends that companies take two steps to determine whether there an active market exists and whether a recent sale is distressed before applying their own models and judgment:

    Step 1: Determine whether there are factors present that indicate that the market for the asset is not active at the measurement date. Factors include:

    If after evaluating all the factors the sum of the evidence indicates that the market is not active, the reporting entity shall apply step 2.

    Step 2: Evaluate the quoted price (that is, a recent transaction or broker price quotation) to determine whether the quoted price is not associated with a distressed transaction. The reporting entity shall presume that the quoted price is associated with a distressed transaction unless the reporting entity has evidence that indicates that both of the following factors are present for a given quoted price:

    The proposed guidance also provides examples of measurement approaches in the event that the observable input is from a distressed sale.

    At Monday's meeting, Herz deflated any beliefs that FASB's new guidance will be a panacea for the many ills of the U.S. economy. "There's not much accounting can do other than help people get the facts and use their best judgment," he said.

    The International Accounting Standards Board, which sets accounting rules followed by more than 100 countries, plans to publish a draft rule to replace and simplify fair-value accounting rules. Critics say the rules have exacerbated the credit crunch by forcing write-downs. "We plan to replace it, the whole thing. We want to stop patching up the standard and we want to write a new one. We are aware that the current model is too complex. We need to simplify.... We will move to exposure draft hopefully within the next six months," said Philippe Danjou, a member of the IASB board.

    FASB's FSP Decisions: Bigger than Basketball?" Seeking Alpha, April 2, 2009 ---
    http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

    Finally, the FASB held its long-anticipated meeting on the two FSPs that would have gutted fair value reporting as it exists. There's been more hoopla (and hope-la) about these two amendments than in all of March Madness.

    Briefly, here's what transpired, as best as I could tell from the webcast of the meeting:

    1. FSP 157-e, the proposal which would have provided a direct route to Level 3 modeling of fair values whenever there was a problem with quoted prices, will be quite different from the original plan. There will be indicators of inactive markets in the final FSP, but they'll only be indicators for a preparer to consider - and more importantly, their presence WILL NOT create a presumption of a distressed price for securities in question. That part of the proposal would have greased the skids for Level 3 modeling. Not now.

    There will be added required disclosures, which were not in the exposure draft. One that I caught: quarterly "aging" disclosures of the securities that are in a continuous loss position for more than 12 months and less than 12 months. As discussed in last week's report on the proposals, these now-annual disclosures are useful for assessing riskiness of assets that could become a firm's next other-than-temporary impairment charge.

    Bottom line: investors didn't lose here.

    2. FSP FAS 115-a, 124-a, and EITF 99-20-b, the proposal that softens the blow of recognizing other-than-temporary impairments, was essentially unchanged from the original proposal. It remains a chancre on the body of accounting literature. The credit portion of an other-than-impairment loss will be recognized in earnings, with all other attributed loss being recorded in "other comprehensive income," to be amortized into earnings over the life of the associated security. That's assuming the other-than-temporary impairment is recognized at all, because the determination will still be largely driven by the intent of the reporting entity and whether it's more likely than not that it will have to sell the security before recovery. This is a huge mulligan for banks with junky securities.

    If OTT charges are taken, the full amount of the impairment will be disclosed on the income statement with the amount being shunted into other comprehensive income shown as a reduction of the loss, leaving only the credit portion to be recognized in current period earnings.

    Bottom line: Investors lost on this vote, and they will have to pay more attention to OCI in the future, as it becomes a more frequently-used receptacle for unwanted debits. When investors note these "detoured charges" in earnings, they should skip the detour and factor the full charge into their evaluation of earnings. A small victory for investors: the original proposal would have included other-than-temporary impairments on equity securities. The final decision will affect only debt securities.

    There was a third, much less-heralded FSP voted upon at the meeting:

    3. FSP FAS 107-a and APB 28-a, which will make the now-annual fair value disclosures for all financial instruments required on a quarterly basis. This will be required beginning in the second quarter, with early implementation allowed in the first quarter.

    All three FSPs will become effective in the second quarter, with early implementation allowed in the first quarter. Note: any firm electing early adoption of the impairment FSP cannot wait until later to adopt the FSP 157-e fair value amendment. If they change the way they recognize impairments, they also have to change how they consider the calculation of fair values.

    Some board members expressed hope that this was the last of the "emergency amendments" to take place at the end of a reporting period. It seems too much to hope for; there could more ahead, depending on how meddlesome the G-20 would like to be. Remember when IFRS in the United States was a hot topic? To a very large degree, that sprouted from a trans-Atlantic summit meeting between the EU and the White House. The same thing could happen again if the G-20 gang decides they know accounting better than the standard-setters.

    "FASB Approves New Mark-to-Market Guidance," by Matthew G. Lamoreaux, Journal of Accountancy, April 2, 2009 ---
    http://www.journalofaccountancy.com/Web/20091601.htm 

    Exactly three weeks after FASB Chairman Robert Herz’s March 12 testimony before a rancorous House Financial Services subcommittee, the independent standard-setting board voted Thursday to release three new pieces of guidance to address concerns over the application of fair value accounting standards in current market conditions.

    All three new pronouncements will be published in the form of FASB Staff Positions (FSPs). FASB Technical Director Russell Golden said in a press conference following the meeting that the final FSPs would not be available until next week.

    FASB Staff Position no. FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed, establishes a process to determine whether a market is not active and a transaction is not distressed. The FSP says companies should look at several factors and use judgment to ascertain if a formerly active market has become inactive. Once a market is determined to be inactive, more work will be required. The company must see if observed prices or broker quotes obtained represent “distressed transactions.” Other techniques such as a discounted cash flow analysis might also be appropriate in that circumstance, as long as it meets the objective of estimating the orderly selling price of the asset in the current market.

    The AICPA’s Accounting Standards Executive Committee (AcSEC) submitted a comment letter to FASB recommending against adoption of FSP FAS 157-e based on concerns that it could be interpreted in a way that would contradict the exit price model of FASB Statement no. 157, Fair Value Measurements.

    But following the meeting, AcSEC Chairman Jay Hanson said he was pleased that FASB clarified during its deliberations on Thursday that the FSP is not intended to change the measurement objective of Statement no. 157.

    The second FASB document—FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments—deals with other-than-temporary impairment (OTTI). This FSP was passed by a 3-2 vote. Under the new rules, once an OTTI is determined for a debt security, the portion of an asset write down attributed to credit losses may flow through earnings and the remaining portion may flow through other comprehensive income, depending on the situation and facts involved. There will be several new required disclosures about how the charges are split.

    Initial reaction from financial institutions regarding the new OTTI rules was positive. “I am pleased to see the changes being made and believe they will provide more accurate financial information,” said Security Financial Bank CFO Mark C. Oldenberg, CPA. “I expect there will be substantial discussion on how to determine ‘credit losses’ versus ‘market losses’ and whether to allow recovery of OTTI losses.”

    But at least some investors did not appear to be quite so enthusiastic. “The new guidance seems to be a result of government pressure,” said Jason S. Inman, CPA, of McDonnell Investment Management LLC. “The fair value concept before the change allowed for greater transparency in the market and for an investor to make a decision as to whether or not the company had the ability to hold those assets until recovery.”

    “Investors lost on this vote,” wrote former FASB Emerging Issues Task Force member Jack Ciesielski, CPA, on the AAO Weblog regarding the new OTTI rules. “And they will have to pay more attention to other comprehensive income in the future, as it becomes a more frequently-used receptacle for unwanted debits. When investors note these ‘detoured charges’ in earnings, they should skip the detour and factor the full charge into their evaluation of earnings.”

    The third piece of guidance—FSP FAS 107-B and APB 28-A, Interim Disclosures About Fair Value of Financial Instruments—will increase the frequency from annually to quarterly of disclosures providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value.

    All three FSPs will be effective for periods ending after June 15, 2009. Early adoption is permitted for periods ending after March 15, 2009. However, if a company wants to adopt the FSP FAS 115-a, FAS 124-a, and EITF 99-20-b in the first quarter, it must also adopt the FSP FAS 157-e at the same time.

    April 3 message from Bob Jensen

    Hi David,

    I think I can correctly surmise what IASB Board members who eventually dissent on easing fair value accounting rules, and I think I it will be for the same reasons why two of five FASB Board members voted against the FASB fair value changes announced at http://www.fasb.org/action/sbd040209.shtml

    Yes Robert Herz
    Yes Leslie Seidman
    Yes Lawrence Smith
    No Thomas Linsmeier
    No Marc Siegel

    Reasons for the No votes have not been announced, but they probably will be published soon by the FASB.

    The same 3-2 voting outcome happened on FSP EITF 99-20-1

    "FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head," by Tom Selling, The Accounting Onion, January 14, 2009 --- http://accountingonion.typepad.com/theaccountingonion/2009/01/fsp-eitf-99-20.html

    Is there a pattern here in FASB voting on Fair Value Accounting? Maybe not if we accept the rationale give to us by Denny Beresford. My own opinion is that this is not really a fundamental change in FAS 157 since Level 3 always allowed valuation based on models. What has changed is that clients and auditors will no longer be so hesitant to move down to Level 3 after this official re-affirmation of Level 3 taken by the FASB on April 2 ---
    http://seekingalpha.com/article/129189-fasb-s-fsp-decisions-bigger-than-basketball

    There are three United States IASB Board Members Mary Barth, John Smith, and Jim Leisenring. My guess is that two of the  three (maybe all three) will strongly dissent if the IASB follows the April 2 lead on easing fair value accounting rules set by the FASB on April 2.

    Mary Barth and John Smith strongly dissented when the IASB voted to allow entities a free choice between the partial and full fair value alternatives to goodwill and NCI measurement. Jim Leisingring went along with the majority of the IASB on that issue, but I think he has stronger feelings about easing fair value accounting rules. I don’t anticipate strong objections from the majority of the IASB voting members.

    If I’m correct the dissent is a straw man if you buy into the Level 3 of the original FAS 157. However, it is a real tiger now that banks will once again be underestimating bad debt reserves and overstating income with less worry about investor class action lawsuits. This so-called change in accounting rules certainly is consistent with “principled-based” accounting standards and will lead to inconsistencies on how virtually identical financial instruments are accounted for in practice.

    Bob Jensen


    April 2, 2009—
     Audio of Today's Press Conference with Robert Herz, Teresa Polley, and Russell Golden on Fair Value and OTTI Actions
    (Posted: 04/02/09)

    April 3, 2009 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU

    One of the IASB board members is on my campus today and he fully expects the IASB to follow the FASB's lead, which he strongly disagrees with. For the record, I think the FASB's action was much needed clarification of the intent of SFAS 157 and I applaud its efforts. This was not at all a situation of "bowing to pressure" but rather one of realizing that earlier guidance hadn't been applied in the intended manner. The FASB clearly accelerated its work in response to Congressional concerns but moving too slowly has been a fault of the FASB from the beginning, including the 10 1/2 years I was there.

    Bob Jensen

    "Herz Should Resign," by: J. Edward Ketz, SmartPros, April 2009 --- http://accounting.smartpros.com/x66142.xml

    April 2, 2009 is a day of accounting infamy. It is a day in which the Financial Accounting Standards Board (FASB) bowed to the pressures of the banking community and Congress to allow distortions, massagings, and manipulations of the U.S. financial reports. Because of these cowardly acts, I think it time for Robert Herz to resign from the FASB.

    Robert Herz is the chairman of the FASB, appointed on July 1, 2002 and reappointed on July 1, 2007. Before this he was a senior partner with PricewaterhouseCoopers. I have read many of his papers and I have heard some of his speeches. I have found Mr. Herz quite intelligent, filled with much knowledge about accounting and finance, well-mannered, articulate, and an avid defender of the accounting profession.

    Unfortunately, I also find Herz lacking in courage and moral fortitude. Whenever some bully comes on the scene and challenges him and the FASB to a fight, he runs away. When accounting truth is at stake, he compromises and enables corporate managers to use methods and vehicles by which they can cook the books. Shame!

    The first thing the FASB did at its April 2 meeting concerns whether a market is not active and a transaction is not distressed. In this FSP FAS 157-e, the board allows business enterprises to weigh the evidence whether the a transaction involved an orderly market; in reality it will permit managers to ignore distressed conditions, some of which they themselves created, and to pretend some “value” based on normalcy. Clearly, this will buoy asset prices on the balance sheet and reduce losses or create gains on the income statement. Too bad this is fiction.

    In the second matter the FASB addressed other-than-temporary impairments. In this FSP the FASB permits managers to overlook other-than-temporary impairments if management believes that it does not have the intent to sell the security and it is more likely than not it will not have to sell the security before recovery of its cost basis. Of course, that will be just about everybody so this is a vacuous recognition condition.

    The FSP goes on to state that gains or losses due to credit risk will go into the income statement, while noncredit gains and losses will bypass the income statement and go directly into comprehensive income. This distinction appears academic as in practice it is hard to distinguish credit losses from noncredit losses. Clearly, this decision will give managers ample room to manipulate the income statement.

    The FASB got pushed into this decision and Robert Herz caved in. This isn’t the first time either. Herz became chairman after Enron’s special purpose entities exploded on Wall Street and has yet to do anything about them. These special purpose entities have also played a part in the current banking crisis. Herz also presided over the new rules on business combinations. While I applaud the elimination of the pooling option, which enabled many corporate frauds, I remain skeptical of the treatment of goodwill, which is another loophole. And Robert Herz keeps preaching against complexity and for simplicity and principles-based accounting, which are keywords to allow corporate executives the power to do as they wish with the recognition and measurement of revenues and other elements. (Bob, if these FSPs are based on any legitimate principles, pray tell us which ones.)

    Writing about these items when originally proposed, Jonathan Weil referred to the FASB as the Fraudulent Accounting Standards Board. I am sympathetic with his f-word, but I think it may be too harsh. After all, the board is “merely” allowing managers to commit fraud without facing any disincentives. But I think there are other f-words that we could employ, such as fearful, feckless, and futile.

    Mr. Herz, please resign. You are making the board ineffective as a standard bearer for accounting truth. While I think you have a sense of right and wrong, you are not willing to hold bankers accountable for their mistakes and you are not willing to stand up against politicians who favor lies.

    This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

    Jensen Comment
    Jonathon Weil was a prominent WSJ reporter during the Enron scandal
    "GLASS LEWIS NAMED JONATHAN WEIL MANAGING DIRECTOR AND EDITOR OF FINANCIAL RESEARCH in 2006 ---
    http://www.glasslewis.com/downloads/354-38.pdf

    The idea that massive changes have been made is a huge overstatement. FASB is basically reiterating what it has said all along. A number of comments from both bank insiders and analysts indicate that no material changes have been made,  . . . Estimates vary but it seems MTM changes won’t have as big an impact as some would like to believe. Remember, as Jim Chanos pointed out, the vast majority of bank assets such as ordinary loans, are NOT marked to market and that the delinquencies on almost all classes of loans continue to rise. Thus relaxing mark to market will not help stop the rising delinquencies across a wide swathe of bank assets. The idea that giving bank executives more leeway in how they price their assets when a large part of the current problems is a lack of transparency is laughable.
    "Latest on Mark to Market Scapegoat," The Fundamental Analyst, on April 2, 2009 --- http://www.thefundamentalanalyst.com/?p=1145

    Jensen Comment
    Although I tend to agree that the FASB's April 2, 2009 change was not that much of a change at all since Level 3 value estimates could come from subjective estimates of future streams of cash flows. However, the problem will be that the banks themselves use this re-enforce banks to depart from market on bad debt reserves. Banks will accordingly understate bad debt reserves and overstate earnings.

     

    Bob Jensen’s threads on fair value accounting --- Bob Jensen’s threads on accounting valuation are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

     

    It's certain that FAS 157 needs some amending for broken markets, but what Isaac and Forbes are proposing serve as no basis for improvements on FAS 157. After Isaac proposed elimination of fair value accounting for troubled banks, Congress ordered, in no uncertain terms, the SEC to do a research study on what was causing so many bank failures like the huge failures of WaMu and Indy Mac. Although the SEC has been disgraced for a lot of reasons as of late, the particular study that emerged in a very short period of time (December 2008) is an excellent study of why banks were failing.

    In particular, beginning on Page 100 of the study the SEC reports on why 22 large-size, medium-size, and small-size banks failed. It turns out that most assets and liabilities of banks are not marked to market in the first place. Secondly, fair value adjustments downward has not been the problem of recent bank failures. The problem is non-performing loans, dangerous management of financial risk, fraud in property valuations (which was especially bad at WaMu), and terrible management in general.

    If you want to blame accountants, blame the auditors for not raising going concern questions about the failed banks --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
    Blame them for badly understating bad debt reserves.
    But don't blame them or the FASB/IASB standard setters for fair value accounting.
    And this is from an old accounting professor who favors fair value accounting for financial and derivative financial instruments but fights against fair value accountign for non-financial instruments --- http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    I'll bet you 99-1 odds that Steve Forbes never read this excellent SEC study:
    "Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting"
    The full report can be freely downloaded at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf. (pdf)

     


    Banking industry pressures to abandon fair value accounting are summarized at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     

     


    How to play tricks on fair value accounting by "managing" the closing price of key securities in the portfolio
    Painting the Tape (also called Banging the Close)
    This occurs when a portfolio manager holding a security buys a few additional shares right at the close of business at an inflated price. For example, if he held shares in XYZ Corp on the last day of the reporting period (and it's selling at, say $50), he might put in small orders at a higher price to inflate the closing price (which is what's reported). Do this for a couple dozen stocks in the portfolio, and the reported performance goes up. Of course, it goes back down the next day, but it looks good on the annual report.
    Jason Zweig, "Pay Attention to That Window Behind the Curtain," The Wall Street Journal, December 20, 2008 --- http://online.wsj.com/article/SB122973369481523187.html?

    Bob Jensen's threads on earnings management are at http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    Bob Jensen's "Rotten to the Core" document --- http://faculty.trinity.edu/rjensen/FraudRotten.htm


    Question
    What recent 3-2 FASB vote riles the feathers of Tom Selling with innuendos that the banking industry and large accounting firms had too much influence on a vote that was not in the best interests of accounting transparency for investors?

    A "Who Done It?"
    "FSP EITF 99-20-1: Dissenting Board Members Hit the Nail on the Head," by Tom Selling, The Accounting Onion, January 14, 2009 --- http://accountingonion.typepad.com/theaccountingonion/2009/01/fsp-eitf-99-20.html
    Jensen Comment
    I perform the despicable deed of (almost) revealing the ending of his mystery to those who've not yet read the mystery. What must our students think?

    About Those Brave Dissenters

    And, who were those masked men (or woman)? If I give you a list of the current FASB members along with a brief description of their backgrounds, I'm betting you can guess correctly, even without knowing anything else about them:

    * Robert Herz -- former ...

    * Thomas Linsmeier -- former ...

    * Leslie Seidman -- former ...

    * Marc Siegel -- a recognized ...

    * Lawrence Smith -- former ...

    They are X and Y, of course -- the only two who did not spend the bulk of their careers serving corporate clients. And incidentally, they are the two most recent additions to the FASB.

    The likes of X and Y give me some hope for the future of standard setting following the second major financial reporting crisis of the decade. If we could somehow get just one more on the board like them, the SEC's recommendations to the FASB can become a reality long before the IASB gets its act together.

    January 17, 2009 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    Like most accounting issues, reasonable people can disagree on the best accounting for this situation. For example, I refer readers to comment letter 7 on this FASB project written by yours truly. The letter agrees with the majority FASB position and further explains why the current "other than temporary impairment" model ought to be reconsidered by the FASB. The SEC staff took a similar position in its recent report on fair value accounting.

    Not to disparage Tom's well considered views on this matter, but I would also observe that those disagreeing with the output of the process might have more influence on the process by expressing their views directly to the FASB or other standard setting body.

    Denny Beresford

    January 18, 2009 reply from Bob Jensen

    I do understand that the FASB is well intended, but I did hate to see it reduce such power to three people no matter what the issue.

    I think where I agree with Tom is the strong wording of the two that dissented this time.

    January 18, 2009 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    Bob,

    You've raised two separate issues:

    1 - Whether new standards should require a larger number of board members or a higher number of votes before becoming effective.

    2 - Whether the dissenters present more compelling arguments (in your view) for their position than do the assenters for the final position taken by the FASB.

    As you know, the size of the FASB was reduced to five members last year after having been comprised of seven members from the beginning of the Board. The FAF Trustees made this change after due process and there were arguments for and against. I was in favor of the change primarily because it allows the Board to be more efficient and reach conclusions more quickly rather than the past practice of working on some issues "forever." I also note that, with only five members, the present members from the user and academic community have more influence (2 of 5 votes) than they did under the old system (2 of 7 votes).

    The voting requirement has changed several times - majority vs. super majority. I served under both regimes and don't believe that it made much difference. In almost all cases I can remember, the Board would have acted on a final standard regardless of the voting requirement. The bare majority rule just allowed one more member to get on his/her soapbox and express a personal view that often didn't affect the overall conclusion but rather one or more of the technical details.

    So my question to you and others is should the Trustees reconsider the composition of the Board to change the size again, change the voting requirement again, or change the composition of the Board by choosing members with different backgrounds? I know there has been a fair amount of research on the effect of voting requirements but I'm not aware of any such research that presents a compelling reason for one approach or the other. The size of the Board is a new development and, again, I'm sure there are research opportunities available. And, of course, individuals can always weigh in with their personal opinions on these matters regardless of supporting research.

    On the second point above about whose opinions should prevail, that seems to be the purpose of a standard setting process that has been thoroughly considered and agreed to by those with interest in the process. In other words, once interested parties have bought into the idea that having standards is likely to improve the quality of financial reporting and that the system for developing those standards is reasonable, then those parties should be willing to accept the results of the system. I'm a pragmatist and always felt that the financial markets were better served by having some accounting standards even if those standards aren't perfect (and who can judge that?). Thus, I only dissented a couple of times during my time as Chairman. And even in those cases I thought it was better that the Board issued a new standard than not, even if I would have preferred a different approach. Since leaving the Board over 11 years ago I have continued to write comment letters because I am passionate about financial accounting and have personal views on most of the topics. Often I've disagreed with the Board but I'm happy to have at least had the chance to participate and I can cite at least a few cases where changes were made as a result of my (and others') comments on a particular issue.

    I've always been surprised that so few academics participated in the FASB's process and I wrote about that at least a couple of times while at the Board. And the situation is actually a bit better these days as the AAA financial reporting committee and some individual professors do contribute. But there is plenty of room for further improvement.

    Sorry for getting a little carried away on this. I need to get back to my weekend reading.

    Denny Beresford


    European-Styled Avoidance of Fair Value Earnings Hits for Loan Loss Impairments

    European banks circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

    European banks resorted to a number of misleading ploys to avoid taking fair value adjustment hits to prevent earnings hits due to required fair value adjustments of investments that crashed such a investments in the bonds of Greece, Ireland, Spain, and Portugal.

    The Market Transitory Movements Argument
    Fair value adjustments can be avoided if they are viewed as temporary transitory market fluctuations expected to recover rather quickly. This argument was used inappropriately by European banks hold billions in the Greece, Ireland, Spain, and Portugal after the price declines could hardly be viewed as transitory. The head of the IASB at the time, David Tweedie, strongly objected to the failure to write down financial instruments to fair value. The banks, in turn, threatened to pressure the EU lawmakers to override the IFRS 9 requirement to adjust such value declines to market.

    One of the major concerns of the  is that some nations at some points in time will simply not enforce the IASB standards that these nations adopted. The biggest problem that the IASB was having with European Banks is that the IASB felt many of many (actually most) EU banks were not conforming to standards for marking financial instruments to market (fair value). But the IASB was really helpless in appealing to IFRS enforcement in this regard.

    When the realities of European bank political powers, the IASB quickly caved in as follows with a ploy that allowed European banks to lie about intent to hold to maturity. The banks would probably love to unload those loser bonds as quickly as possible before default, but they could instead claim that these investments were intended to be held to maturity --- a game of make pretend that the IASB went along with under the political circumstances.

    "New accounting rule would ease Greek pain: IASB," By Silke Koltrowitz and Huw Jones,  Reuters, July 5, 2011 ---
    http://www.reuters.com/article/2011/07/05/us-accounting-idUSTRE7643WU20110705

    European Union banks would have more breathing space from losses on Greek bonds if the bloc adopted a new international accounting rule, a top standard setter said on Tuesday.

    The International Accounting Standards Board (IASB) agreed under intense pressure during the financial crisis to soften a rule that requires banks to price traded assets at fair value or the going market rate.

    This led to huge writedowns, sparking fire sales to plug holes in regulatory capital.

    The new IFRS 9 rule would allow banks to price assets at cost if they are being held over time.

    The European Commission has yet to sign off on the new rule for it to be effective in the 27-nation bloc, saying it wants to see remaining parts of the rule finalized first.

    Continued in article

     

    Dynamic Provisioning:  The Cookie Jar Argument If Banks Had Cookies in the Jar
    European Union officials knew this and let Spain proceed with its own brand of accounting anyway.
    "The EU Smiled While Spain’s Banks Cooked the Books," by Jonathan Weil, Bloomberg, June 14, 2012 ---
    http://www.bloomberg.com/news/2012-06-14/the-eu-smiled-while-spain-s-banks-cooked-the-books.html

    Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.

    But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.

    By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.

    This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.

    What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia (BKIA) group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.

    Name Calling

    Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.

    “Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”

    The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.

    One of the more candid advocates of Spain’s approach was Charlie McCreevy, the EU’s commissioner for financial services from 2004 to 2010, who previously had been Ireland’s finance minister. During an April 2009 meeting of the monitoring board that oversees the International Accounting Standards Board’s trustees, McCreevy said he knew Spain’s banks were violating the board’s rules. This was fine with him, he said.

    “They didn’t implement IFRS, and our regulations said from the 1st January 2005 all publicly listed companies had to implement IFRS,” McCreevy said, according to a transcript of the meeting on the monitoring board’s website. “The Spanish regulator did not do that, and he survived this. His banks have survived this crisis better than anybody else to date.”

    Ignoring Rules

    McCreevy, who at the time was the chief enforcer of EU laws affecting banking and markets, went on: “The rules did not allow the dynamic provisioning that the Spanish banks did, and the Spanish banking regulator insisted that they still have the dynamic provisioning. And they did so, but I strictly speaking should have taken action against them.”

    Why didn’t he take action? McCreevy said he was a fan of dynamic provisioning. “Why am I like that? Well, I’m old enough to remember when I was a young student that in my country that I know best, banks weren’t allowed to publish their results in detail,” he said. “Why? Because we felt if everybody saw the reserves, etc., it would create maybe a run on the banks.”

    So to sum up this way of thinking: The best system is one that lets banks hide their financial condition from the public. Barring that, it’s perfectly acceptable for banks to violate accounting standards, if that’s what it takes to navigate a crisis. The proof is that Spain’s banks survived the financial meltdown of 2008 better than most others.

    Continued in article

    "Accounting Board Criticizes European Banks on Greek Debt," REUTERS, August 30, 2011 ---
    http://www.nytimes.com/2011/08/31/business/global/accounting-board-criticizes-european-banks-on-greek-debt.html 

    Some European financial institutions should have booked bigger losses on their Greek government bond holdings in recent results announcements, the International Accounting Standards Board said in a letter to market regulators.

    The criticism comes as Europe’s lenders face calls to shore up their balance sheets and restore confidence to investors unnerved by the euro zone debt crisis, funding market jitters and a slowing economy.

    In a letter addressed to the European Securities and Markets Authority, the I.A.S.B. — which aims to become the global benchmark for financial reporting — criticized inconsistencies in the way banks and insurers wrote down the value of their Greek sovereign debt in second-quarter earnings.

    It said “some companies” were not using market prices to calculate the fair value of their Greek bond holdings, relying instead on internal models. While some claimed this was because the market for Greek debt had become illiquid, the I.A.S.B. disagreed.

    “Although the level of trading activity in Greek government bonds has decreased, transactions are still taking place,” the board chairman Hans Hoogervorst wrote.

    The E.S.M.A. was not immediately available for comment.

    The letter, which was posted on the I.A.S.B.’s website Tuesday after being leaked to the press, did not single out particular countries or banks.

    European banks taking a €3 billion, or $4.2 billion, hit on their Greek bond holdings earlier this month employed markedly different approaches to valuing the debt.

    The writedowns disclosed in their quarterly results varied from 21 to 50 percent, showing a wide range of views on what they expect to get back from their holdings.

    A 21 percent hit refers to the “haircut” on banking sector involvement in a planned second bailout of Greece now being finalized. A 50 percent loss represented the discount markets were expecting at the end of June, the cut-off period for second-quarter results.

    Two French financial companies, the bank BNP Paribas and insurer CNP Assurances, on Tuesday defended their decision to use their own valuation models rather than market prices.

    “BNP took provisions against its Greece exposure in full agreement with its auditors and the relevant authorities, in accordance with the plan decided upon by the European Union on July 21,” a bank spokeswoman said.

    A CNP spokeswoman said the group’s Greek debt provisions had been calculated in accordance with the E.U. plan and in agreement with its auditors.

    Some investors see the issue as serious, however, even if the STOXX Europe 600 bank index was trading higher on Tuesday.

    “The Greek debt issue has been treated very lightly,” said Jacques Chahine, head of Luxembourg-based J. Chahine Capital, which manages €320 billion in assets. “And it’s not just Greek debt — all of it needs to be written down, Spain, Italy.”

    The E.S.M.A. was unable to impose a uniform Greek “haircut” across the E.U. and its guidance published at the end of July simply stressed the need for banks to tell investors clearly how they reflect Greek debt values.

    The I.A.S.B. also has no powers of enforcement in how banks book impairments but is keen to show the United States, which decides this year whether to adopt I.A.S.B. standards, that its rules are consistent and properly represent what’s happening in markets.

    Auditors warned at the time against a patchwork approach that will confuse investors and concerns over Greek haircut reporting will fuel calls for a pan-Europe auditor regulator.

    “The impact is more likely to be to further reduce investors’ confidence in buying bank debt, rather than sovereign debt,” said Tamara Burnell, head of financial institutions/sovereign research at M&G.

    Using the most aggressive markdown approach — namely marking to market all Greek sovereign holdings — would saddle 19 of the most exposed European banks with another €6.6 billion in potential writedowns, according to Citi analysts.

    BNP would take the biggest hit with €2.1 billion in remaining writedowns, followed by Dexia in Belgium with €1.9 billion and Commerzbank in Germany with €959 million, Citi said.

    The European Commission said on Monday that there was no need to recapitalize the banks over and above what had been agreed after a recent annual stress test .

    Spinning Debt Into Earnings With the Wave of a Fair Value Accounting Wand
    "Euro banks' £169bn in accounting alchemy," by: Lindsey White, Financial Times Advisor, January 19, 2009 --- Click Here

    European banks conjured more than £169bn of debt into profit on their balance sheets in the third quarter of 2008, a leaked report shows.

    Money Managementhas gained exclusive access to a report from JP Morgan, surveying 43 western European banks.

    It shows an exact breakdown of which banks increased their asset values simply by reclassifying their holdings.

    Germany is Europe's largest economy, and was the first European nation to announce that it was in recession in 2008. Based on an exchange rate of 1 Euro to £0.89, its two largest banks, Deutsche Bank and Commerzbank, reclassified £22.2bn and £39bn respectively.

    At the same exchange rate, several major UK banks also made the switch. RBS reclassified £27.1bn of assets, HBOS reclassified £13.7bn, HSBC reclassified £7.6bn and Lloyds TSB changed £3.2bn. A number of Nordic and Italian banks also switched debts to become profits.

    Banks are allowed to rearrange these staggering debts thanks to an October 2008 amendment to an International Accounting Standards law, IAS 39. Speaking to MM, IAS board member Philippe Danjou said that the amendment was passed in "record time".

    The board received special permission to bypass traditional due process, ushering through the amendment in a matter of days, in order to allow banks to apply the changes to their third quarter reports.

    However, it is unclear how much choice the board actually had in the matter.

    IASB chairman Sir David Tweedie was outspoken in his opposition to the change, publicly admitting that he nearly resigned as a result of pressure from European politicians to change the rules.

    Danjou also admitted that he had mixed views on the change, telling MM, "This is not the best way to proceed. We had to do it. It's a one off event. I'd prefer to go back to normal due process."

    While he was reluctant to point fingers at specific politicians, Danjou admitted that Europe's "largest economies" were the most insistent on passing the change.

    As at December 2008, no major French, Portuguese, Spanish, Swiss or Irish banks had used the amendment.

    BNP Paribas, Credit Agricole, Danske Bank, Natixis and Societe Generale were expected to reclassify their assets in the fourth quarter of 2008.

    The amendment was passed to shore up bank balance sheets and restore confidence in the midst of the current credit crunch. But it remains to be seen whether reclassifying major debts is an effective tactic.

    "Because the market situation was unique, events from the outside world forced us to react quickly," said Danjou. "We do not wish to do it too often. It's risky, and things can get missed."

    Jensen Comment
    European banks thus circumvented earnings hits for anticipated billions in loan losses by a number of ploys, including arguments regarding transitory price movements, "dynamic provisioning" cookie jar accounting, and spinning debt into assets with fair value adjustments "accounting alchemy."

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue


    Financial vs. Non-financial Asset and Liability Valuation Controversies
    It's worrisome that the FASB and the IASB are dead set on fair values for both types of items.

    I'm sure that virtually every accounting professor is cognizant of the fact that there is a huge difference between fair value accounting of financial assets and fair value accounting of non-financial assets.

    Exit values of financial assets/liabilities are consistent with the "best use" condition of FAS 157 since they tend to have low covariance values due to synergy, goodwill, reputation, etc. Piecemeal liquidation in most instances is the optimal use for financial items. Thus I tend to favor exit values for financial items, although thin or non-existent markets create enormous problems for FAS 157 valuations. Non-stationary systems virtually rule out Box Jenkins and other time series models. You can read more about these problems at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue  

    Exit values of non-financial assets are inconsistent with the "best use" condition of FAS 157 since they tend to have high covariance values due to synergy, goodwill, reputation, etc. Piecemeal liquidations of exit values are almost always the most non-optimal uses of most non-financial items.

    Entry value (replacement cost, current cost) accounting (such as was once required in FAS 33) in my viewpoint is not a good alternative for non-financial assets since it is so complicated to estimate entry values of unlike assets. For example, if a company is replacing 2,000 laptops purchased in 1998 with laptops purchased in 2008, these are totally different assets in terms of capacity and functionality and usage, such as usage in networking and multimedia.

    Also see The Bull Crap Case --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting


    Question
    How much can the history of accounting theory provide guidance to the bailout mess in 2009?

    February 12, 2009 question from a reader

    Bob

    One of your web pages had the following excerpt.

    “Zane Swanson

    November 25, 2008 reply from Bob Jensen

    Hi Zane,

    There are almost always warnings under most any accounting system. The Paton and Littleton 1940 model required estimation of bad debts.”

    Could you please tell me what the origin of the statement about Paton & Littleton?

    I am doing some expert witness work and I might try to show off to the judge, lawyer (or attorneys as you would say) permitting.

    XXXXX

    February 13, 2009 reply from Bob Jensen

    I was referring to what I think was audit failure on the part of bank auditors to properly warn investors about the default risks in the millions of toxic mortgage investments and CDOs that they sold subject to sale back or other assurance provisions --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
    In my opinion, auditors given clean audit opinions for years to banks that were known to be notorious in underestimating bad debts. The present calamity, however, could bring down our best known international auditing firms --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

    W.A. Paton and A.C. Littleton's 1940 monograph, An Introduction to Corporate Accounting Standards
    Zhiyan Cao at Yale provides an interesting review --- http://www.som.yale.edu/Faculty/sunder/Phdaccountingcontrol/PatonLittletonCao.pdf

     

    On page 55 Paton and Littleton advocate setting up bad debt reserves for matching purposes, i.e., to match the revenues against revenue losses that won’t be recovered.

    On page 123 Paton & Littleton argue against current value adjustments for primary statements but seem to argue on Page 124 that replacement cost adjustments might be desirable for internal operating decisions. On Page 124 they also concede that current value or replacement cost adjustments might be reported “if conditions are such as to make this clearly helpful.” (Page 125) They also claim that parenthetic display values alongside historical costs may be a good idea, particularly for marketable securities.

    The concept of conservatism is conceded on Page 128 but only weakly since the Paton & Littleton focus was on the income statement more than the balance sheet.

    Paton later asserted that the association of his name with this 1940 monograph was a “damn fool thing to do.” Zeff calls Paton in later years "a value man" --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=956163

    Although Littleton clung to the monograph’s theory to the day he died, Paton became a strong advocate of replacement cost (economic) accounting. His earlier work such as his book Accounting Theory in 1922 on Page 442 is more equivocal but he does talk about “the conjectural character of asset values at best and the consequent importance of conservatism …” On Page 407 he states that an extraordinary collapse of values of receivables must be recognized but that they should be reported in a way that differs from the usual bad debt reporting (as a deduction from gross sales).

    Hatfield in Modern Accounting in1909 on Page 84 states “reaction against overvaluation is but natural and in general healthful.” But he also argues against undervaluation for the sole purpose of conservatism is unhealthy since it becomes tempting to set up secret reserves

    It would seem that accounting theorists in the past century never really envisioned the problem of securitization and fraudulent valuation of investment collateral. Hatfield in 1909 (pp. 82-83) strongly argues against exit values in “forced sales” when a firm is deemed a going concern. He argues instead for “going concern” values that do not move up and down with transitory market value fluctuations. But what if an investment of a collateralized security has a receivable significantly in excess of the value of the collateral in foreclosure? The security is not necessarily a bad debt if the borrower does not walk away and continues to make payments. For example, my home and land value is now below my mortgage balance but I’m not about to move out and stop making payments. Hence, the owner of my mortgage probably should not write down the investment in my mortgage. With other borrowers, there clearly is more risk giving rise to what we call “toxic” investments of banks and Fannie and Freddie.

    Writers like Paton, Littleton, and Hatfield just never envisioned the type of massive fraud in the overstatement of collateral value when millions upon millions of mortgages were brokered across the United States in the early 21st Century. There are many possible scenarios for a given investment in such mortgages by a bank that ended up with possible mortgage investments deemed to be toxic:

    1. Many debtors ignore the fact that home values are currently below settlement values and continue to make payments, thereby making the “going concern” values of these investments considerably higher than “forced sale” exit values.

       
    2. Many debtors cannot or will not continue to make full monthly payments at contractual rates but are willing to negotiate lower interest rates and possibly extended maturity dates before deciding to stop payments altogether and surrender to foreclosure. In the United States in early 2009 there is considerable pressure on giant bailed out banks to renegotiate rather than foreclose on such debtors.

       
    3. Many debtors walk away and willingly surrender to foreclosure values that in “forced sales” that fall way short of settlement balances of their mortgages. In doing so they may destroy their credit ratings, but this does not prevent some of them from walking away from their mortgage contracts. This does not mean that the mortgage holder will succumb to a forced sale on each foreclosed property. A going concern might decide to incur the costs of ownership, and possibly even rent the property, until the property values increase substantially. A going concern might decide to negotiate the sale to government at a price that is higher than the forced sale price in a highly distressed real estate market. If the government has not yet decided if it will buy such toxic mortgages and how much it will pay, then this valuation is highly uncertain.

       
    4. Many debtors make only partial payments or zero payments but decline to move out until law enforcement pushes them out to the streets. These people often are hoping that they will get relief from the government or the mortgage holder before being forced to move.

     

    Cases 2, 3, and 4 valuations are contingent upon intent of the mortgage holder, actions of the debtor, and actions of the government, all of which are probably unknown at the balance sheet date. It is also dependent upon whether the mortgage holder (e.g., a troubled bank) is indeed a going concern. If the bank has not yet declared bankruptcy and its auditor questions whether it is a going concern, U.S. GAAP currently prescribes realistic exit values, which in some instances may be very low “forced sale” estimates.

    I don’t think Hatfield, Paton, Littleton, and other early accounting theorists envisioned such complex valuation problems that jointly depend upon renegotiation uncertainties with debtors, unknown terms of government buyouts of toxic mortgages, foreclosure alternatives given to banks that accept billions in bailout funds, unknown settlements with mortgage brokers that sold fraudulent mortgages to the banks, risks of lawsuits from buyers of re-bundled credit default obligations (CDOs) sold by the banks to third parties, many of which are in other countries, unsettled credit derivative swap insurance settlements, and the goodwill losses from publicity that poor families are being turned out to the mean streets by bankers who got millions themselves in bonuses.

    These are unprecedented times that were never anticipated back in the simple days of finance and commerce prior to the 1980s when financial structurings and derivative financial contracting commenced to become unbelievably complex. There are limits beyond which accounting theory of the past just does not suffice in toxic financial worlds having immense uncertainty.

    Add to this the complaint that fair value (mark-to-market) accounting was a major, if not the major, cause of the collapse of the banking system and mounting political pressures to abandon current fair value accounting options or requirements and you have one royal mess --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    Bob Jensen’s summary of fair value controversies are at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

     

     

     


     


     

    Marvene is a poor and unemployed elderly woman who lost her shack to foreclosure in 2008.
    That's after Marvene stole over $100,000 when she refinanced her shack with a subprime mortgage in 2007.
    Marvene wants to steal some more or at least get her shack back for free.
    Both the Executive and Congressional branches of the U.S. Government want to give more to poor Marvene.
    Why don't I feel the least bit sorry for poor Marvene?
    Somehow I don't think she was the victim of unscrupulous mortgage brokers and property value appraisers.
    More than likely she was a co-conspirator in need of $75,000 just to pay creditors bearing down in 2007.
    She purchased the shack for $3,500 about 40 years ago --- http://online.wsj.com/article/SB123093614987850083.html

     


    Marvene Halterman, an unemployed Arizona woman with a long history of creditors, took out a $103,000 mortgage on her 576 square-foot-house in 2007. Within a year she stopped making payments. Now the investors with an interest in the house will likely recoup only $15,000.
    The Wall Street Journal slide show of indoor and outdoor pictures --- http://online.wsj.com/article/SB123093614987850083.html#articleTabs%3Dslideshow
     

    Jensen Comment
    The $15,000 is mostly the value of the lot since at the time the mortgage was granted the shack was virtually worthless even though corrupt mortgage brokers and appraisers put a fraudulent value on the shack. Bob Jensen's threads on these subprime mortgage frauds are at http://faculty.trinity.edu/rjensen/2008Bailout.htm
    Probably the most common type of fraud in the Savings and Loan debacle of the 1980s was real estate investment fraud. The same can be said of the 21st Century subprime mortgage fraud. Welcome to fair value accounting that will soon have us relying upon real estate appraisers to revalue business real estate on business balance sheets --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    CEO to his accountant:  "What is our net earnings this year?"
    Accountant to CEO:  "What net earnings figure do you want to report?"

    The sad thing is that Lehman, AIG, CitiBank, Bear Stearns, the Country Wide subsidiary of Bank America, Fannie Mae, Freddie Mac, etc. bought these
    subprime mortgages at face value and their Big 4 auditors supposedly remained unaware of the millions upon millions of valuation frauds in the investments. Does professionalism in auditing have a stronger stench since Enron?
    Where were the big-time auditors? --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

     


    Question
    Can we put the following quotations to a test in a logic course in the philosophy department?

    "Some Lessons of the Financial Crisis," by Stephen Schwarzman, The Wall Street Journal, November 4, 2008 --- http://online.wsj.com/article/SB122576100620095567.html?mod=djemEditorialPage

    Third, you need full transparency for financial statements. Nothing should be eliminated. Off-balance-sheet vehicles that suddenly return to the balance sheet to wreak havoc make a mockery of principles of disclosure.

    Fourth, you need full disclosure of all financial instruments to the regulator. No regulator can do its job of assessing risk and systemic soundness if large parts of the financial markets are invisible to it. A regulator must be able to monitor all derivatives, including, for example, $60 trillion in credit default swaps.

     

    Sixth, we need to abolish mark-to-market accounting for hard-to-value assets. There is now emerging a broad realization that mark-to-market accounting has exacerbated the current crisis. We are not talking about publicly traded equities with a readily ascertainable value. The problem involves securities held for investment purposes, and those instruments during certain times of the cycle for which there is no readily observable market. These securities and instruments would be fully disclosed to the regulator. However, a financial institution would not be forced to suddenly take huge write downs at artificial, fire-sale prices and thus contribute to financial instability.

    Bob Jensen's threads on a bull crap case against fair value accounting are at http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    Bob Jensen's threads on earnings management are at http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation


    In these hard times, how many going concern doubts will force auditors to shift from going concern GAAP to exit value GAAP with going concern doubts expressed in the audit opinions? Also will broken markets for toxic securities, how will exit values be estimated?

    From The Wall Street Journal's Accounting Weekly Review on December 12, 2008

    AIG Faces $10 Billion in Losses on Bad Bets
    by Serena Ng, Carrick mollenkamp, and Michael Siconolfi
    The Wall Street Journal

    Dec 10, 2008
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB122887203792493481.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Derivatives, Disclosure, Financial Accounting

    SUMMARY: While the article states that AIG faces a potential additional $10 billion in losses on speculative derivatives, the figure actually represents the underlying notional amount of the derivative. AIG responded to the front page article. Their response is listed as a related article. It references disclosure explaining the $10 billion underlying notional amount on page 117 of the 10-Q for the quarter ended September 30, 2008.

    CLASSROOM APPLICATION: The article covers issues related to complex derivative transactions.

    QUESTIONS: 
    1. (Introductory) With respect to derivative securities, what is an underlying notional amount? Give an example of a notional amount in the context of a specific derivative security.

    2. (Advanced) The headline of the article says that AIG faces $10 billion losses on trades. AIG responded in the related article to say that the $10 billion is an underlying notional amount on derivative securities. Is it possible that AIG will face an additional $10 billion in payments related to this amount?

    3. (Introductory) What is the difference between using derivative securities to speculate and using them for hedging? In your answer, define these two terms.

    4. (Advanced) "The $10 billion...stems from...AIG's exposure to speculative investments...which were essentially bets on the performance of bundles of derivatives linked to subprime mortgages, commercial real-estate bonds and corporate bonds." Based on the description in the article, why are these speculative investments not "covered" by the government bailout assistance given to AIG?

    5. (Advanced) In the related article, AIG refers to disclosures on page 117 of its 10-Q filing for the quarter ended September 30, 2008. Refer to the disclosures on that page. What events cause AIG to incur losses and cash payments to counterparties on these securities? Does this description change your answer to question 2?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    AIG Responds to Wall Street Journal Story
    by WSJBlog
    Dec 10, 2008
    Online Exclusive

    "AIG Faces $10 Billion in Losses on Bad Bets," The Wall Street Journal, by Serena Ng, Carrick mollenkamp, and Michael Siconolfi, The Wall Street Journal, December 10, 2008 --- http://online.wsj.com/article/SB122887203792493481.html?mod=djem_jiewr_AC

    American International Group Inc. owes Wall Street's biggest firms about $10 billion for speculative trades that have soured, according to people familiar with the matter, underscoring the challenges the insurer faces as it seeks to recover under a U.S. government rescue plan.

    The details of the trades go beyond what AIG has explained to investors about the nature of its risk-taking operations, which led to the firm's near-collapse in September. In the past, AIG has said that its trades involved helping financial institutions and counterparties insure their securities holdings. The speculative trades, engineered by the insurer's financial-products unit, represent the first sign that AIG may have been gambling with its own capital.

    The soured trades and the amount lost on them haven't been explicitly detailed before. In a recent quarterly filing, AIG does note exposure to speculative bets without going into detail. An AIG spokesman characterizes the trades not as speculative bets but as "credit protection instruments." He said that exposure has been fully disclosed and amounts to less than $10 billion of AIG's $71.6 billion exposure to derivative contracts on debt pools known as collateralized debt obligations as of Sept. 30.

    AIG's financial-products unit, operating more like a Wall Street trading firm than a conservative insurer selling protection against defaults on seemingly low-risk securities, put billions of dollars of the company's money at risk through speculative bets on the direction of pools of mortgage assets and corporate debt. AIG now finds itself in a position of having to raise funds to pay off its partners.

    The fresh $10 billion bill is particularly challenging because the terms of the current $150 billion rescue package for AIG don't cover those debts. The structure of the soured deals raises questions about how the insurer will raise the funds to pay the debts. The Federal Reserve, which lent AIG billions of dollars to stay afloat, has no immediate plans to help AIG pay off the speculative trades.

    The outstanding $10 billion bill is in addition to the tens of billions of taxpayer money that AIG has paid out over the past 16 months in collateral to Goldman Sachs Group Inc. and other trading partners on trades called credit-default swaps. These instruments required AIG to insure trading partners, known on Wall Street as counterparties, against any losses in their holdings of securities backed by pools of mortgages and other assets. With the value of those mortgage holdings plunging in the past year and increasing the risk of default, AIG has been required to put up additional collateral -- often cash payments.

    AIG's problem: The rescue plan calls for a company funded largely by the Federal Reserve to buy about $65 billion in troubled CDO securities underlying the credit-default swaps that AIG had written, so as to free AIG from its obligations under those contracts. But there are no actual securities backing the speculative positions that the insurer is losing money on. Instead, these bets were made on the performance of pools of mortgage assets and corporate debt, and AIG now finds itself in a position of having to raise funds to pay off its partners because those assets have fallen significantly in value.

    The Fed first stepped in to rescue AIG in mid-September with an $85 billion loan when the collateral demands from banks and losses from other investments threatened to send the firm into bankruptcy court. A bankruptcy filing would have created losses and problems for financial institutions and policyholders all over the world that were relying AIG to insure them against the unexpected.

    By November, AIG had used up a large chunk of the government money it had borrowed to meet counterparties' collateral calls and began to look like it would have difficulty repaying the loan. On Nov. 10 the government stepped in again with a revised bailout package. This time, the Treasury said it would pump $40 billion of capital into AIG in exchange for interest payments and proceeds of any asset sales, while the Fed agreed to lend as much as $30 billion to finance the purchases of AIG-insured CDOs at market prices.

    The $10 billion in other IOUs stems from market wagers that weren't contracts to protect securities held by banks or other investors against default. Rather, they are from AIG's exposures to speculative investments, which were essentially bets on the performance of bundles of derivatives linked to subprime mortgages, commercial real-estate bonds and corporate bonds.

    These bets aren't covered by the pool to buy troubled securities, and many of these bets have lost value during the past few weeks, triggering more collateral calls from its counterparties. Some of AIG's speculative bets were tied to a group of collateralized debt obligations named "Abacus," created by Goldman Sachs.

    The Abacus deals were investment portfolios designed to track the values of derivatives linked to billions of dollars in residential mortgage debt. In what amounted to a side bet on the value of these holdings, AIG agreed to pay Goldman if the mortgage debt declined in value and would receive money if it rose.

    As part of the revamped bailout package, the Fed and AIG formed a new company, Maiden Lane III, to purchase CDOs with a principal value of $65 billion on which AIG had written credit-default-swap protection. These CDOs currently are worth less than half their original values and had been responsible for the bulk of AIG's troubles and collateral payments through early November.

    Fed officials believed that purchasing the underlying securities from AIG's counterparties would relieve the insurer of the financial stress if it had to continue making collateral payments. The plan has resulted in banks in North America and Europe emerging as winners: They have kept the collateral they previously received from AIG and received the rest of the securities' value in the form of cash from Maiden Lane III.

    The government's rescue of AIG helped prevent many of its policyholders and counterparties from incurring immediate losses on those traditional insurance contracts. It also has been a double boon to banks and financial institutions that specifically bought protection on now shaky mortgage securities and are effectively being made whole on those positions by AIG and the Federal Reserve.

    Some $19 billion of those payouts were made to two dozen counterparties just between the time AIG first received federal government assistance in mid-September and early November when the government had to step in again, according to a confidential document and people familiar with the matter. Nearly three-quarters of that went to French bank Société Générale SA, Goldman, Deutsche Bank AG, Crédit Agricole SA's Calyon investment-banking unit, and Merrill Lynch & Co. Société Générale, Calyon and Merrill declined to comment. A Goldman spokesman says the firm's exposure to AIG is "immaterial" and its positions are supported by collateral.

    As of Nov. 25, Maiden Lane III had acquired CDOs with an original value of $46.1 billion from AIG's counterparties and had entered into agreements to purchase $7.4 billion more. It is still in talks over $11.2 billion.

    Bob Jensen's threads on previous AIG accounting fraud --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#MutualFunds

    Bob Jensen's threads on the AIG bailout of 2008 --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#MutualFunds


    "SEC Advises No Break in 'Mark' (Fair Value Accounting) Rules," by Michael R. Crittenden, The Wall Street Journal, December 31, 2008 --- http://online.wsj.com/article_email/SB123067591247143735-lMyQjAxMDI4MzMwMDYzNzA1Wj.html 

    The Securities and Exchange Commission recommended against suspending fair-value accounting rules, instead suggesting improvements to deal with illiquid markets and reducing the number of models used to measure impaired assets.

    In a 211-page report to U.S. lawmakers, as expected, the agency's staff Tuesday definitely recommended that fair-value and mark-to-market not be eliminated or suspended. "The abrupt elimination of fair value and market-to-market requirements would erode investor confidence," the report said.

    The banking lobby has argued that financial institutions have been forced to write off as losses still-valuable assets because the market for them had dried up, creating a spiral of write-downs and asset sales.

    The report said that staff found no evidence to suggest that the accounting rules had played a significant role in the collapse of U.S. financial institutions. "While the application of fair value varies among these banks...in each case studied it does not appear that the application of fair value can be considered to have been a proximate cause of the failure," the report said.

    Additionally, the SEC suggests that the Financial Accounting Standards Board narrow the number of accounting models firms can use to assess the impairment for financial instruments.

    Denny Beresford forwarded the above link and recommends that all accounting educators read the full 259 page SEC report that was mandated by Congress --- http://www.sec.gov/news/studies/2008/marktomarket123008.pdf

    Jensen Comment
    The above report makes a good case for financial asset and liability fair value accounting, but does not make a case for similar accounting of non-financial items in a going concern.

    Banking industry pressures to abandon fair value accounting are summarized at
    http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting


    Agency Theory Question
    Why do corporate executives like fair value accounting better than shareholders like fair value accounting?

    Answer
    Cash bonuses on the upside are not returned after the downturn that wipes out the previous unrealized paper profits.

    Phantom (Unrealized) Profits on Paper, but Real Cash Outflows for Employee Bonuses and Other Compensation
    Rarely, if ever, are they forced to pay back their "earnings" even in instances of earnings management accounting fraud

    "On Wall Street, Bonuses, Not Profits, Were Real," by Louise Story, The New York Times, December 17, 2008 --- http://www.nytimes.com/2008/12/18/business/18pay.html?partner=permalink&exprod=permalink

    "Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

    “As a result of the extraordinary growth at Merrill during my tenure as C.E.O., the board saw fit to increase my compensation each year.”

    — E. Stanley O’Neal, the former chief executive of Merrill Lynch, March 2008

    For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.

    The difference between the two amounts was his bonus, a rich reward for the robust earnings made by the traders he oversaw in Merrill’s mortgage business.

    Mr. Kim’s colleagues, not only at his level, but far down the ranks, also pocketed large paychecks. In all, Merrill handed out $5 billion to $6 billion in bonuses that year. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.

    But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

    Unlike the earnings, however, the bonuses have not been reversed.

    As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.

    Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning.

    “Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”

    Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.

    “That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.

    The highest-ranking executives at four firms have agreed under pressure to go without their bonuses, including John A. Thain, who initially wanted a bonus this year since he joined Merrill Lynch as chief executive after its ill-fated mortgage bets were made. And four former executives at one hard-hit bank, UBS of Switzerland, recently volunteered to return some of the bonuses they were paid before the financial crisis. But few think others on Wall Street will follow that lead.

    For now, most banks are looking forward rather than backward. Morgan Stanley and UBS are attaching new strings to bonuses, allowing them to pull back part of workers’ payouts if they turn out to have been based on illusory profits. Those policies, had they been in place in recent years, might have clawed back hundreds of millions of dollars of compensation paid out in 2006 to employees at all levels, including senior executives who are still at those banks.

    A Bonus Bonanza

    For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses. Bonus season became an annual celebration of the riches to be had in the markets. That was especially so in the New York area, where nearly $1 out of every $4 that companies paid employees last year went to someone in the financial industry. Bankers celebrated with five-figure dinners, vied to outspend each other at charity auctions and spent their newfound fortunes on new homes, cars and art.

    The bonanza redefined success for an entire generation. Graduates of top universities sought their fortunes in banking, rather than in careers like medicine, engineering or teaching. Wall Street worked its rookies hard, but it held out the promise of rich rewards. In college dorms, tales of 30-year-olds pulling down $5 million a year were legion.

    While top executives received the biggest bonuses, what is striking is how many employees throughout the ranks took home large paychecks. On Wall Street, the first goal was to make “a buck” — a million dollars. More than 100 people in Merrill’s bond unit alone broke the million-dollar mark in 2006. Goldman Sachs paid more than $20 million apiece to more than 50 people that year, according to a person familiar with the matter. Goldman declined to comment.

    Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities. As the financial industry’s role in the economy grew, workers’ pay ballooned, leaping sixfold since 1975, nearly twice as much as the increase in pay for the average American worker.

    “The financial services industry was in a bubble," said Mark Zandi, chief economist at Moody’s Economy.com. “The industry got a bigger share of the economic pie.”

    A Money Machine

    Dow Kim stepped into this milieu in the mid-1980s, fresh from the Wharton School at the University of Pennsylvania. Born in Seoul and raised there and in Singapore, Mr. Kim moved to the United States at 16 to attend Phillips Academy in Andover, Mass. A quiet workaholic in an industry of workaholics, he seemed to rise through the ranks by sheer will. After a stint trading bonds in Tokyo, he moved to New York to oversee Merrill’s fixed-income business in 2001. Two years later, he became co-president.

    Skip to next paragraph

    Bloomberg News Dow Kim received $35 million in 2006 from Merrill Lynch.

    The Reckoning Cashing In Articles in this series are exploring the causes of the financial crisis.

    Previous Articles in the Series » Multimedia Graphic It Was Good to Be a Mortgage-Related Professional . . . Related Times Topics: Credit Crisis — The Essentials

    Patrick Andrade for The New York Times Brian Lin is a former mortgage trader at Merrill Lynch who lost his job at Merrill and now works at RRMS Advisors. Readers' Comments Share your thoughts. Post a Comment »Read All Comments (363) »

    Even as tremors began to reverberate through the housing market and his own company, Mr. Kim exuded optimism.

    After several of his key deputies left the firm in the summer of 2006, he appointed a former colleague from Asia, Osman Semerci, as his deputy, and beneath Mr. Semerci he installed Dale M. Lattanzio and Douglas J. Mallach. Mr. Lattanzio promptly purchased a $5 million home, as well as oceanfront property in Mantoloking, a wealthy enclave in New Jersey, according to county records.

    Merrill and the executives in this article declined to comment or say whether they would return past bonuses. Mr. Mallach did not return telephone calls.

    Mr. Semerci, Mr. Lattanzio and Mr. Mallach joined Mr. Kim as Merrill entered a new phase in its mortgage buildup. That September, the bank spent $1.3 billion to buy the First Franklin Financial Corporation, a mortgage lender in California, in part so it could bundle its mortgages into lucrative bonds.

    Continued in article

     Bob Jensen's "Rotten to the Core" document --- http://faculty.trinity.edu/rjensen/FraudRotten.htm

     


    Hypothetical Future Value (HPV Accounting

    1996: Rich Kinder loses his CEO position to Jeff Skilling
             Enron's accounting books got cooked early on under his watch while Andersen's auditors turned a blind eye. 

    You can download Enron's Infamous Home Video
    Although it has nothing to do with the above professional movie, Jim Borden sent me a copy of the amateur video recording of Rich Kinder's departure from Enron (Kinder preceded Skilling as President of Enron).  This 1996 video features nearly half an hour of absurd skits, songs and testimonials by company executives.  It features CEO Jeff Skilling proposing Hypothetical Future Value (HPV) accounting with in retrospect is too true to be funny during the subsequent melt down of Enron.  George W. Bush (then Texas Governor Bush and his father) appear in the video.  You can download parts of it at  http://www.cs.trinity.edu/~rjensen/video/windowsmedia/enron3.wmv

    Footnote:  Rich Kinder left Enron, formed his own energy company, and became a billionaire --- http://www.mcdep.com/MR11231.PDF
    See Question 2 at http://faculty.trinity.edu/rjensen/FraudEnronQuiz.htm

    Bob Jensen's threads on HPV Accounting are shown below.


    Market Prices and Consensus Forecasts and Discounted Cash Flow Valuations

    September 24, 2008 message from David Albrecht [albrecht@PROFALBRECHT.COM]

    It seems to me that present valuing the future cash flows is at least as good of an option than making other types of estimates. But then, I don't have a Denny B. caliber mind.

    David Albrecht

    September 24, 2008 reply from Bob Jensen

    Hi David,

    The Consensus Assumption in FAS 157
    I agree with the FASB that discounted cash flow present values are the best for contractual streams of cash flows (such as annuity contracts, leases, and possibly some systems that are actuarial in terms of stationary parameters such as in pension fund contracts). Discounted cash flow is out of the question in severely non-stationary systems. When the assumption of additivity (i.e., negligible covariances) is reasonable such as forecasts of financial items (stocks, bonds, and financial derivatives), then deep market consensus pricing is probably best for these non-stationary systems.

    No one person or one company or one model knows the future stream of cash flows or the appropriate discount rate for most assets and liabilities. Hence FAS 157 assumes that a large body of forecasters who set market prices can reach consensus trading fair value estimates that are more accurate than any single forecaster can arrive at except by happenstance. Market values also give auditors something to attest to when other alternative valuation methods use fantasyland models or dubious wizards. When aggregating assets and liabilities, FAS 157 virtually ignores covariances, so that 100-ton gorilla will be overlooked for the moment.

    Let’s ignore for the moment the problem of non-existent markets, higher order covariance unknowns (that do not apply to financial items quite as much as fair values of non-financial items), and market manipulation frauds. Instead let’s concentrate on consensus (herd) market pricing in non-stationary systems.

    The major problem of economic, athletic, and political forecasting is that, unlike in Casino-game forecasting, the forecasts are made in non-stationary systems. Deep markets are ideal in non-stationary systems because market prices are constantly being reset by lots of participants evaluating changing  parameters of the system. The same is true to a much lesser extent with repeated consensus forecasting of voting outcomes. Repetitive consensus forecasting has become the most popular way of forecasting future voting outcomes.

    Attempts have been made to even have low-stakes futures market simulations (e.g., the IEM) of political outcomes, but the market participants have very low stakes in the game and the markets aren't deep enough for our serious attention --- http://www.biz.uiowa.edu/iem/
    Also see the summary paper at http://edoc.hu-berlin.de/series/sfb-373-papers/2001-57/PDF/57.pdf
    There seems to be some anecdotal evidence that these market games do better than most polls in political forecasting, although the media tends to focus more on the polls than the IEM and other political market games.

    Consensus forecasts, like markets, must reset very frequently because political opinions and most markets are very non-stationary ---- the assumption of stationarity destroys time series forecasting models such as Box-Jenkins models that assume stationary parameters.

    Richard Posner and Nobel Laureate Gary Becker had an interesting recent blog about consensus forecasting in political forecasting..

    “Prediction Markets and the Election” by Richard Posner, The Becker-Posner Blog, September 14, 2008 --- http://www.becker-posner-blog.com/

    The forthcoming presidential election has drawn attention to online predictions markets. The first, and one of the best known, is the Iowa Electronic Market (IEM), started in 1988 to bet on presidential elections. Participants can bet up to $500. The odds and hence the price of a contract are set by the bidders themselves, as in a stock market, rather than by the "house," as in casino gambling. A number of other prediction markets, some using virtual (i.e., play) rather than real money, have emerged, includingTradeSports.com, the Foresight Exchange Market, Newsfutures, Intrade, and the Hollywood Stock Exchange.

    IEM, on which I'll focus, has correctly predicted the outcome of every presidential election since 1988, and its predictions have been consistently more accurate than the polls. An interesting comparison between the Gallup Poll and the Iowa market in the 1996 presidential campaign ( www.biz.uiowa.edu/iem/media/96Pres_VS.html ) reveals that throughout the entire campaign the Iowa market’s predicted outcome was much closer (in margin of victory) to the actual outcome than the Gallup Poll was. Studies have found that prediction markets beat polls and other prediction tools even when a prediction market uses play rather than real money.

    The Pentagon planned to create a prediction market in which participants could bet on the likelihood of terrorist attacks, assassinations, and coups. The plan caused outrage and was abandoned. There was a serious objection to the plan: people planning terrorist attacks, assassinations, and coups have inside information which they could use to make a killing (pun intended) in the prediction market.

    The success of prediction markets is related to though distinct from the success of the "blogosphere" in ferreting out information that eludes the mass media. Both the blogosphere and prediction markets aggregate greater amounts of information than any centralized information gatherer can obtain. In the case of the blogosphere, it is easy to see why this is so. It is virtually costless (except in time) to become a blogger, and among the millions of people drawn to blogging are people with all sorts of pockets of specialized information, which the internet enables to be pooled rapidly. This pooling resembles the economic market, in which vast amounts of information, encapsulated in prices, are pooled (the basic insight of Friedrich Hayek, and the secret of capitalism’s superiority to socialism as a means of optimizing economic activity).

    Prediction markets provide an even closer analogy to the market, since they (or rather some of them, for others permit betting only with play money) provide financial rewards for correct information (as blogging rarely does), in this resembling ordinary commercial speculation. Someone who thinks he has superior insight into political processes will have an incentive to place a bet in IEM or some other political prediction market. This method of aggregating information--call it expert aggregation--is different from public opinion polling, which is based on randomness. The political pollsters quiz a random sample of likely voters for their likely vote; they do not ask them for an opinion of how other people will vote, a matter on which randomly selected respondents cannot be expected to have an expert opinion. The idea behind the prediction market is that the opportunity to make money or just the fun of betting on one's insights or hunches (the only reward that the virtual prediction markets offer participants) will elicit expert opinions--more so, certainly, than random polling, which anyway, as I have said, does not ask respondents for an opinion about anyone's voting except their own..

    I don't think the success of prediction markets is due to a "wisdom of crowds" phenomenon--the idea that somehow large groups of seemingly nonexpert people are bound to "get it right." The "wisdom of crowds" is really just a matter of reducing sampling error. Suppose 100 people guess the weight of a person. Some will guess too low, some too high, but the average guess will be close to the true weight. If, however, just one person is asked to guess, the chances are great that his guess will be either too high or too low.

    One problem with prediction markets, a problem that occurred on the day of the 2004 presidential election, is that a market can swing on the basis of unreliable information until the information is corrected. (That happened last week when the price of stock in United Airlines plummeted on a mistaken report that the airline was about to declare bankruptcy.) Exit polls showed Kerry winning a disproportionate number of the votes cast early in the morning, and immediately the prediction markets predicted that he would win the election; and of course he lost.

    Another potential problem with the prediction-market model is that the limits of the bets that can be placed, illustrated by the Iowa market’s $500 limit, are so low. One understands why there are limits: otherwise there would be a danger of market manipulation. Expenditures on the current presidential election campaign will exceed a billion dollars. It must be that the prediction markets attract people who derive nonpecuniary satisfaction from successful bets and that among those people are likely to be a number who really do have insight into the issues bet on in the market, since their bets are more likely to be correct and therefore they are more likely to derive the satisfaction that comes from successful betting. Probably most people who bet on horse racing think they know something about horses, and probably most people who bet on the outcome of a political campaign know something about politics.

    It may seem odd, though, that a stranger would have a better sense of how people will vote than a random sample of people would know, each of them, how he or she will vote. But only about half of all eligible voters actually vote in a presidential election, many people refuse to talk to pollsters, some people do not make up their mind until the last minute (but may be hesitant to reveal their indecision to a pollster), some respondents will tell the pollster what they think he wants to (or will be impressed to) hear, and the number of persons sampled is never large enough to avoid a confident prediction of a point outcome, as distinct from a range (say a 95 percent probability that one candidate's vote percentage will be between 47 and 50 percent and the other's between 49 and 52 percent).

    There is an interesting question whether prediction markets should be thought of as "gambling” and perhaps prohibited. As a matter of policy, that would be a mistake, even if one thinks that gambling should be prohibited. The prediction markets are markets for speculation, rather than for game-playing or risk-taking. Slot machines, card-playing, roulette wheels, and other conventional forms of gambling do not generate socially valuable information. Speculation does. Commercial speculation serves to hedge commercial risks and bring prices into closer phase with value. Political, cultural, etc. prediction markets also yield socially valuable information. The outcome of elections is important to companies and even individuals for whom particular public policies are important; they may wish to make adjustments to avert or exploit looming political change. Politicians too need to have as sharp a sense as possible about the effects on the electorate of their and their opponents' strategies. Apparently they can get more accurate information from the prediction markets than from the public opinion pollsters.

     

    “Prediction Markets and the Election” by Richard Posner, The Becker-Posner Blog, September 14, 2008 --- http://www.becker-posner-blog.com/

    Prediction markets are pervasive in finance, especially in modern derivative markets. Someone who is long on the S&P 500 Index is betting that average stock prices in the United States will be going up, while those who are short in this market are betting that they will go down. Price movements in these markets are a good measure of aggregate sentiment, where the aggregation process gives greater weight to those willing to risk larger sums.

    The aggregation in online political prediction markets, such as the Iowa Electronic Market (IEM), is more democratic because these markets usually place sharp limits on how much can be bet- the IEM limits bets to no more than $500. Yet as Posner indicates, this and other online political markets have been successful in predicting the outcomes of American elections-more successful than various polls. In the present election, the IEM odds in favor of the Democrats winning the presidency hovered around 60 per cent From May of 2007 to the end of August, but these odds have narrowed considerably since then to about 51-52 per cent for the Democrats to 48-49 per cent for the Republicans. Narrowing has also occurred in various polls. The IEM market is indicating that Senator Obama now has a small lead over Senator McCain.

    Since bets on political online markets are small, the motivation of bettors can hardly be the amounts they win or lose. Nor can the usual economic theories of risky choices be of much relevance since the risks to bettors' wealth are rather insignificant. These gambles are made because of utility derived from the gambling itself, not because of the amounts won or lost. This has the very important implication that the positions taken by bettors-for example, whether they bet that the Democratic rather than the Republican presidential candidate would win- is not necessarily determined by which one they expect to win. On the contrary, their betting behavior may be in good measure determined by whom they want to win rather than whom they expect to win.

    Studies of betting on sports events show a home team "bias" in the sense that the odds tend to be skewed in favor of home teams relative to the actual winning percentages of home teams. This may be because many local residents bet on their home team, such as Chicagoans betting on the Chicago Cubs, at odds where objectively they should be shifting their bets to visiting teams, and also because individuals in home cities are more likely to bet on games in their cities.

    This home team bias is likely to be even more pronounced in political betting markets like the IEM since bets are small. However, if biases of Democratic and Republican bettors are about equally strong, and if a non-negligible fraction of all bettors are making prediction bets, then aggregate betting would tend to give on the whole accurate predictions about who will win, although these predictions would be quite noisy. Predictions rather than hopes may be of relatively large importance in the IEM and other online political prediction markets because the main bettors have been academic economists and financial experts rather than the general public. This type of wishful betting presumably is quite different in betting on other types of events, such as the unemployment rate shown by data to be released on a certain date.

    I believe that online political prediction markets, and other online prediction markets as well, should be legal in the United States and elsewhere, even if the amounts bet were quite large. There is no important substantive difference between such online betting markets and the Chicago Mercantile Exchange and other exchanges that allow individuals and organizations to take positions on movements of stock indexes, housing price indexes, and prices of other derivatives. A distinction is sometimes made between political betting markets and derivative markets since participants in derivative markets may be hedging other risks that they face. Yet this distinction has little substance since if larger bets were allowed in online political markets, groups whose welfare depended greatly on political outcomes would make greater use of these markets. For example, if a Republican presidential win would mean greater spending on military weapons, companies in the arms business might hedge their risks by betting on Barack Obama.

    If large bets were allowed, some wealthy groups may bet a lot on their candidates in order to exert bandwagon influences on public opinion through their large bets affecting market odds. If so, these markets likely would become less reliable as predictors of outcomes, and hence would have less influence on opinions. To a large extent, therefore, these markets would be self correcting, although online political markets might place various other restrictions on bets, as is common in derivative and other exchanges.

    Jensen Comment
    And thus I agree with the FASB that discounted cash flow present values are the best for contractual streams of cash flows (such as annuity contracts, leases, and possibly some systems that are actuarial in terms of stationary parameters such as in pension fund contracts). Discounted cash flow is out of the question in severely non-stationary systems. When the assumption of additivity (i.e., negligible covariances) is reasonable such as forecasts of financial items (stocks, bonds, and financial derivatives), then deep market consensus pricing is probably best for these non-stationary systems.

    FAS 157 admits full well that there are many situations where an item does not have a suitable deep market. FAS 157 then recommends extrapolations from similar items that have deeper markets. And if that fails, FAS 157 recommends forecasting from models, but it is impossible to specify what models. Most conventional models do not deal well with non-stationary systems. Gaming models like the IEM are better-suited for forecasting in non-stationary systems, but it's impossible to have an IEM market simulation for every item that a company must forecast for fair value accounting in an annual report.

    I've become an advocate of fair value accounting for most financial items for which covariance terms are probably negligible. For non-financial items the covariance terms are enormous, and advocates of exit value or replacement value accounting are assuming zero covariances. In other words, exit value accounting assumes assets and liabilities will be sold piecemeal in liquidation rather than used jointly in a going concern.

    The FASB and the IASB are both inconsistent in advocating market-based exit value accounting while at the same time advocating valuation of assets and liabilities in their "best possible uses." In most instances piecemeal liquidation of such items is not the best possible use of each item in a going concern. The items are used jointly and thus covary to add synergy value to that going concern.


    A Bull Crap Teaching Case from an article by the former head of the FDIC --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    From IASPlus on November 1, 2008 --- http://www.iasplus.com/index.htm

    1 November 2008: IASB publishes fair value guidance
    The IASB has published educational guidance on the application of fair value measurement when markets become inactive. The guidance consists of a summary document prepared by IASB staff and the final report of the expert advisory panel established to consider the issue:
    • The summary document sets out the context of the expert advisory panel report and highlights important issues associated with measuring the fair value of financial instruments when markets become inactive. It takes into consideration and is consistent with recent documents issued by the US FASB and the US SEC.
    • The report of the expert advisory panel identifies practices that experts use for measuring the fair value of financial instruments when markets become inactive and practices for fair value disclosures in such situations. The report provides useful information and educational guidance about the processes used and judgements made when measuring and disclosing fair value.
    Here are links to:

     

    You may also want to take a look at the following working paper:
    Some Fair Values are Fairer than Others and Few if Any are True Values,” by G. Peter Wilson, Boston College ---
    http://commons.aaahq.org/files/1b268f3cc0/Some_Fair_Values_are_Fairer_than_Others.pdf

     

     


    Question
    What did the PCAOB, in its inspection reports, to be the biggest problem encountered in the area of auditor independence?

    Answer --- Prohibited Non-auditor Services

    The most common deficiency noted in the independence area involves preparation of an issuer's financial statements and related footnotes. Under the SEC's rules, an auditor is not independent of its audit client if the auditor maintains or prepares the audit client's accounting records, prepares source data underlying the audit client's financial statements, or prepares the audit client's financial statements that are filed with the SEC.28/ Even when dealing with inexperienced accounting personnel in small public companies, auditors cannot provide these prohibited non-audit services to these issuer audit clients. In some cases, the deficiency consisted of the preparation of a portion of the issuer's financial statements (such as the statement of cash flows) or of the statements or disclosures in a single, specialized area (such as the income tax provision and the related deferred tax asset and liability balances). Even these more limited preparation services impair the firm's independence. Other identified deficiencies include instances in which firms provided bookkeeping services by, for example, maintaining the trial balance or the fixed asset subledger, classifying expenditures in the general ledger, preparing the consolidating schedules, or preparing and posting journal entries to record transactions or the results of calculations. In other instances, firms prepared source data underlying their issuer audit client's financial statements by, for example, determining the fair values assigned to intangible assets acquired in a business combination or to stock options and warrants, or calculating depreciation expense and accumulated depreciation.
    PCAOB Release No. 2007-010 October 22, 2007 --- http://www.pcaobus.org/Inspections/Other/2007/10-22_4010_Report.pdf
     

    Jensen Comment
    I mention this because as we move under the joint IASB-FASB era of fair value accounting, auditors will be under increased pressures to assist clients struggling with how to measure fair value. I'm not opposed to requiring fair value accounting for financial assets and to footnote disclosures of fair values of many non-financial items.

    I am avoiding at this point any discussion of booking fair values of non-financial items for which there is no practical means of estimating value in use ---

    There are of course many other audit deficiencies other than independence that are mentioned in this PCAOB Release, particularly problems in revenue recognition. Students of accounting should definitely be assigned to study this report at http://www.pcaobus.org/Inspections/Other/2007/10-22_4010_Report.pdf 

    Bob Jensen's threads on audit professionalism and independence are at http://faculty.trinity.edu/rjensen/Fraud001.htm#Professionalism

    Bob Jensen's threads on valuation, intangibles, and other accounting theory issues are at http://faculty.trinity.edu/rjensen/theory01.htm

     


    Not everything that can be counted, counts. And not everything that counts can be counted.
    Albert Einstein

    Bob Jensen's threads on fair value accounting are at various other links:

    I recently completed the first draft of a paper on fair value at http://faculty.trinity.edu/rjensen/FairValueDraft.htm 
    Comments would be helpful.

    http://faculty.trinity.edu/rjensen/roi.htm

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

    "Fair Value Adoption --- An Update," Deloitte White Paper, August 2008 --- http://www.iasplus.com/usa/0808fairvalueupdate.pdf

    Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts of Private Companies ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm


    September 20, 2008 message from Zane Swanson [ZSwanson@UCOK.EDU]

    On page A23 of Friday September 29th Wall Street Journal, an editorial by Mr. Isaac called for the SEC to suspend “Fair Value Accounting and require that assets be marked to their true economic value.” True economic value is defined as “the discounted cash-flow analysis”. However, what will the discount rate be measured upon? If it is the market yield, then the resulting present value is the same as the market value. What’s the difference? Perhaps … maybe … it would be more meaningful if the calculation of the present value (at risk) is a judgment that is determined by the probability of default of the underlying mortgages.

    Even so, it may still be argued that the current fair value accounting information has contributed to the recent bad spiral of financial events which are based on fair market values at the margin. Paulson’s proposed solution today is to remove the subprime loans from the market place, temporarily. Thus, the remaining “good “ mortgage securities which are presumed to be of responsible quality will function at the margin in good order. Have no doubt, all US taxpayers will pay to manage the “bad” mortgage-backed securities (however they are measured/selected). From an accounting measurement perspective, the investors who make decisions based upon accounting data need “relevant” information (as per the statement of financial concepts and the FASB current project proposal). Both of these aforementioned directions to fix the current financial problem appear to be superficial at best with respect to the underlying mortgage security information and long-term satisfactory arms-length transaction economics. I would be interested to hear from anyone else who has greater detail to share on these measurement processes. In some respects, Paulson should be given the benefit of the doubt and perhaps the weekend discussions will give resolution to the problem. Even in the worst of a crisis, one hopes/looks for light at the end of the tunnel.

    Question
    Will fair value accounting reduce or exacerbate the problem of economic and stock market bubbles?

    September 2008 reply from Bob Jensen

    One time I posed a question to the, then, Editor of The Wall Street Journal Editorial Page (my former fraternity brother Bob Bartley) about why the WSJ on that very day was attacking Mike Milken as a felonious thief on Page 1 and praising Milken as a creative capitalist on the Editorial Page. Bob Bartley's truthful response was that the WSJ, more than any other newspaper, is really two newspapers bundled into one copy. The Editorial Page is an unabashed advocate of free-reining capital markets (Damn the Torpedoes). The rest of the newspaper reports the facts (and I think the WSJ reporters are among the best in the world, especially when they commenced to prickle Ken Lay and Jeff Skilling about hidden related party transactions at Enron). See Question 22 at http://faculty.trinity.edu/rjensen/FraudEnronQuiz.htm
    It's interesting that WSJ reporters discovered related party transactions when Enron's auditors pleaded ignorance about such fraudulent dealings. But then Andersen was becoming notorious at that time for bad audits.

    Although I’m not the world’s biggest fan of fair value accounting, I thought Isaac's article was misleading. It glossed over the fundamental problem with the recent investment bank failures (personal infectious greed, disregard for shareholder risk, an ever-fraudulent real estate appraisal profession, and questionable auditor independence) in an attempt to put the blame on the fair value accounting standards. If the auditors had really insisted on adjusting bad debt allowances to what fair values should’ve been, we might have avoided some of this Wall Street meltdown. The auditors are partly to blame, although they most likely were deceived as well by greedy Wall Street analysts and brokers.

    Isaac's opinion piece fits right into the WSJ's repeated and undeserving hammering of SOX and efforts by standard setters to bring about greater accounting transparency. The WSJ editors (certainly not all of their great reporters) have the opinion that accounting stifles growth and creative capitalism on Wall Street.

    It is interesting to compare the Isaac’s attack (a biased, self-serving attack in my viewpoint) with Paul Miller’s hopes (Journal of Accountancy, May 2008) for fair value accounting (that naively relies on the ability and integrity of the fair value estimation and attestation system):

     

    "The Capital Markets’ Needs Will Be Served: Fair value accounting limits bubbles rather than creates them," by Paul B.W. Miller

    With regard to the relationship between financial accounting and the subprime-lending crisis, I observe that the capital markets’ needs will be served, one way or another.

    Grasping this imperative leads to new outlooks and behaviors for the better of all. In contrast to conventional dogma, capital markets cannot be managed through accounting policy choices and political pressure on standard setters. Yes, events show that markets can be duped, but not for long and not very well, and with inevitable disastrous consequences.

    With regard to the crisis, attempts to place blame on accounting standards are not valid. Rather, other factors created it, primarily actors in the complex intermediation chain, including:

    Borrowers who sought credit beyond their reach.

    Borrowers who sought credit beyond their reach.

    Investment bankers who earned fees for bundling and selling vaporous bonds without adequately disclosing risk.

    Institutional investors who sought high returns without understanding the risk and real value.

    In addition, housing markets collapsed, eliminating the backstop provided by collateral. Thus, claims that accounting standards fomented or worsened this crisis lack credibility.

    The following paragraphs explain why fair value accounting promotes capital market efficiency.

    THE GOAL OF FINANCIAL REPORTING The goal of financial reporting, and all who act within it, is to facilitate convergence of securities’ market prices on their intrinsic values. When that happens, securities prices and capital costs appropriately reflect real risks and returns. This efficiency mutually benefits everyone: society, investors, managers and accountants.

    Any other goals, such as inexpensive reporting, projecting positive images, and reducing auditors’ risk of recrimination, are misdirected. Because the markets’ demand for useful information will be satisfied, one way or another, it makes sense to reorient management strategy and accounting policy to provide that satisfaction.

    THE PERSCRIPTION The key to converging market and intrinsic values is understanding that more information, not less, is better. It does no good, and indeed does harm, to leave markets guessing. Reports must be informative and truthful, even if they’re not flattering.

    To this end, all must grasp that financial information is favorable if it unveils truth more completely and faithfully instead of presenting an illusory better appearance. Covering up bad news isn’t possible, especially over the long run, and discovered duplicity brings catastrophe.

    SUPPLY AND DEMAND To reap full benefits, management and accountants must meet the markets’ needs. Instead, past attention was paid primarily to the needs of managers and accountants and what they wanted to supply with little regard to the markets’ demands. But progress always follows when demand is addressed. Toward this end, managers must look beyond preparation costs and consider the higher capital costs created when reports aren’t informative.

    Above all, they must forgo misbegotten efforts to coax capital markets to overprice securities, especially by withholding truth from them. Instead, it’s time to build bridges to these markets, just as managers have accomplished with customers, employees and suppliers.

    THE CONTENT In this paradigm, the preferable information concerns fair values of assets and liabilities. Historical numbers are of no interest because they lack reliability for assessing future cash flows. That is, information’s reliability doesn’t come as much from its verifiability (evidenced by checks and invoices) as from its dependability for rational decision making. Although a cost is verifiable, it is unreliable because it is a sample of one that at best reflects past conditions. Useful information reveals what is now true, not what used to be.

    It’s not just me: Sophisticated users have said this, over and over again. For example, on March 17, Georgene Palacky of the CFA Institute issued a press release, saying, “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors.” This expressed demand should help managers understand that failing to provide value-based information forces markets to manufacture their own estimates. In turn, the markets defensively guess low for assets and high for liabilities. Rather than stable and higher securities prices, disregarding demand for truthful and useful information produces more volatile and lower prices that don’t converge on intrinsic values.

    However it arises, a vacuum of useful public information is always filled by speculative private information, with an overall increase in uncertainty, cost, risk, volatility and capital costs. These outcomes are good for no one.

    THE STRATEGY Managers bring two things to capital markets: (1) prospective cash flows and (2) information. Their work isn’t done if they don’t produce quality in both. It does no good to present rosy pictures of inferior cash flow potential because the truth will eventually be known. And it does no good to have great potential if the financial reports obscure it.

    Thus, managers need to unveil the truth about their situation, which is far different from designing reports to prop up false images. Even if well-intentioned, such efforts always fail, usually sooner rather than later.

    It’s especially fruitless to mold standards to generate this propaganda because readers don’t believe the results. Capital markets choose whether to rely on GAAP financial statements, so it makes no sense to report anything that lacks usefulness. For the present situation, then, not reporting best estimates of fair value frustrates capital markets, creates more risk, diminishes demand for a company’s securities and drives prices even lower.

    THE ROLE FOR ACCOUNTING REPORTING Because this crisis wasn’t created by poor accounting, it won’t be relieved by worse accounting. Rather, the blame lies with inattention to CDOs’ risks and returns. It was bad management that led to losses, not bad standards.

    In fact, value-based reporting did exactly what it was supposed to by unveiling risk and its consequences. It is pointless to condemn FASB for forcing these messages to be sent. Rather, we should all shut up, pay attention, and take steps to prevent other disasters.

    That involves telling the truth, cleanly and clearly. It needs to be delivered quickly and completely, withholding nothing. Further, managers should not wait for a bureaucratic standard-setting process to tell them what truth to reveal, any more than carmakers should build their products to minimum compliance with government safety, mileage and pollution standards.

    I cannot see how defenders of the status quo can rebut this point from Palacky’s press release: “…only when fair value is widely practiced will investors be able to accurately evaluate and price risk.”

    THE FUTURE Nothing can prevent speculative bubbles. However, the sunshine of truth, freely offered by management with timeliness, will certainly diminish their frequency and impact.

    Any argument that restricting the flow of useful public information will solve the problem is totally dysfunctional. The markets’ demand for value-based information will be served, whether through public or private sources. It might as well be public.

    --------------------------------------------------------------------------------

    Paul B.W. Miller, CPA, Ph.D., a professor of accounting at the University of Colorado, served on both FASB’s staff and the staff of the SEC’s ­Office of the Chief Accountant. He is also a member of the JofA’s Editorial Advisory Board. His e-mail address is pmiller@uccs.edu.

     

     

    A Challenge to Your Students
    Was Paul Miller correct or out in left field in terms of theory vs. implementation vs. both?
    An interesting accounting theory exercise for students would be to compare how fantasyland (fair value) accounting can in theory can be used to prevent fantasyland bubbles and then have those students consider the implementation realities (non-additive fair values due to covariance terms in going concerns, mixing of realized and unrealized changes in value, huge fair value measurement error bounds, less-than-independent auditors engaged by clients suffering from infectious greet
    , etc.).

     

     

    "Don't Blame Mark-to-Market for Banks' Problems," by Jonathan Weil, Bloomberg ---
    http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aJFrPa3rqhHw

    If only we didn't know how badly off the banks are, then maybe we could save the financial system as we used to know it.

    That is the growing mantra from financial executives and their water carriers in Washington. The major problem isn't that banks made poor decisions and lost credibility with investors, in their view. The problem is that mark-to-market accounting is dragging down financial institutions and the U.S. economy, as House Financial Services Committee Chairman Barney Frank said last week.

    They couldn't be more wrong. And there's so much misinformation floating around the markets on this subject that it's time, once again, to debunk the myths.

    Myth No. 1: The rules known as Financial Accounting Standard No. 157 are to blame.

    The latest iteration on this tired saw comes from Christopher Whalen, a managing director at Institutional Risk Analytics, who gave an interview on the subject Friday. Among his recommendations:

    ``Rescind FAS 157 so if you have a real quoted price for an asset, fine, use it. Otherwise you allow companies to use historic cost. You had a transaction, you know what you paid for it, it's a fact. All this other stuff is speculation. We are literally creating the impression of losses.''

    The Awful Truth

    The truth: FAS 157 doesn't expand the use of fair-value accounting. Rather, it requires companies to divulge more information about the reliability of their reported fair values.

    Most companies won't even adopt FAS 157 until this quarter. All the standard does is require companies to disclose how much of their assets and liabilities are valued using quoted market prices, how much are measured using valuation models, and how much come from models using inputs that aren't observable in the market. That's it.

    Myth No. 2: Mark-to-market accounting is new.

    Companies have been ``marking to model'' for decades, and few people complained when banks and others were recording large gains as a result. The difference now, thanks to FAS 157, is that outsiders can see the extent to which companies' fair-value results are based on estimates, at least at companies that adopted the rules early.

    Financial statements always have been piles of estimates heaped upon a bunch of guesswork. Look through the footnotes to any company's financial statements, and you'll see that estimates are used for everything from loan-loss reserves, to income-tax and stock-option costs, even revenue.

    Solves Nothing

    Moving everything to historical-cost accounting wouldn't solve anything. For assets that aren't marked-to-market each quarter, such as goodwill and inventory, they still must be written down to fair value whenever their values have declined sharply and show no sign of bouncing back. The accountants call this an ``other-than-temporary impairment.''

    So even if we had historical-cost accounting today for all the mortgage-related holdings that have plummeted in value and for which there is no liquid market, companies still would have to estimate the assets' fair values and write them down accordingly. That's because the values probably won't come back anytime soon, if ever.

    Myth No. 3: Companies aren't allowed to explain their mark- to-market values.

    This is a fairly new one. Last week, the Securities and Exchange Commission said it is drafting a letter to let companies tell investors when they think the market values of their plunging assets don't reflect the holdings' actual worth. Companies also would be allowed to disclose ranges showing what their models say the assets might fetch in the marketplace.

    Guess what? Companies are allowed to do these things already in the discussion-and-analysis sections of their SEC reports each quarter. They also can make such disclosures in their financial-statement footnotes. What they can't do is print ranges on their balance sheets or income statements, any more than taxpayers can put down ranges on their Internal Revenue Service returns.

    Myth No. 4: Eliminating mark-to-market accounting will prevent margin calls.

    If you're a banker for, say, Thornburg Mortgage Inc. or Carlyle Capital Corp., do you think for a minute that you would hesitate to call in one of these companies' loans just because they started using historical cost to account for hard-to-value financial instruments? No way. The moment lenders decide the collateral isn't worth enough to support the loans, they'll demand more collateral or pull the plug, no matter what the financial statements say.

    Myth No. 5: The public would be better off without mark-to- market accounting.

    Investors are fully capable of understanding that unrealized losses on hard-to-value assets are estimates. They're also smart enough to know that values change over time. And in the case of things such as credit-default swaps that eventually might reach some settlement date, the fair-value changes include vital forward-looking information about what the future economic costs of these derivatives may be.

    What most investors can't tolerate is being kept in the dark, when companies in their portfolios are sliding toward insolvency and whistling along the way that all is well.

    We've got a meltdown, folks. Deal with it.

     

    Absurd claims are being made that the 2008 U.S. economic meltdown might have been avoided without fair value accounting
    But then maybe it's not so clear cut in the real world:  Fair Value Theory vs. Fair Value Fraud

    In the current environment, I am an ardent supporter of those who would resist calls to suspend fair value accounting rules. But, when I was at the SEC, I had a front-row seat on what was perhaps one of the most brazen abuses of fair value accounting in history. I was reminded of it by Joseph Stiglitz's recent commentary on CNN.com, in which he characterized the mortgage securitization craze as just another pyramid scheme. Keep that in mind as I tell you the story of Stephen Hoffenberg's $400 million fraud.
    Tom Selling, "The Anti-Fair Value Lobby Has a Point (Even if They Don't Know It)" The Accounting Onion, September 22, 2008 --- http://accountingonion.typepad.com/

    But, how could fair value accounting be the device by which one scheme was kept alive, yet could have prevented another? Like the Hoffenberg case, there is no question that the two main ingredients of the current fraud were lack of transparency into what was going on, and accounting tricks to give the illusion that all was well. The difference is that in the case of our present extreme unction, it was the ability to hide actual losses (as opposed to create fictitious gains) by not using fair value accounting for junk assets. The answer for the apparent paradox lies in a significant flaw in 'fair value' accounting.

    ...

    And another big difference between Towers and the current crisis is that Hoffenberg got 20 years. Today's CEOs are smart enough to take their money and run.

     

    Bob Jensen's threads on fair value accounting are at
    http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aJFrPa3rqhHw

    Bob Jensen's Rotten to the Core threads are at
    http://faculty.trinity.edu/rjensen/FraudRotten.htm

    Bob Jensen's home page is at http://faculty.trinity.edu/rjensen/


    "Disclose the fair value of complex securities," by Robert Kaplan, Robert Merton and Scott Richard, Financial Times, August 17, 2009 --- http://www.ft.com/cms/s/0/f206cf68-8b59-11de-9f50-00144feabdc0.html?nclick_check=1 

    Banks and other financial institutions are lobbying against fair-value accounting for their asset holdings. They claim many of their assets are not impaired, that they intend to hold them to maturity anyway and that recent transaction prices reflect distressed sales into an illiquid market, not what the assets are actually worth. Legislatures and regulators support these arguments, preferring to conceal depressed asset prices rather than deal with the consequences of insolvent banks.

    This is not the way forward. While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea.

    A bank typically argues that a mortgage loan for which it continues to receive regular monthly payments is not impaired and does not need to be written down. A potential purchaser of the loan, however, is unlikely to value it at its origination value. The purchaser calculates a loan-to-value ratio using the current, much lower value of the house. After calculating the likelihood of default, the potential buyer works out a price balancing the risk of default and amount that might be lost – a price well below the carrying value on the bank’s books.

    The bank is likely to ignore this offered price, or trades of similar assets, with the claim that unusual market conditions, not a decline in the value of the assets, causes a lack of buyers at the origination price. Its real motive, however, is to avoid recognising a loss. Yet, by keeping assets at their origination value, the bank creates the curious possibility that its traders could buy an identical loan more cheaply and so carry two identical securities in the same not-for-sale account at vastly different prices.

    Financial assets, even complex pools of assets, trade continuously in markets. Markets function best when companies disclose valid information about the values of their assets and future cash flows. If companies choose not to disclose their best estimates of the fair values of their assets, market participants will make their own judgments about future cash flows and subtract a risk premium for non-disclosure. Good accounting should reduce such dead-weight losses.

    This already happens in another financial sector. Mutual funds in the US now use models, rather than the last traded price, to provide estimates of the fair values of their assets that trade in overseas markets. The models forecast the prices at which these overseas assets would have traded at the close of the US market, based on the closing prices of similar assets in the US market. In this way, the funds ensure that their shareholders do not trade at biased net asset values calculated from stale prices. Banks can similarly use models to update the prices that would be paid for various assets. Trading desks in financial institutions have models that allow them to predict prices to within 5 per cent of what would be offered for even their complex asset pools.

    Obtaining fair-value estimates for complex pools of asset-backed securities, of course, is not trivial. But these days it is possible for a bank’s analysts to use recent market transaction prices as reference points and then adjust for the unique characteristics of the assets they actually hold, such as the specific local housing prices underlying their mortgage assets.

    For fair-value estimates made by internal bank analysts to be credible, they need to be independently validated by external auditors. Many certified auditors, however, have little training or experience in the models used to calculate fair-value estimates. In this case, auditing firms can use outside experts, much as they do today with actuaries and lawyers who provide an independent attestation to other complex estimates disclosed in a company’s financial statements. The higher cost of using independent experts is part of the price of originating and investing in complex, infrequently traded financial instruments.

    Legislators and regulators fear that marking banks’ assets down to fair-value estimates will trigger automatic actions as capital ratios deteriorate. But using accounting rules to mislead regulators with inaccurate information is a poor policy. If capital calculations are based on inaccurate values of assets, the ratios are already lower than they appear. Banks should provide regulators with the best information about their assets and liabilities and, separately, allow them the flexibility and discretion to adjust capital adequacy ratios based on the economic situation. Regulators can lower capital ratios during downturns and raise them during good economic times.

    No system of disclosing the fair value of complex securities is perfect. Models can be misused or misinterpreted. But reasonable and auditable methods exist today to incorporate the information in the most recent market prices. Investors, creditors, boards and regulators need not base decisions on biased values of a company’s financial assets and liabilities.

    Robert Kaplan and Robert Merton, 1997 Nobel laureate in economics, are professors at Harvard Business School. Scott Richard is a professor at the Wharton School of the University of Pennsylvania

    Jensen Comment
    I am also in favor of fair value accounting for financial instrument. The unresolved controversy is whether to post unrealized changes in value of these securities to current earnings or accumulated OCI where the changes do not affect earnings until if and when they are realized. In the case of held-to-maturity securities the accumulated value changes wash out and never are realized. If unrealized fair value changes are posted to earnings, bankers especially hate the volatility in earnings that comes about from mixing realized with unrealized revenues. Kaplan, Merton, and Richard due not address this primary concern of bankers.


    From The Wall Street Journal Accounting Weekly Review on October 17, 2008

    Accountants Asked for Financial and Valuation Data
    by Robert W. Owens, Ph.D.
    The Wall Street Journal

    Oct 15, 2008
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB122403125701034771.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting Theory, Advanced Financial Accounting, Banking, Fair Value Accounting, Fair-Value Accounting Rules, FASB, Financial Accounting, Governmental Accounting, Historical Cost Accounting, International Accounting Standards Board, Mark-to-Market, Mark-to-Market Accounting

    SUMMARY: Dr. Owens is a Professor of Finance at Missouri State University. He responds to an Opinion page piece from October 6, 2008 (see related article) in which, Owens argues, L. Gordon Crovitz "...criticizes accounting for failing in its basic mission of being informative, while also suggesting that federal regulators cannot trust the numbers that accountants provide when establishing capital requirements for banks." Dr. Owens argues that, to provide "informative accounting, requires a major paradigm shift. The prototype for what financial accountants should be doing can be found in the fund accounting process used by municipalities," he concludes! Dr. Owens is apparently unaware of GASB statements now requiring financial statements, based on a business-type model rather than the fund accounting model, though most governmental entities still prepare financial statements for external reporting by consolidating underlying fund records still maintained for statutory purposes.

    CLASSROOM APPLICATION: Comparing different accounting systems is a hallmark of the exchange of these two opinion pieces, including issues such as: mark-to-market (fair value) versus historical cost; accrual based accounting versus fund accounting; and usefulness of financial statements for bank regulatory purposes versus the overall objectives of financial reporting as established in the U.S. under the FASB's Conceptual Framework, the international community under the IASB, or the current joint project between these two Boards.

    QUESTIONS: 
    1. (Introductory) According to L. Gordon Crovitz, in the related article, one of the factors which will indicate, "when things are returning to normal" is "when accounting approximates reality." What is the difficulty with using fair value in financial reporting in today's market circumstances?

    2. (Introductory) As reported in both the Crovitz and the Owens editorial pieces, federal regulators have concerns about the accounting measurements used in bank balance sheets and on which bank's capital requirements are based. Compare and contrast, in a summary form, mark-to-market accounting for financial assets, versus historical cost methods for these types of assets.

    3. (Advanced) What is the purpose of capital requirements for banks? How will the two methods of accounting described in your answer to question above impact the determination of these capital requirements?

    4. (Advanced) Mr. Crovitz's characterization of two opposing methods of accounting as problematic when "marking to a nonexistent market communicates little information, but likewise a guestimate of ultimate value also conveys little." What methods of accounting is Mr. Crovitz referring to? Specifically compare these two descriptions to methods of accounting and explain their meaning.

    5. (Advanced) What is(are) the stated objective(s) of financial reporting? Identify the source for this answer. Does this document provide a basis for resolving the issues of informativeness raised by Mr. Crovitz and Dr. Owens? Support your answer.

    6. (Advanced) Dr. Owens suggests using an accounting system based on governmental fund accounting to solve the issues raised by Mr. Crovitz. How are government financial statements now required to be presented? Since what date has the current reporting format been required? Is the reporting format based on fund accounting? Explain.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Seeking Rational Exuberance
    by L. Gordon Crovitz
    Oct 06, 2008
    Online Exclusive
     

     

    "Accountants Asked For Financial and Valuation Data," by Robert W. Owens, The Wall Street Journal, October 15, 2008 --- http://online.wsj.com/article/SB122403125701034771.html?mod=djem_jiewr_AC

    L. Gordon Crovitz ("Seeking Rational Exuberance," Information Age, Oct. 6) justifiably criticizes accounting for failing in its basic mission of being informative, while also suggesting that federal regulators cannot trust the numbers that accountants provide when establishing capital requirements for banks.

    Mr. Crovitz's first concern, informative accounting, can be addressed but requires a major paradigm shift. The problem here is that over the years the accounting profession has commingled its primary role of providing meaningful financial information with a secondary role of providing "valuation-type" information, however described. The first of these roles lies unquestionably with financial accountants. The second role lies largely outside the accounting profession and with valuation experts who take information provided by accountants and integrate it into their decision process. Some of the information provided by accountants may be valuation in nature, such as information on the current value of short-term receivables or the current value of loans outstanding, but this should be considered extracurricular accounting activity.

    The prototype for what financial accountants should be doing can be found in the fund accounting process used by municipalities. In the governmental funds, where most municipal accounting occurs, daily accounting activity is in the areas of revenue, expenditures, cash, cash receipts, cash disbursements, short-term payables, and short-term receivables. All other types of financial information (such as plant and equipment records, long-term debt records, and pension records) are kept in supplementary records outside the governmental fund accounting records and can be provided in a variety of user-friendly formats.

    The second of Mr. Crovitz's concerns can be readily addressed by not basing capital requirements on subjective accounting figures. For example, capital requirements can be set at a flat dollar amount (say, based on an average of deposits over the preceding five years) plus some (hopefully, safe) percentage of end-of-period deposits. Financial information on deposits is part of the accounting records but is not subjective in the sense that it can be unduly influenced through one person's interpretation of the various rules and regulations that underpin current financial accounting.

    Robert W. Owens, Ph.D.
    Professor of Finance
    Missouri State University
    Springfield, Mo.

     

    October 19, 2008 reply from Roger Debreceny [roger@DEBRECENY.COM]

    As discussed in Double Entries 14(33), the recent bank rescue legislation (Emergency Economic Stabilization Act of 2008) requires the SEC to study mark-to-market accounting http://www.sec.gov/news/press/2008/2008-242.htm

    Under the terms of the EESA, the study will focus on:

    1. The effects of such accounting standards on a financial institution's balance sheet

    2. The impacts of such accounting on bank failures in 2008

    3. The impact of such standards on the quality of financial information available to investors

    4. The process used by the Financial Accounting Standards Board in developing accounting standards

    5. The advisability and feasibility of modifications to such standards

    6. Alternative accounting standards to those provided in [Financial Accounting Standards Board] Statement Number 157

    SEC Chairman Christopher Cox announced that James Kroeker, Deputy Chief Accountant for Accounting at the SEC, will serve as staff director for the study.”

    Roger Debreceny

    Don't Blame Fair Value Accounting for the Bank Failures --- http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/theory01.htm


    "Among Different Classes of Equity:  Valuation models can be tailored to unique financing structures." by Andrew C. Smith and Jason C. Laurent, Journal of Accouintancy, March 2008 --- http://www.aicpa.org/pubs/jofa/mar2008/allocating_value.htm 

    EXECUTIVE SUMMARY
    It is essential for board members, executive officers, CFOs, auditors and private equity investors to comprehend option-pricing models used to determine the per-share values of common and preferred shares.

    The AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes three methods of allocating value between preferred and common equity, which include:

    Current Value Method (“CVM”) Probability Weighted Expected Return Method (“PWERM”) Option-Pricing Method (“OPM”)

    OPM, which is based on the Black-Scholes model, is a common method for allocating equity value between common and preferred shares.

    Valuation models must be tailored to the specific facts and circumstances of the equity in the company being valued.

    Bob Jensen's threads on valuation are at http://faculty.trinity.edu/rjensen/roi.htm


    Question
    Where were the auditors when reviewing bad debt allowances?

    Hint
    The were hiding behind the reasons to be used again and again when fair value accounting is required by the IASB and the FASB.

    From The Wall Street Journal Accounting Weekly Review on September 12, 2008 ---
    http://online.wsj.com/article/SB122083722708908863.html?mod=djem_jiewr_AC

    No End Yet to the Capital Punishment
    by Peter Eavis
    The Wall Street Journal

    Sep 08, 2008
    Page: C10
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB122083722708908863.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Allowance For Doubtful Accounts, Bad Debts, Banking, Financial Analysis, Financial Statement Analysis, Loan Loss Allowance, Reserves

    SUMMARY: "The chief problem at Fannie and Freddie -- an inadequate capital cushion against losses -- also bedevils large banks in the U.S. and Europe more than 12 months into the credit crunch. The broader strains now facing the markets are not as easily relieved by central banks or governments as the company specific crises at Fannie and Freddie or Bear Stearns earlier this year. Of course, central banks could cut interest rates in the face of this threat. The trouble is banks are being extra cautious, justifiably, about lending as the economy slows. And while banks are reluctant to lend, many are having problems borrowing to fund themselves. That is because the market's assessment of their creditworthiness is darkening."

    CLASSROOM APPLICATION: Couching the continued problems in credit markets in terms of adequacy of loan loss reserves can help students in accounting classes better understand the credit market issues--and put a real world example to the academic learning about the importance of the accrual for bad debts. The article therefore is useful in any financial or MBA accounting course covering bad debts and the impact of the accounting for loan losses on capital accounts. Questions also discuss a related article on the topic of Fannie Mae, Freddie Mac, and banks' preferred stock.

    QUESTIONS: 
    1. (Introductory) Describe the recent events undertaken by the U.S. government in relation to the Federal National Mortgage Association (nickname Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). You may use the related articles to do so. In your answer, describe the roles of these entities in facilitating mortgage lending and home ownership across the U.S.

    2. (Introductory) The article states "the chief problem at Fannie and Freddie is an inadequate capital cushion against losses." Whether they are business accounts receivable for a company or mortgage loan receivables on a bank or mortgage entity's balance sheet, how do we establish an allowance for losses on receivables? How does this procedure help to properly present a receivable balance on the balance sheet and an uncollectable accounts expense on the income statement?

    3. (Introductory) What is the impact of recording an allowance for doubtful accounts on an entity's capital or stockholders' equity?

    4. (Advanced) What is the purpose of requirements for banks, Fannie Mae and Freddie Mac to maintain a "cushion" of capital? How is that "cushion" eroded when loan losses prove greater than previously anticipated?

    5. (Advanced) How is it possible that Fannie Mae and Freddie Mac have inadequate allowances for doubtful mortgage loans?

    6. (Advanced) Why is it likely that inadequate allowances for losses on loan and accounts receivable are established in times of significant change in the product market generating the receivables? Did such a change occur in mortgage loan markets?

    7. (Introductory) One of the related articles discusses the implications of the government takeover and its suspension of dividends on the value of Fannie Mae and Freddie Mac preferred stock. How does preferred stock differ from common stock? How are these types of ownership interests similar in cases of failure of the entity issuing them?

    8. (Advanced) Why do debtholders fare better than common and preferred shareholders in this case of government takeover or any case of corporate failure?

    9. (Advanced) Why might investors "view preferred stock as debt by another name"?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    No Longer Preferred: A Lesson From Paulson
    by David Reilly and Peter Eavis
    Sep 08, 2008
    Page: C10

    Mounting Woes Left Officials with Little Room to Maneuver
    by Deborah Solomon, Sudeep Reddy and Susanne Craig
    Sep 08, 2008
    Page: A1

    U.S. Seizes Mortgage Giants
    by James R. Hagerty, Ruth Simon and Damina Palette
    Sep 08, 2008
    Page: A1
     

    "No End Yet to the Capital Punishment," by Peter Eavis and David Reilly, The Wall Street Journal, September 8, 2008; Page C10             http://online.wsj.com/article/SB122083722708908863.html?mod=djem_jiewr_AC 

    Investors may be tempted to see the government's takeover of Fannie Mae and Freddie Mac as the kind of cathartic action that marks a decisive turning point for the U.S. banking system and the wider stock market.

    But the chief problem at Fannie and Freddie -- an inadequate capital cushion against losses -- also bedevils large banks in the U.S and Europe more than 12 months into the credit crunch.

    While the capital shortage may not be as dire as at Fannie and Freddie, private banks can't count on a government rescue. Some will fail. Others will have to issue massive amounts of capital to shore up their shaky balance sheets.

    Make no mistake, the government's move to shore up Fannie and Freddie will likely give markets a short-term boost, especially if investors believe this can help underpin house prices in the U.S. But this move by the Treasury comes just as a new, more general threat looms: On top of U.S. economic problems, underlined by Friday's jump in the unemployment rate, the rest of the world is slowing.

    The broader strains now facing the markets are not as easily relieved by central banks or governments as the company specific crises at Fannie and Freddie or Bear Stearns earlier this year.

    Of course, central banks could cut interest rates in the face of this threat. Even the Federal Reserve has some room to cut the Fed Funds rate from 2%. That may be one reason bank stocks rallied Friday in the U.S. despite the dismal unemployment figure.

    Rate cuts would theoretically allow banks to harvest easy profits by borrowing more cheaply and lending to high-quality borrowers at attractive rates. The trouble is, banks are being extra cautious, justifiably, about lending as the economy slows.

    The shakeout of the past year has done almost nothing to improve the average U.S. household balance sheet. So while a government commitment to buy mortgage-backed securities, also announced Sunday, may cause mortgage rates to fall, banks may not want to lend at lower rates because they don't feel they're being compensated for the risks in this uncertain economy.

    And while banks are reluctant to lend, many are having problems borrowing to fund themselves. That is because the market's assessment of their creditworthiness is darkening.

    A closely followed yardstick that measures the gap between interbank lending rates and the expected federal-funds rate has widened beyond July's distressed levels. When this gap widens, banks are perceived to be riskier.

    Also, the cost of insuring against default by large banks is rising.

    The takeover of Fannie and Freddie could even worsen that sentiment, as investors grow even more cynical of regulatory measures of capital.

    For months, Fannie, Freddie, their regulator and other government officials have assured investors that measures of regulatory capital showed the mortgage firms weren't financially hobbled.

    The government's takeover shows this wasn't the case. Given that, investors are going to want concrete actions from banks, not continued pronouncements that losses on mortgage-related securities are only temporary and will one day bounce back.

    That will translate into highly dilutive issues of common stock, which will be necessary if banks are to raise capital to the levels required to reassure anxious funding sources.

    And that is why bank investors who place too much hope in the bailout of Fannie and Freddie could get burned.

    Bob Jensen's threads on independence and professionalism in auditing are at
    http://online.wsj.com/article/SB122083722708908863.html?mod=djem_jiewr_AC

    Say What?
    Editorial in the ... no ... can't be ... well maybe ... yes ... YES!
    ... The New York Times, September 8, 2008 ---
    http://www.nytimes.com/2008/09/09/opinion/09tue1.html?_r=1&oref=slogin

    The Bailout’s Big Lessons

    As an act of crisis management, the government takeover of Fannie Mae and Freddie Mac, the mortgage-finance giants, was a reasonable and reassuring move. It ensures the flow of mortgage credit and is likely to reduce mortgage rates, which are important steps toward the eventual recovery of the ailing United States housing market.

    And it does so while putting taxpayers first for future dividends or money that may be earned when the firms are reprivatized, holding out hope that the bailout costs may someday be recouped. Beyond the immediate crisis, however, the takeover raises disturbing issues that may get lost in the tumult of the moment.

    ¶ The need for an explicit bailout underlines the economic vulnerabilities of the United States. In July, Congress gave Treasury Secretary Henry Paulson unlimited authority to pay the debts of Fannie and Freddie and to shore up their capital, if need be. Yet investors the world over continued to doubt the companies’ viability, shunning their securities or demanding unusually high interest rates on loans. In effect, investors deemed the government’s commitment to Fannie and Freddie as either insufficient or not credible — an extraordinary vote of no confidence that, in the end, led to the bailout.

    ¶ There is no single reason for the lack of confidence. But investors have good cause to be concerned about the deep indebtedness of the United States, about the nation’s apparent political unwillingness to restore its fiscal health and about the ability of the government to responsibly make good on its commitments. A pledge of the full faith and credit of the United States still means something. That’s why the markets responded favorably to the takeover. But investors’ refusal to accept a promise to act is another sign of the need to reverse the fiscal mismanagement of the Bush years.

    ¶ The United States must acknowledge that its deep indebtedness is especially dangerous in times of economic crisis. The level and stability of American interest rates and of the dollar are now dependent on the willingness of foreign central banks and other overseas investors to continue lending to the United States. The bailout became inevitable when central banks in Asia and Russia began to curtail their purchases of the companies’ debt, pushing up mortgage rates and deepening the economic downturn.

    ¶ The bailout is new evidence of the need for better regulation of the American financial system. As the housing bubble inflated, the Bush administration often claimed that America’s unfettered markets were the envy of the world. But, in fact, they have sowed mistrust.

    ¶ The cost of the bailout needs to be carefully monitored. Fannie and Freddie own or back nearly $800 billion of generally junky mortgages, and some of those will inevitably go bad. So it is reasonable to assume that the cost could easily near $100 billion. There may be ways to make back some of that money later, but for a long time, the bailout will divert resources from other needs.

    Senators John McCain and Barack Obama have both voiced support for the bailout, which shows good judgment. But what the next president will need to worry about, and both candidates need to talk about, is the depth of the country’s economic problems. It will take discipline and sacrifice to address them.

    Jensen Comment
    The national debt is the reason for a weakening dollar, higher oil prices, inflation, and our diminishing stature in the world. George Bush was a spendthrift who plunged us deeper into debt by failing to veto spending bills of a run-away Congress. Barack Obama's unfundable populist programs will only bury us deeper in debt. John McCain is probably maverick enough to veto some spending cuts. Our real economic hope may lie in the ultimate veto pen of . . . gasp . . . Sarah Palin.

    For once (actually the second time in 2008) The New York Times had an editorial that makes economic sense:

    Longer term, the challenge is perhaps even more daunting. Saving more is ultimately the only way to dig out of the budget hole that the nation is in. That will be painful, because higher government savings, done properly, means higher taxes and restrained spending. Candidates for president do not like to be pessimistic, or even candid, really, about the economy. But a leader who wants to steer the nation through tough times should not spend the campaign telling Americans they can have it all.
    "There He Goes Again," The New York Times, July 12, 2008 ---
    http://www.nytimes.com/2008/07/12/opinion/12sat1.html?_r=1&oref=slogin
    Jensen Comment
    But true to form, the NYT only criticizes John McCain's balanced budget goals in this context. No mention is made of the NYT's favorite candidate who certainly, albeit truthfully, is not promising anything within light years of a balanced budget. The question is which candidate, if elected, will heavily veto the outrageous spending bills that most certainly emerge from Congress over the next four or eight years. Sadly, George Bush, unlike Reagan, rarely inked a spending veto in his eight years. This country does not know what a life-threatening debt crisis is and will have a rude awakening after November when the U.S. dollar skids to all time lows never imagined. The real problem is that Congress is leaning to more of entitlement time bombs.

    We Can't Tax Our Way Out of the Entitlement Crisis," by R. Glenn Hubbard, The Wall Street Journal,August 21, 2008; Page A13 --- http://online.wsj.com/article/SB121927694295558513.html 

    We can also secure a firm financial footing for Social Security (and Medicare) without choking off economic growth or curtailing our flexibility to pursue other spending priorities. Three actions are essential: (1) reduce entitlement spending growth through some form of means testing; (2) eliminate all nonessential spending in the rest of the budget; and (3) adopt policies that promote economic growth. This 180-degree difference from Mr. Obama's fiscal plan forms the basis of Sen. McCain's priorities for spending, taxes and health care.

    The problem with Mr. Obama's fiscal plans is not that that they lack vision. On the contrary, the vision is plain enough: a larger welfare state paid for by higher taxes. The problem is not even that they imply change. The problem is that his plans are statist.

    While the candidate is sending a fiscal "Ich bin ein Berliner" message to Americans, European critics of his call for greater spending on defense are the canary in the coal mine for what lies ahead with his vision for the United States.

    Professor R. Glenn Hubbard is Dean of the College of Business at Columbia University and a member of the President's Council of Economic Advisors.

    Bob Jensen's threads on the "Entitlement Crisis" are at http://faculty.trinity.edu/rjensen/entitlements.htm

     

    So I vote for an old age pension for McCain and lots of ink in Sarah Palin’s ink well.

    Bob Jensen's threads on entitlements are at http://faculty.trinity.edu/rjensen/entitlements.htm


    Earnings Management Via Hidden Reserves in Banks
    The upgrading of valuation methods, in particular with respect to the valuation of illiquid assets. Work is being led by the Basle Committee and the International Accounting Standards Board (IASB), who have established a panel on fair valuation. Advice is expected by the end of the third quarter of 2008. The IASB is also working on off-balance sheet items with the key question being: when should an entity be brought onto another entity's balance sheet? The input received in these meetings will help the IASB in shaping its forthcoming proposals on reviewing consolidation rules under IFRS. Deliverables are expected in 2009. Proper due process must be carried out. I believe we need to look hard at issues such as dynamic provisioning* – and how to account for prudential reserves built up by banks to buffer for bad times. It should not have escaped people's attention that banks in Spain were better placed to withstand the turmoil because they had not yet adopted the relevant IFRS Standard. There is a lesson there that needs to be drawn .... On accounting, SEC Chairman Cox has unveiled a roadmap where US companies would switch from US GAAP to IFRS by 2014. Unthinkable only two years ago! A dramatic signal indeed. Following the EU's lead, the US is indicating it also wants to choose global standards. One set, in sight, at last. And of course we need to strengthen the governance of the IASB. That is why we are working hard with some of our major counterparts to install new, strengthened oversight mechanisms.
    Charlie McCreevy, European Commissioner for Internal Market, Speech, September 10, 2008 --- http://www.iasplus.com/europe/0809mccreevy.pdf


    The Mortgage Meltdown:  All the feet were together in one bed

    September 16, 2008 message from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    I have some "top line" thoughts on accounting & the credit crisis.

    First, I don't believe accounting "causes" crises. However, in my view, US GAAP accounting rules contributed to the lack of transparency about the financial position & performance of companies who engaged in securitizations involving sub-prime mortgages.

    So here are some tidbits for thought re: the failure of financial reporting to provide relevant information for economic decision-making:

    (1) Securitization SPE/VIEs could be moved off-balance sheet if they were "legally isolated" from the company that created them. Legal isolation was based on opinions of attorneys. These vehicles proved not to be legally isolated when "legal isolation" was tested by the market place.

    (2) Models measuring fair values of financial instruments include assumptions about the characteristics of the instruments. Rarely, if ever, do they include assumptions about more fundamental economics, such as real estate prices or general market collapse. Since the belief was that "real estate prices would always rise", the possibility of a general collapse of real estate prices would have received an extremely low weighting even if this variable was included in a fair value model. There is nothing that accounting rules can do (in my view) to create a comprehensive & complete list of variables to be included in fair value models. All we can do is provide guidance on who to estimate fair values.

    (3) Only when defaults started to occur did the information begin to creep in the financial statements through

    (a) more realistic estimates of fair values of instruments on the books and

    (b) through moving back onto the books assets that had been moved off-balance sheet in SPEs.

    On the IFRS front, I wrote a monograph on this issue for the Institute of Chartered Accountants in Australia. If anyone is interested in my emailing them a copy, email me off-list.

    Regards,
    Pat Walters
    Fordham University

    September 16, 2008 reply from

    Many made excellent points on this topic

    You hear from these giant firms (e.g., AIG, GM, Ford, etc.) telling the government “we are too big to fail” sounds like blackmailing the government. Are they expecting us to consider the size of the company as factor in the going concern determination? Also both presidential campaigns call for “tougher” regulations on markets, are they talking about us? Are they talking about regulators (government agencies) who now will be operating major firms in Wall Street? BTW, should GASB rules apply to these firms?

    In my opinion, it is hard to believe gurus in financial markets such as Bear Stern, Lehman Brothers, or Goldman Sachs with top experts were unaware of risk of real estate loans, or could not manage their greed as they did in the past. After all, they have gone through several cycles of real estate ups and downs over last 100+ years.

    I think this time accountants cannot be blamed, and Bob did a good job explaining that mark-to-market is not the source of the problem. I keep looking for more theories to help me understand what happened so I can better manage my retirement funds in the future. To start, I would like to research whether mixing trade and politics played a role in this crisis (Zane commented on the intertwining nature of the problems), or perhaps sudden devaluation of dollar caused massive sell off on mortgage securities packages in foreign markets; and finally created the run on financial institutions.

    Saeed R.

    September 17, reply from Bob Jensen

    Hi Saeed,

    You stated  “.To start, I would like to research whether mixing trade and politics played a role in this crisis . . . “

    David Albrecht has a picture of bare feet at the end of the September 16, 2008 module at http://profalbrecht.wordpress.com/

    What does this picture mean? 

    Hint:
    They were, and still are, all in bed together.

    In the mortgage meltdown crisis, these are the feet of ignorant and all-powerful representatives in Congress and the Senate (Chris Dodd in particular), investment bankers, greedy local bankers, crooked real estate appraisers, greedy credit insurance brokers, and yes the international auditing firms that did not insist on proper bad debt allowances because they feared losing their biggest clients. In fairness, PwC did insist on providing details about how Fannie could get kicked in the tail, but the seemingly endless footnotes overwhelmed even the most diligent analysts. Most other sets of audited financial statements, in retrospect, were more like the “feet together” picture.

    In the IFRS transition fiasco, these are the bedded-together feet of SEC Chairman Cox, FASB Chairman Herz, the IASB members, and the CEOs of all the large international auditing firms.

    As for me, Father Goose, up here in the mountains, “I’ve got me ten fine toes to wiggle on the rocks” --- http://faculty.trinity.edu/rjensen/NHcottage/NHcottage.htm
    From Father Goose
    Pass Me By (lyrics by Carolyn Leign) --- http://hk.youtube.com/watch?v=C-F3vSrJIUQ

     Bob Jensen

    Don't Blame Mark-to-Market for Banks' Problems," by Jonathan Weil, Bloomberg ---
    http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aJFrPa3rqhHw

    If only we didn't know how badly off the banks are, then maybe we could save the financial system as we used to know it.

    That is the growing mantra from financial executives and their water carriers in Washington. The major problem isn't that banks made poor decisions and lost credibility with investors, in their view. The problem is that mark-to-market accounting is dragging down financial institutions and the U.S. economy, as House Financial Services Committee Chairman Barney Frank said last week.

    They couldn't be more wrong. And there's so much misinformation floating around the markets on this subject that it's time, once again, to debunk the myths.

    Myth No. 1: The rules known as Financial Accounting Standard No. 157 are to blame.

    The latest iteration on this tired saw comes from Christopher Whalen, a managing director at Institutional Risk Analytics, who gave an interview on the subject Friday. Among his recommendations:

    ``Rescind FAS 157 so if you have a real quoted price for an asset, fine, use it. Otherwise you allow companies to use historic cost. You had a transaction, you know what you paid for it, it's a fact. All this other stuff is speculation. We are literally creating the impression of losses.''

    The Awful Truth

    The truth: FAS 157 doesn't expand the use of fair-value accounting. Rather, it requires companies to divulge more information about the reliability of their reported fair values.

    Most companies won't even adopt FAS 157 until this quarter. All the standard does is require companies to disclose how much of their assets and liabilities are valued using quoted market prices, how much are measured using valuation models, and how much come from models using inputs that aren't observable in the market. That's it.

    Myth No. 2: Mark-to-market accounting is new.

    Companies have been ``marking to model'' for decades, and few people complained when banks and others were recording large gains as a result. The difference now, thanks to FAS 157, is that outsiders can see the extent to which companies' fair-value results are based on estimates, at least at companies that adopted the rules early.

    Financial statements always have been piles of estimates heaped upon a bunch of guesswork. Look through the footnotes to any company's financial statements, and you'll see that estimates are used for everything from loan-loss reserves, to income-tax and stock-option costs, even revenue.

    Solves Nothing

    Moving everything to historical-cost accounting wouldn't solve anything. For assets that aren't marked-to-market each quarter, such as goodwill and inventory, they still must be written down to fair value whenever their values have declined sharply and show no sign of bouncing back. The accountants call this an ``other-than-temporary impairment.''

    So even if we had historical-cost accounting today for all the mortgage-related holdings that have plummeted in value and for which there is no liquid market, companies still would have to estimate the assets' fair values and write them down accordingly. That's because the values probably won't come back anytime soon, if ever.

    Myth No. 3: Companies aren't allowed to explain their mark- to-market values.

    This is a fairly new one. Last week, the Securities and Exchange Commission said it is drafting a letter to let companies tell investors when they think the market values of their plunging assets don't reflect the holdings' actual worth. Companies also would be allowed to disclose ranges showing what their models say the assets might fetch in the marketplace.

    Guess what? Companies are allowed to do these things already in the discussion-and-analysis sections of their SEC reports each quarter. They also can make such disclosures in their financial-statement footnotes. What they can't do is print ranges on their balance sheets or income statements, any more than taxpayers can put down ranges on their Internal Revenue Service returns.

    Myth No. 4: Eliminating mark-to-market accounting will prevent margin calls.

    If you're a banker for, say, Thornburg Mortgage Inc. or Carlyle Capital Corp., do you think for a minute that you would hesitate to call in one of these companies' loans just because they started using historical cost to account for hard-to-value financial instruments? No way. The moment lenders decide the collateral isn't worth enough to support the loans, they'll demand more collateral or pull the plug, no matter what the financial statements say.

    Myth No. 5: The public would be better off without mark-to- market accounting.

    Investors are fully capable of understanding that unrealized losses on hard-to-value assets are estimates. They're also smart enough to know that values change over time. And in the case of things such as credit-default swaps that eventually might reach some settlement date, the fair-value changes include vital forward-looking information about what the future economic costs of these derivatives may be.

    What most investors can't tolerate is being kept in the dark, when companies in their portfolios are sliding toward insolvency and whistling along the way that all is well.

    We've got a meltdown, folks. Deal with it.


    "Accounting for the auditors: As huge corporations tumble, what of the auditing firms paid millions to provide them with clean,"
    by Prem Sikka, The Guardian, September 18, 2008
    http://www.guardian.co.uk/commentisfree/2008/sep/18/marketturmoil.economics?commentpage=1&commentposted=1

    In the current financial turmoil, companies are falling like ninepins. Lehman Brothers is in administration. Northern Rock, Fannie Mae and Freddie Mac have been bailed out and the list of vulnerable banks is growing. Bear Stearns and Merrill Lynch have been sold at knockdown prices and HBOS has merged with Lloyds TSB. Governments are pouring vast amounts of money to bail out financial institutions. Amidst the mayhem, we need to ask questions about the role of auditors, who have been paid millions of pounds to give opinions on company financial statements. Yet companies are sinking within weeks of getting a clean bill of health.

    Ever since the 1998 collapse of Long Term Capital Management (LTCM) and its rescue by the US Federal Reserve, it has been acknowledged that derivatives are very difficult to value. In this case Nobel prize winners in economics could not work out the value of such financial instruments. Derivatives are central to the demise of Lehman. Its annual accounts mention derivatives contracts with a face value of $738bn and fair value of $36.8bn.

    Lehman Brothers, incorporated in the tax haven of Delaware, was audited by the New York office of Ernst & Young. On January 28 2008, the firm gave a clean bill of health to Lehman accounts for the year to November 30 2007. The auditor's report (page 75 of the accounts) says, "Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances". Lehman Brothers filed quarterly accounts with the SEC for the period of May 31 2008 and on July 10 2008 and these (see page 52) too received a clean bill of health. Despite the deepening financial crisis, auditors did not express any reservations about the value of the derivatives or any scenarios under which company may be unable to honour its obligations. Just two months later, Lehman collapsed.

    During 2007, Ernst & Young collected fees (see page 43) of $31,307,000 from Lehman Brothers, compared to $29,451,000 for 2006. The fees for 2005 and 2004 were $25,324,000 and $24,748,000 respectively. Over the last four years, Ernst & Young collected over $110m in fees, of which nearly $14m is for advice on tax and other consultancy services.

    The scale of fees raises questions about auditor independence. By providing other services auditors begin to perform quasi management functions and cannot objectively evaluate the outcome of the transactions they themselves have helped to create. The fee of $110m for the New York office of Ernst & Young is likely to be significant in influencing the financial rewards of local partners and managers. The fee dependency exerts pressure on auditors to acquiesce with management. Such concerns were raised during the demise of WorldCom, Maxwell, Enron and more recently in the insolvency examiner's report on the collapse of New Century.

    Audit opinions are akin to financial mirages. In recent weeks, within a short period of receiving clean bills of health Bear Stearns, Carlyle Capital Corporation and Thornburg Mortgage hit the financial buffers, closely followed by Lehman Brothers.

    Time and time again it has been shown that the basic audit model is faulty. Private sector auditors cannot be independent of the companies that they audit. This fundamental faultline has not been addressed by the post Enron reforms. In addition, the ex-post financial audits are too late and cannot alert financial regulators of problems. The financial regulators have a wider remit and are also concerned with the financial health of the whole system. These shortcomings were recognised after the 1929 stock market crash. The draft legislation that created the SEC in the 1930s contained a provision making the SEC the auditor for public companies, but under pressure from corporate interests, legislation was diluted.

    It is time to go back to the future and ensure that audits of major companies, at least banks and financial institutions, are carried out directly by the regulators. These audits should be on a real-time basis. Audits by regulators have the advantage of independence and can address regulatory issues. Accounting firms and companies used to softer audits will no doubt fight tooth-and-nail to retain their privileges, but we can't continue to indulge accounting firms and pay billions to rescue banks

    Bob Jensen's threads on auditor independence and professionalism are at
    http://faculty.trinity.edu/rjensen/fraud001.htm#Professionalism


    Notable Quotations About the SEC's New Proposals for Oil & Gas Accounting

    I think I can always tell when the fix is in. First, big lies are woven into a large dose of truth, so they won't look to be as big as they are. There are certainly many things in the SEC's proposal to recommend it, especially along the lines of expanding the types of reserves that would be disclosed, and updating important definitions. Second, when the justification for a proposal makes no sense, there can be no debate; you can't tell the emperor he's naked. The lesson of the Cox's SEC is to never forget about the big special interests that write big checks to the big politicians that made him emperor for a day.
    Tom Selling, "SEC on Oil and Gas Disclosures: Current Prices Aren't 'Meaningful'?" The Accounting Onion, July 25, 2008 --- http://accountingonion.typepad.com/theaccountingonion/2008/07/oil-and-gas-dis.html


    Tom Selling put together a nice summary of some key issues in fair value accounting at
    The SEC's Fair Value Roundtable” The Accounting Onion, July 16, 2008 ---
     http://accountingonion.typepad.com/theaccountingonion/2008/07/the-secs-fair-v.html  

    On July 9, 2008, in Washington, DC, the SEC hosted a roundtable "to facilitate an open discussion of the benefits and potential challenges associated with existing fair value accounting and auditing standards." The roundtable was webcast and lasted about four hours. I admit that I literally fell asleep after listening to the discussion for the better part of three hours, so I missed the end. For all I know, the grand finale was a fireworks display, but I doubt it – this time, both literally and figuratively. When the SEC schedules these roundtable events for 9 a.m. on the east coast, I can't help but wonder what they are trying to tell those of us located in PAC-10 country (Go Sun Devils!). Maybe they would really prefer that no one listens.

    Anyway, the topics included, among other things, discussions of the aspects of current standards that could be improved, and the usefulness of fair value accounting to investors. I'm going to address three issues that are so basic and important enough that accounting professors may want to consider using them for a class discussion.

    Issue #1: "Held-to-Maturity" Investments

    James Tisch of Loews Corp., when talking about his company's insurance subsidiaries, teed up this issue by describing a situation where his company would invest in marketable debt securities whose valuation might be affected by interest rate changes -- even though there would be no changes to the borrower's credit risk. Being an insurance company subject to various regulatory authorities, a rise in interest rates would supposedly force Loews to declare the investments in the held- to-maturity-category of marketable debt securities, the least onerous of three evils (the other two requiring fair value accounting).

    Without the held-to-maturity option, the carrying amount of the investment would initially decline as interest rates rose, but could be expected to recover to the amount of the contractual obligation as the maturity date approached. Tisch's view seems to be that either fair value accounting would unreasonably record losses when it is highly probable that the entire investment plus interest will be recovered, or that constraints imposed by regulators trump the accounting that is most appropriate from an investor's viewpoint.

    I think that the best way to approach a question like this is to ask yourself a simple question: did Mr. Tisch's company suffer a loss because it chose to invest in fixed-rate, as opposed to variable-rate, debt instruments? Yes it did. While regulators may find that it obscures their own peculiar needs, there must surely more straightforward ways to solve the conflict with investor needs than to muck up the financial statements.

    And don't forget that apart from appeasing the needs of regulators, the held-to-maturity category is chicken salad for management: as Mr. Tisch implied, his company would manage its reported financial position by "cherry picking": if interest rates were to decline instead of rise, those same investments are probably classified as trading in order to get the asset and earnings bumps.

    In short, FAS 115 on marketable securities could have been a lot simpler if the goals for financial statements could be (and should be) a lot simpler. As another panelist observed, one shouldn't need a legal degree to be capable of reading all the disclosures. I believe the disclosures he was referring to owe their existence to low-quality solutions cobbled together to meet the needs of someone else besides investors. The SEC should be telling other regulators to go and make their own accounting rules if they don't like the ones that are supposed to protect investors.

    Issue #2: Fair Value of Liabilities

    Joseph Price, the CFO of Bank of America, expressed his opposition to applying fair value measurements to contractual obligations such as litigation (and by the way, one of my more recent posts discusses the misguided way in which the IASB would require fair value measurement for some non-contractual obligations). Mr. Price has no problem with a mixed attribute model of accounting, which is just another way of saying that he has no problem adding apples and oranges.

    The larger question, however, is whether any liability should be subject to fair value measurement. In addition to the claims that gain recognition on liabilities from deterioration of credit risk would distort earnings, other speakers pointed out that the character of the gain itself, often incapable of being monetized absent liquidation, creates problems.

    The academic, Kathy Petroni, conceded that it can be confusing when an operating loss can be more than offset by gains from writing down the value of one's own debt. However, she is also of the view that the gain on the debt is representationally faithful; in other words, the problem is not with the current valuation of the debt, but with incomplete asset revaluation. This is because not all balance sheet assets are measured at fair value, and not all economic assets are even recognized. Tom Linsmeier, of the FASB and also an academic, made the interesting observation that a write-down to liabilities could be reasonably interpreted by investors as a signal of the asset losses that were not recognized.

    As you may already have guessed, I am not sympathetic to stating liabilities at something other than current values. For one thing, we will never get to the point where all of the assets of a business are recognized, so we will never get to the point of measuring all of the components of economic income. Investor's don't expect financial reporting to account for all of the components of economic income. (Actually, that's what changes in stock prices do, but they have the distinct disadvantage of not allowing an analyst to directly identify the drivers of stock price changes.) What investors do expect is that the components of economic income that are measured are measured properly. If the deterioration of a company's credit worthiness creates an opportunity, amidst the other problems it must be experiencing, for it to restructure its debt advantageously, doesn't that opportunity benefit shareholders? Absolutely.

    And, by the way, I am not advocating that all liabilities, regardless of the likelihood that a cash outflow will occur, be given recognition. And perhaps, some non-contractual liabilities, due to their nature, should be excluded from recognition. So the problem of incomplete recognition extends to the liability side just as much as to the asset side.

    As the old saying goes, "perfection is the enemy of the good". What that means here is that we should not be distorting liability valuation just because some other element is not perfectly taken account of.

    Issue #3: Fair Value Accounting for Non-Financial Assets

    There was some discussion and support for measuring non-financial assets at fair value, but that support may have been even less enthusiastic than the support for fair value measurement of financial assets.

    Logic dictates that whatever approach to fair value for financial assets is taken, that same approach should be applicable to non-financial assets. What's good for the goose is good for the gander; otherwise, we permanently consign ourselves to adding apples and oranges. And speaking of which, I have also pointed out here that some folks who don't care whether they are adding apples and oranges don't even care how assets and liabilities are measured -- just so long as they can control what is reported on the (their) income statement. One of my favorite examples is the historic cost of a tract of land carried on the balance sheet of a foreign subsidiary: when multiplied by today's current exchange rate to translate into dollars, we don't end up with an historic cost in dollars, or a current value in dollars. We end up with what is essentially a random number. How do you test impairment of a random number?

    Speaking impairment, for those of you who have had to apply FAS 144 on the impairment of long-lived assets, or FAS 142 on goodwill impairment, or even inventory impairment, you would know from that unfortunate experience that the impairment model of accounting is perhaps the biggest source of complexity, if not broken altogether. Some would argue that it is a reason, in and of itself, to abandon historic cost accounting and move to some version of current costs.

    So, what if we went to fair value accounting for non-financial assets? That might solve the impairment problem, but it would raise another big issue, that being gain recognition before the non-financial assets, usually inventory, were actually sold. In a nutshell, that's why I think proponents of fair value are hesitant to extend the concept to non-financial assets -- more than anything, it exposes the main problem of fair value serving as a core accounting principle.

    The appropriate non-financial asset attribute to measure is replacement cost (entry prices), and not fair value (exit prices). To further appreciate this, take for example the issue of transaction costs to acquire inventory. If FAS 157 were applied to purchases of raw materials inventory, transaction costs (perhaps a brokerage fee) would be expensed immediately upon acquisition. We all know that this makes no sense: we immediately have an expense to report before we have any chance at all to generate a return on our investment. (By the way, the same anomaly applies to financial assets, but it has already been established by FAS 157 that the FASB doesn't seem to care much about this.)

    A replacement cost approach, on the other hand, would mean that all of the expenditures required to replace the asset should be part of the carrying amount of the asset. If we ultimately sell inventory for an amount greater than it would cost us to replace it, then we have a profit.

    Getting back to geese and ganders, if replacement cost is the appropriate attribute to measure for non-financial assets, then it must be the appropriate attribute for financial assets as well.

    Oh, Well…

    Overall, the roundtable contributed very little to the fair value debate that hasn't already been expressed and considered before. Nonetheless, it reinforces two points that may well conclude that class discussion that was suggesting:

    First, I would prefer to have a dialogue at the SEC instead of in London at IFRS headquarters. Chairman Cox himself unwittingly pointed this out when he asked one set of panelists whether they believe current accounting rules contributed in some way to the economic issues the financial institutions are now dealing with. What if the answer to his question is "yes"? That, by itself, should settle for ever the debate about who should be setting accounting standards for the U. S. capital markets. What if the answer to Cox's question is "we don't know"? QED.

    Second, it would be refreshing if for once, an issue were settled by simply asking what it is that investors would want. Why does it seem that policy makers are incapable of doing that?

     


    "FAS 157: Auditors are ready to assign fair value to financial assets," AccountingWeb, November 2007 --- 
    http://www.accountingweb.com/cgi-bin/item.cgi?id=104246

    When credit markets all but dried up as a result of the sub-prime mortgage crisis in the late summer, auditors of investment and commercial banks that elected to adopt Financial Accounting Standard 157, Fair Value Measurements, earlier than the effective date of November 15th were called upon to play a key role in determining the market value of mortgage-backed assets when few were being traded. Many of these banks had to report huge write-downs in the third quarter from declining assets values. But auditors of public companies have made it clear in three recently published white papers from their newly formed Center for Audit Quality that despite the severity of the current market crunch, they intend to apply the fair value standard consistently, and market problems will not influence their professional judgment about the quality of valuation models and assumptions used by banks.

    Continued in article

    Jensen Comment
    The following standards are especially pertinent to fair value accounting:
    FAS 105, 107, 115, 130, 133, 141(R), 142, 155, 157, 159
    FAS 157 is mainly a definitional standard. The key standard to date is FAS 159 that allows companies to cherry pick which contracts are to be carried at fair value and which are to be carried at amortized historical cost. To me FAS 159 is a terrible standard that can lead to all sorts of subjective manipulation, earnings management, and aggregation of apples and door knobs in summations of assets, liabilities, and earnings components. I think the FASB viewed FAS 159 as a political expedient way to expand fair value accounting into financial statements without having to fight the huge political battle with banks and other corporations who aggressively oppose required fair value accounting for all financial and derivative financial instruments.

    The FAS 141(R) revision of the business combinations standard FAS 141 makes a giant leap into fair value accounting for intangibles acquired with business combinations.


    From The Wall Street Journal Accounting Weekly Review on May 16, 2008

    MBIA's Book-Value View
    by David Reilly
    The Wall Street Journal

    May 13, 2008
    Page: C12
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB121065046561187725.html?mod=djem_jiewr_ac
     

    TOPICS: Accounting, Banking, Fair Value Accounting, Financial Accounting, Financial Analysis, Financial Reporting, Financial Statement Analysis, GAAP, Generally accepted accounting principles, Mark-to-Market, Market-Value Approach

    SUMMARY: Mr. Reilly advises that investors "should stick to figures the company compiles according to generally accepted accounting principles" in analyzing MBIA's financial position, particularly its $8.70 per share book value. MBIA management provides an alternative book value measure that ignores items with which it disagrees about the treatment under generally accepted accounting principles, particularly mark-to-market requirements.

    CLASSROOM APPLICATION: Financial accounting, financial statement analysis, and accounting theory courses all may use this article to discuss the bias inherent in choosing alternative measures to GAAP.

    QUESTIONS: 
    1. (Introductory) Define the terms book value and book value per share. Why do these measures, based on financial statements, differ from market value per share?

    2. (Advanced) What is mark-to-market accounting? In general, for what MBIA balance sheet items do you think the company must employ this measurement method?

    3. (Introductory) " Some investors may...think mark-to-market accounting is overestimating losses at MBIA and other financial firms." How does overstating losses lead to concerns with accurately assessing book value and book value per share? What arguments support the assessment that losses may be overestimated?

    4. (Advanced) How is MBIA management trying to divert attention from book value per share according to generally accepted accounting principles to a measure it says 'provides an economic basis for investors to reach their own conclusions about the fair value of the company'? What qualitative characteristics of accounting information may be violated in the measures chosen by management?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    "MBIA's Book-Value View:  Bond Insurer Dons Rosier Glasses; Dot-Bomb Move?" by David Reilly, The Wall Street Journal, May 13, 2008; Page C12 --- http://online.wsj.com/article/SB121065046561187725.html?mod=djem_jiewr_ac

    Back in the dot-bomb days, companies liked to guide investors to rosy variations of their stated profit. These profit figures eventually became known as EBBS, or "earnings before bad stuff."

    Bond insurer MBIA Inc. is taking a page from that playbook. In its first-quarter earnings release Monday, MBIA said investors shouldn't look to its stated book value -- the measure of a company's net worth based on assets minus liabilities. Instead it prefers a metric it calls "analytic adjusted book value" that "provides an economic basis for investors to reach their own conclusions about the fair value of the company."

    A better name for this measure might have been SEEMM, or "shareholders equity excluding mortgage mess." At its core, this means avoiding marking assets to market -- that is, adjusting their value down to what they would sell for today. So MBIA's variation on book value excludes things like the $3.5 billion mark-to-market loss on derivatives that drove its $2.4 billion net loss in the first quarter. Rather, it includes management's expectations of losses, plus gains from future expected premium payments.

    This method leads to book value per share of about $42. By excluding only the mark-to-market losses, it shows an adjusted book value of $24 a share.

    That looks a lot better than MBIA's stated book value of $8.70 at the end of March, and its share price Monday of $9.85, up 42 cents, or 4.5%, in 4 p.m. New York Stock Exchange composite trading.

    Investors shouldn't forget the lessons of the Internet-stock bubble; they should stick to figures the company compiles according to generally accepted accounting principles. On the basis of that $8.70-a-share figure, the stock, even at its current level, isn't a bargain.

    MBIA Chief Financial Officer C. Edward Chaplin countered that the firm believes accounting rules don't provide a true view of long-term value. Items valued using market prices are in many cases "distorting the book value of the company as opposed to providing additional useful information to investors," he said.

    The company is in better position following the $2.6 billion in capital it has raised in recent months. That has led ratings firms to maintain its triple-A ratings and calmed investor fears that MBIA could go under.

    Some investors may be tempted to side with the company because they, too, think mark-to-market accounting is overestimating losses at MBIA and other financial firms. And the company's book value likely has improved since the end of March, given improvements in the debt markets.

    MBIA still has a lot of problems. One big one is the $18 billion in home-equity loans and second-lien mortgages to which it has exposure. This is one of the hardest-hit, and worsening, areas of the mortgage markets. Some 55% of these loans were originated by Countrywide Financial Corp., whose lending practices are under investigation by federal authorities.

    Another worry is the $40 billion in securities it insures that are backed by commercial mortgages. These haven't gone sour, but as the economy weakens, many analysts expect them to.

    MBIA Chief Executive Jay Brown said on a conference call he believed the company's various loss estimates were realistic. "We sell a promise," he said, referring to the company's pledge to make good on losses it insures against. So investors "are rightly focused on our ability to fulfill that promise."

    They should also be focused on reported numbers, not made-up ones that conjure memories of the market's last bubble.

    HSBC Cheers Investors, but Pitfalls Remain

    Monday's earnings numbers make HSBC Holdings PLC look tempting. Its write-downs were below consensus and growth is coming from Asia and the Middle East. But after the recent 20% rally in the stock, the good news is largely priced in and the bank's warning of a further slowdown in 2009 in the U.S. isn't.

    More worrisome is investors, who bid up HSBC shares 3.1% Monday, seem to believe that the bank has seen the worst of write-downs in the U.S. That is hard to believe since the U.S.-based HSBC Finance unit is deeply entrenched in states like California, Florida and Arizona, where house prices are continuing to decline. More than 40% of HSBC Finance consumer lending's real-estate portfolio is concentrated in states where delinquency is expected to keep rising.

    At the end of March, its portfolio of adjustable-rate mortgages stood at $17.1 billion. About $2 billion of those will have their first interest rates reset in 2008 and double that will reset in 2009. HSBC Finance's portfolio of "stated income loans" -- loans given out without verifying borrower's income -- is $7.2 billion.

    HSBC appears less optimistic than its investors. It is one of the first global banks to put out a serious warning of potential 2009 pain. If the warning comes true, the United Kingdom bank is preparing its investors for hurt and investors should pay heed

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Bob Jensen's threads on alternative valuations --- http://faculty.trinity.edu/rjensen/Theory01.htm#UnderlyingBases


    "SEC on Oil and Gas Disclosures: Current Prices Aren't "Meaningful"?" by Tom Selling, The Accounting Onion, July 25, 2008 ---

    "The Futility of SEC Oil and Gas Disclosures: Part II," by Tom Selling, The Accounting Onion, August 26, 2008 --- http://feeds.feedburner.com/~r/typepad/theaccountingonion/~3/374957122/the-futility-of.html


    Question
    How did fair value accounting turn a $215 million loss into a $195 million gain for the Radian Group?

    Answer
    Because the bonds it insured had been falling in value for a while, the swaps' values had been increasing, leading to charges in previous quarters. In the first quarter, a big chunk of that was reversed. That turned a loss into profit. In theory, the logic of the new accounting approach holds up. But that doesn't change the fact that for investors, the real-world outcome is perverse.

    From The Wall Street Journal Accounting Weekly Review on May 23, 2008

    When a Loss Is a Gain
    by David Reilly
    The Wall Street Journal

    May 19, 2008
    Page: C12
    Click here to view the full article on WSJ.com
    http://online.wsj.com/article/SB121116684762202957.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Financial Accounting, Mark-to-Market Accounting

    SUMMARY: Radian Group managed to post net profit of $195 million, despite a rough first quarter. The profit was a controversial byproduct of a new accounting rule that caused the company to report gains of about $2 billion on some of its liabilities.

    CLASSROOM APPLICATION: This situation clearly shows the ironic results possible as a result of the new mark-to-market accounting rule. Use this article for a good critical thinking exercise analyzing the issues resulting from this rule.

    QUESTIONS: 
    1. (Advanced) How did Radian manage to post a net profit of $195 million when it had a loss of $215 million?

    2. (Introductory) What is the basic accounting rule when a firm experiences a reduction in the value of a liability? What is the reasoning behind this basic rule?

    3. (Introductory) What is mark-to-market accounting? Why was this new rule instituted? What is the value of the rule?

    4. (Advanced) The article states that Radian "clearly flagged" the impact of its application of the new rule. What does that mean? Is this required? What would happen if a company did not clearly flag the impact?

    5. (Advanced) What is the ironic result of this new rule? Do you think that this result was anticipated when the rule was drafted? Why or why not? How does this affect investors?

    6. (Advanced) What could happen if Radian's financial health improves in the future?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast
     

    "When a Loss Is a Gain:  New Rule Helped Radian Turn Woes Into a Net Profit," by David Reilly, The Wall Street Journal, May 19, 2008; Page C12  --- http://online.wsj.com/article/SB121116684762202957.html?mod=djem_jiewr_AC

    Like other companies that insure bonds and mortgages, Radian Group Inc. had a rough first quarter. What a surprise then that it managed to post net profit of $195 million.

    How that happened holds a cautionary tale for investors. Radian was in the black because its hobbled financial condition caused it to report gains of about $2 billion on some of its liabilities.

    The profit was a controversial byproduct of a new accounting rule involving mark-to-market accounting. Without the benefit of this quirk, Radian's loss would have been about $215 million.

    One of the basic rules of accounting says that a reduction in the value of a liability leads to a gain that usually boosts profit. Under the new rule, companies have to take into account the market's view of their own financial health when considering the market value of some liabilities. In this case, a company's poor health can lead to a reduction in the liability's value.

    Radian hasn't done anything wrong. It properly applied the new rule and clearly flagged its impact when it reported earnings last week. Others might not be so forthright, meaning investors will have to be even more sharp-eyed as the credit crisis plays itself out.

    The irony is that by marking these particular assets to market as the new rule requires, the weaker a company gets, the stronger it may look.

    "The most bizarre aspect of this is that if I'm going bankrupt, the market's diminishing perception of my credit-worthiness fuels my profits," said Damon Silvers, associate general counsel at the AFL-CIO and a longtime critic of market-value accounting.

    Another twist: If perceptions of Radian's financial health increase in coming quarters, the company could reverse the gain. That could lead it to take losses on some of its assets.

    Radian Chief Financial Officer C. Robert Quint doesn't take issue with the overall notion of market-value accounting. But he said aspects of it, such as these gains, can be troubling. "For investors to really understand what's going on behind the numbers is proving more and more difficult," he said.

    Other companies, notably big banks and brokers, have in recent months seen similar gains from declines in the value of their own debt, which also leads to a reduction of liabilities and a boost in profit. But the impact is more pronounced at Radian and other insurers because the gains are coming instead from their core insurance business, at least when it involves derivatives. Radian and others also saw an outsized impact because their first-time adoption of the rule led to a big, all-at-once adjustment.

    Here is how it plays out. Say a company holds a bond and insures against the bond's default by buying a credit-default swap from an insurer. If the bond falls 10%, the value of the swap would increase, say, by the same amount. The bond is considered riskier, so insurance on the bond is more valuable.

    In the past, a bondholder would have booked offsetting gains and losses as the bond fell in value and the insurance rose in value. But the new accounting rule on measuring market values says companies also have to consider how much something would fetch if sold today.

    If the market has doubts about the financial health of the insurer that issued the credit-default swap, that swap might not fetch the full 10% premium. While the bond it insures is riskier, the insurer that issued it is riskier, too. Maybe it could be sold for only a 5% gain. In that case, the initial 10% moves in both the bond and swap wouldn't cancel each other out and the bondholder would record a loss of 5%.

    For the insurer issuing the swap, though, this works in reverse. When bonds that Radian insured fell in value, the increase in the value of the swap, or liability, would be taken as a charge. The new rule added a wrinkle -- they could no longer assume that the only driver of the swap's value was the bond it insured. Instead, the insurers had to figure in the impact of their own perceived credit-worthiness and how that would affect the swap's value in a sale.

    Radian's perceived credit-worthiness plummeted in the first quarter as billions of dollars of mortgages it insured fell in value. With Radian's credit-worthiness in question, the value of the credit-default swaps it issued fell in value. That led to a big decline in the value it ascribed to swaps.

    Because the bonds it insured had been falling in value for a while, the swaps' values had been increasing, leading to charges in previous quarters. In the first quarter, a big chunk of that was reversed. That turned a loss into profit.

    In theory, the logic of the new accounting approach holds up. But that doesn't change the fact that for investors, the real-world outcome is perverse.

    Bob Jensen's threads on interest rate swap valuations are at http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

    Bob Jensen's threads on FAS 133 and IAS 39 are at http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    Question
    What is the meaning of the new buzz acronym EBITDAGSAC?

    "EBITDAGSAC: A Guide to Cash Generation for Bankers," Long or Short Capital, April 28, 2008 ---
    http://longorshortcapital.com/ebitdagsac-a-guide-to-cash-generation-for-bankers.htm 


    "The Role of Fair Value Accounting in the Subprime Mortgage Meltdown," Journal of Accountancy, May 2008 --- http://www.aicpa.org/pubs/jofa/may2008/in_my_opinion.htm

    As the credit markets froze and stocks gyrated, investors and pundits naturally looked for someone, or some thing, to blame. Fair value accounting quickly emerged as an oft-cited problem. But is fair value really a cause of the crisis, or is it just a scapegoat? And might it have prevented an even worse calamity? On the following pages, the JofA presents three views on the debate.

     "Both Sides Make Good Points," by Michael R. Young

    How often do we get to have a raging national debate on an accounting standard? Well, we’re in one now.

    And while the standard at issue—FASB Statement no. 157, Fair Value Measurements—is fairly new, the underlying substance of the debate goes back for decades: Is it best to record assets at their cost or at their fair (meaning market) value? It is an issue that goes to the very heart of accountancy and stirs passions like few others in financial reporting. There are probably two reasons for this. First, each side of the debate has excellent points to make. Second, each side genuinely believes what it is saying.

    So let’s step back, take a deep breath, and think about the issue with all of the objectivity we can muster. The good news is that the events of the last several months involving subprime-related financial instruments give us an opportunity to evaluate the extent to which fair value accounting has, or has not, served the financial community. Indeed, some might point out that the experience has been all too vivid.

    WHAT HAPPENED We’re all familiar with what happened. This past summer, two Bear Stearns funds ran into problems, and the result was increasing financial community uncertainty about the value of mortgage backed financial instruments, particularly collateralized debt obligations (CDOs). As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary complexity of the instruments provided a significant impediment to insight into the underlying financial data.

    As a result, the markets seized. In other words, everyone got so nervous that active trading in many instruments all but stopped.

    The practical significance of the market seizure was all too apparent to both owners of the instruments and newspaper readers. What was largely missed behind the scenes, though, was the accounting significance under Statement no. 157, which puts in place a “fair value hierarchy” that prioritizes the inputs to valuation techniques according to their objectivity and observability (see also “Refining Fair Value Measurement,” JofA, Nov. 07, page 30). At the top of the hierarchy are “Level 1 inputs” which generally involve quoted prices in active markets. At the bottom are “Level 3 inputs” in which no active markets exist.

    The accounting significance of the market seizure for subprime financial instruments was that the approach to valuation for many instruments almost overnight dropped from Level 1 to Level 3. The problem was that, because many CDOs to that point had been valued based on Level 1, established models for valuing the instruments at Level 3 were not in place. Just as all this was happening, moreover, another well-intended aspect of our financial reporting system kicked in: the desire to report fast-breaking financial developments to investors quickly.

    To those unfamiliar with the underlying accounting literature, the result must have looked like something between pandemonium and chaos. They watched as some of the most prestigious financial organizations in the world announced dramatic write downs, followed by equally dramatic write downs thereafter. Stock market volatility returned with a vengeance. Financial institutions needed to raise more capital. And many investors watched with horror as the value of both their homes and stock portfolios seemed to move in parallel in the wrong direction.

    To some, this was all evidence that fair value accounting is a folly. Making that argument with particular conviction were those who had no intention of selling the newly plummeting financial instruments to begin with. Even those intending to sell suspected that the write-downs were being overdone and that the resulting volatility was serving no one. According to one managing director at a risk research firm, “All this volatility we now have in reporting and disclosure, it’s just absolute madness.”

    IS FAIR VALUE GOOD OR BAD? So what do we make of fair value accounting based on the subprime experience?

    Foremost is that some of the challenges in the application of fair value accounting are just as difficult as some of its opponents said they would be. True, when subprime instruments were trading in active, observable markets, valuation did not pose much of a problem. But that changed all too suddenly when active markets disappeared and valuation shifted to Level 3. At that point, valuation models needed to be deployed which might potentially be influenced by such things as the future of housing prices, the future of interest rates, and how homeowners could be expected to react to such things.

    The difficulties were exacerbated, moreover, by the suddenness with which active markets disappeared and the resulting need to put in place models just as pressure was building to get up-to-date information to investors. It is hardly surprising, therefore, that in some instances asset values had to be revised as models were being refined and adjusted.

    Imperfect as the valuations may have been, though, the real-world consequences of the resulting volatility were all too concrete. Some of the world’s largest financial institutions, seemingly rock solid just a short time before, found themselves needing to raise new capital. In the aftermath of subprime instrument write-downs, one of the most prestigious institutions even found itself facing a level of uncertainty that resulted in what was characterized as a “run on the bank.”

    So the subprime experience with fair value accounting has given the naysayers some genuine experiences with which to make their case.

    Still, the subprime experience also demonstrates that there are two legitimate sides to this debate. For the difficulties in financial markets were not purely the consequences of an accounting system. They were, more fundamentally, the economic consequences of a market in which a bubble had burst.

    And advocates of fair value can point to one aspect of fair value accounting—and Statement no. 157 in particular—that is pretty much undeniable. It has given outside investors real-time insight into market gyrations of the sort that, under old accounting regimes, only insiders could see. True, trying to deal with those gyrations can be difficult and the consequences are not always desirable. But that is just another way of saying that ignorance is bliss.

    For fair value advocates, that may be their best argument of all. Whatever its faults, fair value accounting and Statement no. 157 have brought to the surface the reality of the difficulties surrounding subprime-related financial instruments. Is the fair value system perfect? No. Is there room for improvement? Inevitably. But those favoring fair value accounting may have one ultimate point to make. In bringing transparency to the aftermath of the housing bubble, it may be that, for all its imperfections, the accounting system has largely worked.

    --------------------------------------------------------------------------------

    Michael R. Young is a partner in the New York based law firm Willkie Farr & Gallagher LLP, where he specializes in accounting irregularities and securities litigation. He served as a member of the Financial Accounting Standards Advisory Council to FASB during the development of FASB Statement no. 157. His e-mail address is myoung@willkie.com.

    --------------------------------------------------------------------------------

    "The Capital Markets’ Needs Will Be Served: Fair value accounting limits bubbles rather than creates them," by Paul B.W. Miller

    With regard to the relationship between financial accounting and the subprime-lending crisis, I observe that the capital markets’ needs will be served, one way or another.

    Grasping this imperative leads to new outlooks and behaviors for the better of all. In contrast to conventional dogma, capital markets cannot be managed through accounting policy choices and political pressure on standard setters. Yes, events show that markets can be duped, but not for long and not very well, and with inevitable disastrous consequences.

    With regard to the crisis, attempts to place blame on accounting standards are not valid. Rather, other factors created it, primarily actors in the complex intermediation chain, including:

    Borrowers who sought credit beyond their reach.

    Borrowers who sought credit beyond their reach.

    Investment bankers who earned fees for bundling and selling vaporous bonds without adequately disclosing risk.

    Institutional investors who sought high returns without understanding the risk and real value.

    In addition, housing markets collapsed, eliminating the backstop provided by collateral. Thus, claims that accounting standards fomented or worsened this crisis lack credibility.

    The following paragraphs explain why fair value accounting promotes capital market efficiency.

    THE GOAL OF FINANCIAL REPORTING The goal of financial reporting, and all who act within it, is to facilitate convergence of securities’ market prices on their intrinsic values. When that happens, securities prices and capital costs appropriately reflect real risks and returns. This efficiency mutually benefits everyone: society, investors, managers and accountants.

    Any other goals, such as inexpensive reporting, projecting positive images, and reducing auditors’ risk of recrimination, are misdirected. Because the markets’ demand for useful information will be satisfied, one way or another, it makes sense to reorient management strategy and accounting policy to provide that satisfaction.

    THE PERSCRIPTION The key to converging market and intrinsic values is understanding that more information, not less, is better. It does no good, and indeed does harm, to leave markets guessing. Reports must be informative and truthful, even if they’re not flattering.

    To this end, all must grasp that financial information is favorable if it unveils truth more completely and faithfully instead of presenting an illusory better appearance. Covering up bad news isn’t possible, especially over the long run, and discovered duplicity brings catastrophe.

    SUPPLY AND DEMAND To reap full benefits, management and accountants must meet the markets’ needs. Instead, past attention was paid primarily to the needs of managers and accountants and what they wanted to supply with little regard to the markets’ demands. But progress always follows when demand is addressed. Toward this end, managers must look beyond preparation costs and consider the higher capital costs created when reports aren’t informative.

    Above all, they must forgo misbegotten efforts to coax capital markets to overprice securities, especially by withholding truth from them. Instead, it’s time to build bridges to these markets, just as managers have accomplished with customers, employees and suppliers.

    THE CONTENT In this paradigm, the preferable information concerns fair values of assets and liabilities. Historical numbers are of no interest because they lack reliability for assessing future cash flows. That is, information’s reliability doesn’t come as much from its verifiability (evidenced by checks and invoices) as from its dependability for rational decision making. Although a cost is verifiable, it is unreliable because it is a sample of one that at best reflects past conditions. Useful information reveals what is now true, not what used to be.

    It’s not just me: Sophisticated users have said this, over and over again. For example, on March 17, Georgene Palacky of the CFA Institute issued a press release, saying, “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors.” This expressed demand should help managers understand that failing to provide value-based information forces markets to manufacture their own estimates. In turn, the markets defensively guess low for assets and high for liabilities. Rather than stable and higher securities prices, disregarding demand for truthful and useful information produces more volatile and lower prices that don’t converge on intrinsic values.

    However it arises, a vacuum of useful public information is always filled by speculative private information, with an overall increase in uncertainty, cost, risk, volatility and capital costs. These outcomes are good for no one.

    THE STRATEGY Managers bring two things to capital markets: (1) prospective cash flows and (2) information. Their work isn’t done if they don’t produce quality in both. It does no good to present rosy pictures of inferior cash flow potential because the truth will eventually be known. And it does no good to have great potential if the financial reports obscure it.

    Thus, managers need to unveil the truth about their situation, which is far different from designing reports to prop up false images. Even if well-intentioned, such efforts always fail, usually sooner rather than later.

    It’s especially fruitless to mold standards to generate this propaganda because readers don’t believe the results. Capital markets choose whether to rely on GAAP financial statements, so it makes no sense to report anything that lacks usefulness. For the present situation, then, not reporting best estimates of fair value frustrates capital markets, creates more risk, diminishes demand for a company’s securities and drives prices even lower.

    THE ROLE FOR ACCOUNTING REPORTING Because this crisis wasn’t created by poor accounting, it won’t be relieved by worse accounting. Rather, the blame lies with inattention to CDOs’ risks and returns. It was bad management that led to losses, not bad standards.

    In fact, value-based reporting did exactly what it was supposed to by unveiling risk and its consequences. It is pointless to condemn FASB for forcing these messages to be sent. Rather, we should all shut up, pay attention, and take steps to prevent other disasters.

    That involves telling the truth, cleanly and clearly. It needs to be delivered quickly and completely, withholding nothing. Further, managers should not wait for a bureaucratic standard-setting process to tell them what truth to reveal, any more than carmakers should build their products to minimum compliance with government safety, mileage and pollution standards.

    I cannot see how defenders of the status quo can rebut this point from Palacky’s press release: “…only when fair value is widely practiced will investors be able to accurately evaluate and price risk.”

    THE FUTURE Nothing can prevent speculative bubbles. However, the sunshine of truth, freely offered by management with timeliness, will certainly diminish their frequency and impact.

    Any argument that restricting the flow of useful public information will solve the problem is totally dysfunctional. The markets’ demand for value-based information will be served, whether through public or private sources. It might as well be public.

    --------------------------------------------------------------------------------

    Paul B.W. Miller, CPA, Ph.D., a professor of accounting at the University of Colorado, served on both FASB’s staff and the staff of the SEC’s ­Office of the Chief Accountant. He is also a member of the JofA’s Editorial Advisory Board. His e-mail address is pmiller@uccs.edu.

    --------------------------------------------------------------------------------

    "The Need for Reliability in Accounting:   Why historical cost is more reliable than fair value," by Eugene H. Flegm

    In 1976, FASB issued three documents for discussion: Tentative Conclusions on Objectives of Financial Statements of Business Enterprises; Scope and Implications of the Conceptual Framework Project; and Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement. These documents started a revolution in financial reporting that continues today.

    As the director of accounting, then assistant comptroller-chief ­accountant, and finally as auditor general for General Motors Corp., I have been involved in the resistance to this revolution since it began.

    Briefly, the proposed conceptual framework would shift the determination of income from the income statement and its emphasis on the matching of costs with related revenues to the determination of income by measuring the “well offness” from period to period by measuring changes on the two balance sheets on a fair value basis from the beginning and the ending of the period. The argument was made that these data are more relevant than the historic cost in use and not as subjective as the concept of identifying costs with related revenues. In addition, those in favor of the change claimed that the fair value data was more relevant than the historic cost data and thus more valuable to the possible lenders and investors, ignoring the needs of the actual managers and, in the case of private companies, the owners.

    RELEVANCY REQUIRES RELIABILITY It seems to me that the recent meltdown in the finance industry as well as the Enron experience would have made it clear that to be relevant the data must be reliable.

    Enron took advantage of the mark-to-market rule to create income by just writing up such assets as Mariner Energy Inc. (see SEC Litigation Release no. 18403).

    Charles R. Morris writes in his recently released book, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, that “Securitization fostered irresponsible lending, by seeming to relieve lenders of credit risk, and at the same time, helped propagate shaky credits throughout the global financial system.”

    There is much talk of the need for “transparency,” and it now appears we have completely obscured a company’s exposure to loss! We still do not know the extent of the meltdown!

    ASSIGNING BLAME We are still trying to assign blame—Morris identifies former Federal Reserve Chairman Alan Greenspan’s easy money policies—and certainly the regulators allowed the finance industry to get out of control. However, FASB and its fascination with “values” and mark to market must be a part of the problem.

    Holman W. Jenkins Jr. began his editorial, “Mark to Meltdown,” (Wall Street Journal, p. A17, March 5, 2008) by stating, “No task is more thankless than to write about accounting for a family newspaper, yet it must be shared with the public that ‘mark to market,’ an accounting and regulatory innovation of the early 1990s, has proved another of Washington’s fabulous failures.”

    Merrill Lynch reported a $15 billion loss on mortgages for 2007. Citicorp had about $12 billion in losses, and Bear Stearns failed. These huge losses came from mortgages that had been written up to some fictitious value based on credit ratings during the preceding years! In addition there is some doubt that those loss estimates might be too conservative and at some point in the future a portion of them may be reversed.

    THE BASIC PURPOSE OF ACCOUNTING Anyone who has ever run an accounting operation knows that the basic purpose of accounting is to provide reliable, transaction-based data by which one can control the assets and liabilities and measure performance of both the overall company and its individual employees.

    A forecast of an income statement each month as well as an analysis of the actual results compared to the previous month’s forecast are a key factor in controlling a company’s operations. The balance sheet will often be used by the treasury department to analyze cash flows and the need for financing. I do not know of a company that compares the values of the beginning and ending balance sheets to determine the success of its operations.

    How did we reach the current state of affairs where the standard setters no longer consider the stewardship needs of the manager but focus instead on the potential investor or creditor and potential values rather than transactional results?

    The problem developed because of the conflict between economics, accounting and finance—and the education of accountants. All three fields are vital to running a company but each has its place. In what some of us perceive to be an exercise of hubris, FASB has attempted to serve the needs of all three fields at the expense of manager or owner needs for control and performance measurements.

    HOW WE GOT HERE The debate over the need for any standards began with the 1929 market crash and the subsequent formation of the SEC. Initially, Congress intended that the chief accountant of the SEC would establish the necessary standards. However, Carmen Blough, the first SEC chief accountant, wanted the American Institute of Accountants (a predecessor to the AICPA) to do this. In 1937 he succeeded in convincing the SEC to do just that. The AICPA did this through an ad hoc committee for 22 years but finally established a more formal committee, the Accounting Principles Board, which functioned until it was deemed inadequate and FASB was formed in 1973.

    FASB’s first order of business was to establish a formal “constitution” as outlined by the report of the Trueblood Committee (Objectives of Financial Statements, AICPA, October 1973). With the influence of several academics on that committee, the thrust of the “constitution” was to move to a balance sheet view of income versus the income view which had arisen in the 1930s. Although the ultimate goal was never clarified, it was obvious to some, most notably Robert K. Mautz, who had served as a professor of accounting at the University of Illinois and partner in the accounting firm Ernst & Ernst (a predecessor to Ernst & Young) and finally a member of the Public Oversight Board and the Accounting Hall of Fame. Mautz realized then that the goal was fair value accounting and traveled the nation preaching that a revolution was being proposed. Several companies, notably General Motors and Shell Oil, led the opposition that continues to this day.

    The most recent statement on the matter was FASB’s 2006 publication of a preliminary views (PV) document called Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information. It is clear that FASB has abandoned the real daily users who apply traditional accounting to manage their businesses. The PV document refers to investors and creditors only. It mentions the need for comparability and consistency but does not attempt to explain how this would be possible under fair value accounting since each manager would be required to make his or her own value judgments, which, of course, would not be comparable to any other company’s evaluations.

    The only reference to the management of a company states that “…management has the ability to obtain whatever information it needs.” That is true, but under the PV proposal management would have to maintain a third set of books to keep track of valuations. (The two traditional sets would be the operating set based on actual costs and sales, which would need to be continued to allow management or owners to judge actual performance of the company and personnel, while the other set is that used for federal income tax filings.)

    Since there are about 19 million private companies that do not file with the SEC versus the 17,000 public companies that do, private companies are in a quandary. The majority of them file audited financial statements with banks and creditors based on historical costs and for the most part current GAAP. They are already running into trouble with several FASB standards that introduce fair value into GAAP. What GAAP do they use?

    Judging by the crash of the financial system and the tens of billions of dollars in losses booked by investment banks this year, the answer seems clear: Return to establishing standards that are based on costs and transactions, that inhibit rather than encourage manipulation of earnings (such as mark to market, FASB Statements no. 133 and 157 to name a few), and that result in data as reliable as it can be under an accrual accounting system.

    The analysts and other investors and creditors will have to do their own estimates of a company’s future success. However, the success of any company will depend on the quality of its products and services and the skill of its management, not on a guess at the “value” of its assets. Writing up assets was a bad practice in the 1920s and as bad a practice in recent years.

    --------------------------------------------------------------------------------

    Eugene H. Flegm, CPA, CFE, (now retired) served for more than 30 years as an accounting executive for General Motors Corp. He is a frequent contributor to various accounting publications. His e-mail address is ehflegm@earthlink.net.

    --------------------------------------------------------------------------------

    Jensen Comment
    There are many factors that interacted in causing the subprime scandals of 2008. But the one key factor that could have prevented both the Savings & Loan scandals in the 1980s and the Subprime Mortgage scandals of 2008 is professionalism in the real estate appraising industry. In both of these immense scandals real estate appraisers repeatedly provided fair value estimates above and beyond anything that could be considered a realistic fair value. There's genuine moral hazard in the relationships between real estate appraisal firms and real estate brokerage firms who desperately want buyers to get financing needed to close the deals. Banks also want desperately to close the deals so they can sell the mortgages to mortgage buyers like Fannie Mae and Freddie Mac quasi-government corporations designed to buy up mortgages from banks.

    These huge scandals provide evidence of the unreliability and nonstationarity of fair value estimates. The freight train that's hauling in fair value standards to replace existing standards in the FASB and the IASB is fraught with peril. There are, of course, many instances where fair value is the only reasonable choice such as in derivative financial instruments where historical cost is usually zero or some miniscule premium paid relative to the huge risks involved. There are other instances such as with leases and pensions having contractual future cash flows where fair value estimation is reasonably accurate. But more often than not fair value estimates are little more than pie in the sky.

    As earnings numbers are increasingly impacted by unrealized adjustments for fair values, many of which wash out to a zero cumulative effect over time, the more firms are contracting based upon earnings before unrealized fair value adjustments. Labor unions are increasingly concerned that companies can manage earnings by such simple devices as implementation of hedge accounting effectiveness testing. Companies like Southwest Airlines exclude these unrealized fair value changes in earnings from compensation contracts with employees in order to ease the fears of employees.

    This is the driving force behind the FASB's bold initiative to eliminate bottom line reporting.
    Five General Categories of Aggregation
    "The Sums of All Parts: Redesigning Financials:  As part of radical changes to the income statement, balance sheet, and cash flow statement, FASB signs off on a series of new subtotals to be contained in each," byMarie Leone, CFO Magazine, November 14, 2007 --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    "Profit as We Know It Could Be Lost With New Accounting Statements," by David Reilly, The Wall Street Journal, May 12, 2007; Page A1 --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    "A New Vision for Accounting: Robert Herz and FASB are preparing a radical new format for financial, CFO Magazine, by Alix Stuart, February 2008, pp. 49-53 --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    Bob Jensen's threads on alternative valuations --- http://faculty.trinity.edu/rjensen/Theory01.htm#UnderlyingBases


    Question
    What is liquidity stress testing in the context of FAS 157?

    Definition --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#StressTest
    There are two categories:  Sensitivity Analysis and Scenario Analysis

    Ira Kawaller pulished a paper that talks about liquidity stress testing in conjunction with FAS 157 valuation definitions
    "Watching out for FAS 157: Fair Value Measurement," by Ira Kawaller, Bank Asset/Liability Management, April 2008 --- http://www.kawaller.com/pdf/BALMWatchingoutforFAS157.pdf
    Also at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/StressTestKawaller.pdf

    Liquidity Risk Measurement Techniques and Stress Tests

    In the first article in this series on the considerations to the formulation of a liquidity stress testing framework, the background to liquidity risk and liquidity stress testing was presented (see March 2008 BALM). This second article in the series investigates various stress-testing categories in order to gain a better understanding of stress testing and how it could be applied in liquidity risk measurement. The basic liquidity risk measurement techniques are explored to establish a framework of potential analytical techniques to apply in the formulation of a liquidity stress testing methodology.

    Liquidity Stress Testing. The formulation of a liquidity stress testing framework requires a clear and decisive understanding of the stress testing technique applied, exactly what is stress tested, and the type of analyses conducted. This section will explore the methods of stress testing that can be applied in the liquidity risk management process. Furthermore, the types of analyses conducted in measuring liquidity risk and other considerations that should be incorporated in the stress testing framework will be discussed.

    Categories of Stress Testing. Generally, stress testing falls in two main categories – sensitivity tests and scenario tests.

    • Sensitivity tests specify financial parameters that are moved instantaneously by a unitary amount, for example, a 10 percent decline or a 10 basis point increase. This approach is a hypothetical perspective to potential future changes in the risk factor(s). Such sensitivity tests lack historical and economic content which limits its usefulness for longer-term risk management decisions. Sensitivity tests can also examine historical movements in a number of financial parameters. Historical movements in parameters can be based on worst case movements over a set historical period (e.g., the worst change in interest rates, equity prices and currencies over the past 10 years). Alternatively, actual market correlations between various factors may be analyzed over a set period of time to determine the movement in factors that would have resulted in the largest loss for the current portfolio. In sensitivity stress tests, the source of the shock is not identified and the time horizon for sensitivity tests is generally shorter, often instantaneous, unlike scenario tests.

    See my glossary at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#StressTest


    "SEC Gives Firms More Leeway In Pricing Asset-Backed Issues," by Judith Burns, The Wall Street Journal, March 31, 2008; Page C7 --- http://online.wsj.com/article/SB120692976040976073.html?mod=todays_us_money_and_investing

    Chief financial officers of public companies received new guidance Friday from the Securities and Exchange Commission, giving firms more leeway to value asset-backed securities in cases where market prices or other relevant pricing information cannot be obtained.

    Public companies may use "unobservable inputs" to value asset-backed securities, but only when actual market prices or relevant observable inputs are not available, according to a letter from SEC staff accountants that will be sent to financial chiefs of public companies holding significant amounts of asset-backed securities.

    Firms that rely on "unobservable inputs" to value illiquid asset-backed securities must determine if that would have a material impact on their financial results, according to the letter. In such cases, the letter said, corporate results must include written explanations of how a firm determined the value of its asset-backed assets and liabilities, as well as how those values might change and what impact that would have on operations, liquidity and capital. SEC staffers said such explanations should appear in quarterly and annual results.

    Additionally, the SEC said public companies might need to provide more disclosure on risky, "Level 3" assets and liabilities, including changes that increased or decreased the amount of assets in that category. It also said firms might need to detail the nature and type of assets underlying asset-backed securities, such as riskier subprime home mortgages or home-equity lines of credit, along with credit ratings on such securities and changes or potential changes to those ratings.

    My threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    My free tutorials on FAS 133 and IAS 39 are linked at http://faculty.trinity.edu/rjensen/caseans/000index.htm

    My FAS 133 and IAS 39 glossary is at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

    You can find quite a few interesting problems and answers about embedded derivatives in my exam material at  http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/PracticeQuestions/


    "FAS 157: The FASB's Prelude and Fugue on Fair Value of Liabilities," by Tom Selling, The Accounting Onion, May 4, 2008 --- http://accountingonion.typepad.com/theaccountingonion/2008/05/fas-157-the-fas.html

    FAS 157 on fair value measurements was supposed to provide comprehensive guidance for determining the fair value of pretty much any asset or liability.  Yet, almost two years after its initial publication, and well after companies have had to apply the standard to certain accounts, CFO.com reports that the FASB is still making up some of its rules on the fly, and having a tough slog to boot.  The problem described in the article has immediate consequences for derivative financial instruments that are classified as liabilities, but it could eventually affect the measurement of many other liability accounts as fair value measurement becomes more broadly applied:

    "At an unusually heated FASB meeting last week [no minutes published on the FASB's website yet], for instance, the members debated how companies should estimate the market value of liabilities when there's no actual market on which to base the estimate.

    During one point in the discussion, which concerned a proposed guidance by FASB's staff on how to mark liabilities to market under 157, chairman Robert Herz seemed, to member Leslie Seidman, to be contemplating an overhaul of the brand-new standard itself. Matters got so confusing that the board ordered its staff to go back and summarize the members' positions so that they could understand what they themselves had said.

    At issue was the question of how to measure the fair value of a liability for "which there is little, if any, market activity," according to 157. The standard defines fair value as "the price that would be received ... to transfer a liability in an orderly transaction between market participants at the measurement date." The question that FASB struggled with was: How do you determine the fair value of a liability that can only be settled, rather than sold?

    ...Often, for instance, when a company borrows money, it can't transfer its obligation to another party without an agreement from the bank. Or a market may not exist for transferring such liabilities."

    It's a mess that the FASB has gotten itself into for two related reasons.  The first is that the problems now being addressed are significant, and they were known long before FAS 157 was let out the door. The second is that FAS 157 is fundamentally flawed in its approach to fair value measurement of liabilities.  The solution, as I am about to describe, seems to me to be surprisingly simple. 

    This particular flaw in FAS 157 (see my previous post on many others) occurs in paragraph 5:

    "Fair value is the price that would be received to sell an asset or paid to transfer a liability [italics supplied] in an orderly transaction between market participants at the measurement date." 

    For every liability there is a counter party that holds an asset, and the economic value of the liability must be equal to the economic value of the asset. These are basic economic principles, which are not acknowledged in FAS 157.    If they were acknowledged, there would be no need for the phrase "or paid to transfer a liability."  That's because the value of any liability -- even one that cannot be transferred --must equal the value of the counter party's asset, which, perforce, can always be transferred.  Even though the evidence directly available to value the liability may be scant, the asset value might even be quoted in the newspaper; the non-transferability restriction on the debtor is just one more valuation parameter from the viewpoint of the creditor. 

    If you need further convincing that the solution to the problem of valuing any liability is to value the counter party's asset, let's consider an even thornier non-transferable liability that the FASB briefly considered and then dropped like a hot potato:  contingent environmental liabilities.  My understanding of federal environmental law is that the cleanup liability of a "potentially responsible party" is joint and several.  No other party can assume the liability, so the only way out from under it is to settle with the government.  Although I am not aware that the government has done this, it is theoretically possible for the government to transfer its contingent receivable to a third party.  Is the contingent receivable difficult to value?  Yes, but certainly no harder than many of the complex, illiquid derivatives that are roiling the global economy.  (And by the way, I recall seeing the issue of the fair value of contingent environmental liabilities posted on the FASB's website during the project phase of FAS 157.  The Board expressed a tentative conclusion, but it soon disappeared mysteriously, and without explanation.  I have searched Board minutes, and have come up with nothing.  If anyone has any further information on this that they would like to share, please contact me!)

    Because my solution to liability valuation is so simple (attention: CIFiR - SEC Advisory Committee on Improvements to Financial Reporting) and obvious, I can't help but fear I have overlooked something.  If that is indeed the case, I hope a reader of this post will take the time to point it out, and I will gladly issue a mea culpa forthwith.  Yet, I derive some measure of comfort (and optimism) by an entry in the minutes of an FASB meeting (11/14/07) where Bob Herz stated that he disagrees with the measurement principles for liabilities in SFAS 157. 

    Who knows, maybe Bob and I are thinking along the same lines?  That gives me hope for the future.  But, I have to express my disappointment that liabilities were not dealt with in a comprehensive way before SFAS 157 was issued. There is much to be said for getting it right the first time.

    Jensen Comment

    Tom wrote the following:

    For every liability there is a counter party that holds an asset, and the economic value of the liability must be equal to the economic value of the asset. These are basic economic principles, which are not acknowledged in FAS 157.    If they were acknowledged, there would be no need for the phrase "or paid to transfer a liability."  That's because the value of any liability -- even one that cannot be transferred --must equal the value of the counter party's asset, which, perforce, can always be transferred.  Even though the evidence directly available to value the liability may be scant, the asset value might even be quoted in the newspaper; the non-transferability restriction on the debtor is just one more valuation parameter from the viewpoint of the creditor. 

    For one party the Pacioli equation A=L+E is tautological since E is the sink hole makes everything balance. But it does it necessarily hold that A(Bank) = L(Homeowner) for 30 years after Bank loaned Homeowner $1 million in cash in a jumbo 30-year mortgage for a home on June 16, 2006. In fact it may well be that A(Bank) = L(Homeowner) did not even hold on the June 16, 2006 since Bank and Homeowner probably had different opportunity costs of capital. Most likely Bank charged for a risk premium and holds the asset (the mortgage note) with values that vary from day-to-day with Homeowner's credit rating and with resale value of the home itself that is the collateral on the loan.

    In conventional mortgages the Bank can transfer the asset (mortgage note) wholesale to another buyer such as Fannie Mae. But Homeowner cannot transfer the liability since most conventional mortgages now have a clause that says the mortgage must be prepaid if Homeowner sells the house. What Fannie will pay Bank for the asset (mortgage note) wholesale varies with market conditions in the wholesale market for mortgages.

    At some point in time Homeowner can go back to Bank and ask to refinance the mortgage (which is tantamount to prepaying the original mortgage), but Homeowner must refinance in the retail market. Bank can deal in both the wholesale and retail markets for mortgages whereas Homeowner is confined to the retail market. The two markets are highly correlated like they are in blue book car markets, but they are not perfectly correlated. Hence I don't think Tom can assume that Bank's transferable asset is equal in value to Homeowner's non-transferrable liability. Homeowner does not have access to all the buyers and sellers in the wholesale market.

    Then there is the other problem that exploded in both the Savings & Loan crisis of the 1980s and the subprime crisis of 2008. In both scandals crooked appraisers overstated the lending value of real estate way beyond realistic selling prices. Suppose Homeowner got the $1 million mortgage on a house that realistically only had a $500,000 value on June 16, 2006 and has sunk to a fair value of only $200,000 on June 16, 2008. How would FAS 157 be applied to a non-transferrable mortgage liability? What is the value of L(Homeowner) on June 16, 2008? Is it necessarily the same as the A(Bank) or A(Fannie) value of the asset held by the current holder of the mortgage investment?

    The fair value of the L(Homeowner) liability to Homeowner is affected by many factors, one of which is the cost of having a lower credit rating simply by turning the property over the Bank. Homeowner may have troubles even getting another loan for several years, and Former Homeowner may have to pay premium rates to get another loan. But the value of the collateral (the house now valued at only $200,000) is far less than the unpaid balance on the loan of nearly $1 million since the( principal amount owing does not decline much in the first two years of a 30-year mortgage). In this instance I don't think Professor Selling can assume that L(Homeowner) = A(Bank) on June 16, 2008. In fact I think the two values are vastly different.

    And Bank (or Fannie Mae) is very sad since what they paid out for homeowners' mortgages is still way in excess of what the combined collateral is really worth in 2008. Fortunately many homeowners are still making payments even though their property is now probably worth less than the discounted cash flows of their remaining mortgage payments.

    The problem with FAS 157 is that it cannot make a silk purse out a sow's ear when valuing assets and liabilities for which markets are non-existent, including surrogate markets. There is also a problem of dynamics of markets. FAS 157 wants reported values of L(Homeowner) and A(Bank) on June 16, 2008. Homeowner may continue to make payments on a $1 million 30-year mortgage for property that is now worth only $200,000 because of transactions costs (including adverse credit ratings) today of walking away from the mortgage and because of hope that this is only a market bleep before the value rises back up in value to more than $1 million in anticipation of soaring inflation.

    There is always the feeling that markets will bounce back. And there are what the mathematicians call non-convexities caused by transactions costs that are real but undeterminable when the cost of lowered credit ratings are factored into transactions costs. For years, accounting theorists criticized economists for unrealistic assumptions of rationality and non-convexities in their models. Economic value was deemed by accountants as unrealistic due to unknown future cash flows, unknown future market conditions at affect prices and interest rates, and unknown future legislative actions and taxes. Now FAS 157 and 159 along with IAS 39 on the international scene wants to turn accountants into economists.

    Valuation is an art rather than a science. Accountants and economists who are teaching free cash flow and residual income valuation models might as well be teaching astrology to FAS 157 implementers. It all boils down to attaching precise-looking number tags to cloud movements that are beyond anybody's control.


    Question
    How does IFRS fair value accounting differ for financial instruments versus derivative financial instruments?

    The IASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    Whereas firms are increasingly pressured by the FASB and the IASB to maintain financial assets at fair value, maintaining financial liabilities at fair values is much more controversial since the future cash flows of fixed-rate debt may depart greatly from current fair value. For cash flows of a fixed rate mortgage are well defined whereas the fair value of those cash flows may fluctuate day-to-day with interest rates. Fair value adjustments of debt that the firm either cannot or does not intend to liquidate may be quite misleading regarding financial risk.

    The same cannot be said for derivative financial instruments where FAS 133 and IAS 39 require maintaining the current reported balances at fair value.

    However, the FASB is proposing an amendment to IAS 39 that will give the option to maintain financial instrument liabilities at fair value with gains and losses going to AOCI instead of current earnings. However, this does not make the fair value accounting totally consistent with fair value accounting for derivative financial instruments where changes in fair value go to current earnings except in qualified hedging transactions.

    "Exposure Draft on measurement of financial liabilities," IAS Plus, May 11, 2010 --- http://www.iasplus.com/index.htm

    The IASB has published for public comment an exposure draft (ED) of proposing to amend the way the fair value option in IAS 39 Financial Instruments: Recognition and Measurement is applied with respect to financial liabilities. Many investors and others have said that volatility in profit or loss resulting from changes in an entity's own credit risk is counter-intuitive and does not provide useful information – except for value changes relating to derivatives and liabilities held for trading (such as short sales). The IASB is proposing, therefore, that all gains and losses resulting from changes in 'own credit' for those financial liabilities that an entity chooses to measure at fair value should be recognised as a component of 'other comprehensive income', not in profit or loss. The ED does not propose any other changes for financial liabilities. Consequently, the proposals will affect only those entities that elect to apply the fair value option to their financial liabilities. Importantly, those who prefer to bifurcate financial liabilities when relevant may continue to do so. That is consistent with the widespread view that the existing requirements for financial liabilities work well, other than the 'own credit' issue that these proposals cover.

    Unlike FAS 133, IAS 39 no longer requires bifurcation of embedded derivatives that are not "clearly and closely related" to the host instrument.

    Bob Jensen's threads on accounting for financial instruments and hedging activities are at
    http://faculty.trinity.edu/rjensen/caseans/000index.htm

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue


    Why do bankers resist expanding FAS 159 into required accounting for all financial instruments?
    Misleading Financial Statements:  Bankers Refusing to Recognize and Shed "Zombie Loans"

    One worrying lesson for bankers and regulators everywhere to bear in mind is post-bubble Japan. In the 1990s its leading bankers not only hung onto their jobs; they also refused to recognise and shed bad debts, in effect keeping “zombie” loans on their books. That is one reason why the country's economy stagnated for so long. The quicker bankers are to recognise their losses, to sell assets that they are hoarding in the vain hope that prices will recover, and to make markets in such assets for their clients, the quicker the banking system will get back on its feet.
    The Economist, as quoted in Jim Mahar's blog on November 10, 2007 --- http://financeprofessorblog.blogspot.com/

    After the Collapse of Loan Markets Banks are Belatedly Taking Enormous Write Downs
    BTW one of the important stories that are coming out is the fact that this is affecting all tranches of the debt as even AAA rated debt is being marked down (which is why the rating agencies are concerned). The San Antonio Express News reminds us that conflicts of interest exist here too.
    Jime Mahar, November 10, 2007 --- http://financeprofessorblog.blogspot.com/

    Jensen Comment
    The FASB and the IASB are moving ever closer to fair value accounting for financial instruments. FAS 159 made it an option in FAS 159. One of the main reasons it's not required is the tremendous lobbying effort of the banking industry. Although many excuses are given resisting fair value accounting for financial instruments, I suspect that the main underlying reasons are those "Zombie" loans that are overvalued at historical costs on current financial statements.

    Daniel Covitz and Paul Harrison of the Federal Reserve Board found no evidence of credit agency conflicts of interest problems of credit agencies, but thier study is dated in 2003 and may not apply to the recent credit bubble and burst --- http://www.federalreserve.gov/Pubs/feds/2003/200368/200368pap.pdf

    In September 2007 some U.S. Senators accused the rating agencies of conflicts of interest
    "Senators accuse rating agencies of conflicts of interest in market turmoil," Bloomberg News, September 26, 2007 --- http://www.iht.com/articles/2007/09/26/business/credit.php
    Also see http://www.nakedcapitalism.com/2007/05/rating-agencies-weak-link.html

    Bob Jensen's Rotten to the Core threads are at http://faculty.trinity.edu/rjensen/FraudRotten.htm


    Three Articles from the American Bankers Association on Fair Value Accounting (as of the end of 2007) --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/AmericanBankersAssn/


    Student Rap Video on FAS 159 --- http://www.youtube.com/watch?v=hBoZTM8_cVw&feature=related
    This link was forwarded by Denny Beresford, I think with his tongue in his cheek. Denny knows that I consider FAS 159 to be rediculous.


    Question
    When is the purpose of reclassifying loans as "Held-to-Maturity" for purposes of stabilizing earnings rather than a true strategy to hold those notes to maturity, especially when the value of those notes is plunging daily? "Even analysts think so. "If you thought the accounting for investments in debt and equity securities was unnecessarily complex, the accounting for loans will make your head spin,"

    "Is Fair-Value Accounting Always Fair?" Matt A. Greenberg, The Wall Street Journal, March 5, 2008; Page A15 --- http://online.wsj.com/article/SB120468197325912303.html?mod=todays_us_page_one

    Is Fair-Value Accounting Always Fair? March 5, 2008; Page A15 Regarding "Wave of Write-Offs Rattles Market" by David Reilly (page one, March 1): Thirty years ago, no accounting principle was more accepted than that assets are worth what they cost, absent proof of a permanent impairment of value. When such impairment was understood and confirmed, the carrying value was adjusted.

    Today, I see the overzealous accounting profession calling for long-term assets, those which the owners do not intend to sell, nor have need to sell, being forced to mark such assets to market on a regular basis. While this may make sense for equities, where market values tend to reflect economic reality or assets which may need to be sold in the normal course of operating the business, it makes no sense for assets intended to be held to maturity. The marking of long-term complex financial instruments where market values are temporarily depressed and meaningless for the longer term is terribly destructive. In many cases, the only market prices available are distressed sellers or some thin index which is regularly shorted by investment professionals.

    These are not real values, and marking to these prices causes unnecessary volatility and contractions in capital which restrict the ability of financial institutions to operate and grow. Perhaps the accounting profession is trying to overcompensate for its failures in the Enron fiasco and other similar cases, and to prevent lawsuits. Fair-value accounting, particularly for long-term complex instruments that do not trade in liquid markets, is illogical and destructive and should be re-examined immediately.

    Jensen Comment
    One problem here is bank's want it both ways. The want to classify investments and loans as "held-to-maturity" (HTM) so that they can avoid having to carry them at fair value such as allowed in FAS 115. However, bands want to classify them as HTM but want to sell them when fair value hits trigger points. Hence a lot of those "HTM" securities are not HTM after all.

    From The Wall Street Journal Accounting Weekly Review on February 29, 2008

    Banks Use Quirk as Leverage Over Brokers in Loan Fallout
    by David Reilly
    The Wall Street Journal

    Feb 27, 2008
    Page: C1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB120407667879295385.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Advanced Financial Accounting, Banking, Fair Value Accounting, Investment Banking, Investments, Loan Loss Allowance

    SUMMARY: "Leveraged loans for buyouts were originally made with the idea that banks and brokers would quickly sell them to investors." That approach proved impossible when markets froze in August 2007. "Among banks, Citigroup and J.P. Morgan have the most at stake, with $43 billion and $26.4 billion in exposures, respectively....among brokers, Goldman has the biggest leveraged-loan exposure, at $26 billion, followed by Lehman Brothers...with $23.8 billion....By reclassifying (to held-to-maturity) some of the loans they hold, banks can avoid marking these loans to market, unlike brokerages which have to price these assets" at current market value at each balance sheet date. "J.P. Morgan...Chief Executive James Dimon said during a January conference call...[that] the bank reclassified loans...because it believed that at current depressed prices, some of its leveraged loans 'may be terrific long-term assets to hold.' That said, the more favorable accounting treatment doesn't hurt, either."

    CLASSROOM APPLICATION: Accounting for investments versus loans is the main topic in the article. The article refers to market value (fair value) measurement, lower or cost-or-market and the cost method as applied to held-to-maturity investments.

    QUESTIONS: 
    1.) Three methods of valuing loans and investments -- fair value, lower of cost or market and cost basis -- are described in the article, without using these terms. Summarize how each of these methods is described in the article.

    2.) Why do banks and investment brokerage houses face different requirements in accounting for loans they have offered in leveraged buyout transactions?

    3.) How might a bank face fewer reported losses by using the cost method of valuing loans than the fair value method? In your answer, comment on the possibility that the bank may have to report allowances for uncollectibility of these loans.

    4.) What is the significance of J.P. Morgan Chief executive James Dimon's statement that "at current depressed prices, some of its leveraged loans 'may be terrific long-term assets to hold'?"
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    "Banks Use Quirk as Leverage Over Brokers in Loan Fallout," by David Reilly, The Wall Street Journal, February 27, 2008; Page C1 --- http://online.wsj.com/article/SB120407667879295385.html?mod=djem_jiewr_AC 

    When it comes to losses on "leveraged loans" -- a big source of worry for investors in financial firms -- banks may have an advantage over their brokerage-house rivals in weathering the storm.

    Thanks to a quirk in accounting rules, banks such as J.P. Morgan Chase & Co. don't always have to book losses immediately on those loans even as brokers like Goldman Sachs Group Inc. are forced to take hits right away.

    Leveraged loans -- used by companies, usually with low credit ratings, and often to fund buyouts -- were originally made with the idea that banks and brokers would quickly sell them to investors. When markets froze in August, institutions found themselves stuck with billions of these loans that they couldn't unload.

    That led to losses last fall as financial firms were forced in many cases to mark these loans down by about 5%. The market for these loans is again struggling, and prices are falling further -- in some cases to about, or even less than, 90 cents on the dollar -- which will likely lead to another round of losses at financial firms.

    This makes it more likely some banks will look to shield at least part of their holdings from the swings in market prices. By reclassifying some of the loans they hold, banks can avoid marking these loans to market, unlike brokerages, which have to price these assets at whatever investors say they are worth.

    This isn't to say that banks will be able to entirely sidestep losses stemming from leveraged loans issued to fund huge corporate buyouts. But any kind of shock absorber would be welcome, given the depressed market conditions now.

    Still, while the accounting peculiarity may give banks an edge, it could also pose a danger to their investors, analysts warn. That is because investors could be lulled into complacency when it comes to the size and scope of the hits that the banks may face.

    Banks and brokers have nearly $200 billion in leveraged-loan exposure. Given recent falls in market prices of these loans, that could lead to $10 billion to $14 billion in write-downs, Oppenheimer analyst Meredith Whitney estimated in a recent note.

    Among banks, Citigroup and J.P. Morgan have the most at stake, with $43 billion and $26.4 billion in exposures, respectively, as of the end of last year. Among brokers, Goldman has the biggest leveraged-loan exposure, at $26 billion, followed by Lehman Brothers Holdings Inc. with $23.8 billion.

    The fact that a bank and a broker holding the same kind of loan could see very different effects highlights what some analysts feel is a major flaw in the accounting for leveraged loans. Brokers for years have argued that banks should also be required to assess the values of all their financial assets using market prices.

    The differing approaches also underscore that even as the use of so-called market values cause some firms to quickly recognize big losses -- even if there are growing questions about the reliability of these values in frozen markets -- not every financial player always has to measure up against this same yardstick.

    Seem strange? Even analysts think so. "If you thought the accounting for investments in debt and equity securities was unnecessarily complex, the accounting for loans will make your head spin," Credit Suisse accounting analyst David Zion wrote in a recent research note looking at issues surrounding loans.

    J.P. Morgan, for example, said last month that it had reclassified about $5 billion of $26 billion in leveraged loans it holds. J.P. Morgan declined to comment beyond what Chief Executive James Dimon said during a January conference call. At that time, he said the bank reclassified the loans this way because it believed that at current depressed prices, some of its leveraged loans "may be terrific long-term assets to hold."

    That said, the more favorable accounting treatment doesn't hurt, either. Here is how it works: Companies either classify loans as being "held for sale" or as investments, sometimes referred to as "holding to maturity." Loans held for sale are carried at whichever is lower: the original cost or the current market value. That is similar to "marking to market prices." Any losses are taken in the current period.

    But the value of loans held for investment doesn't change with every uptick or downtick in the market. Instead, such loans are said to be held at their cost, although they are initially marked to market prices if a firm is reclassifying them from held for sale.

    The big benefit is that holding loans for investment reduces volatility. Brokers like Goldman, Lehman, Morgan Stanley or Merrill Lynch & Co., on the other hand, have to mark just about everything they hold to market prices. So the firms -- which together have about $91 billion in leveraged-loan exposure, according to Oppenheimer -- take losses right away.

    This isn't to say banks completely avoid losses on loans held for investment. Mr. Dimon said in the bank's conference call that while it wouldn't mark the reclassified loans to market prices, it would "have to build up proper loan-loss reserves against those, and we would fully disclose that so there's no issue about what that did to the company."

    But in checking to see whether the value of a held-for-investment loan is impaired, a bank would look to see if there has been a change in the credit rating of an issuer, if the issuer has fallen behind in interest payments or if it looks like a delinquency could be looming.

    A bank wouldn't necessarily have to consider what the loan would fetch if sold in the market today, analysts say. That view, which reflects market perceptions, is what is causing big losses at many firms today. So looking only to credit quality could prove to be advantageous.


    From The Wall Street Journal Accounting Weekly Review, March 7, 2008

    Wave of Write-Offs Rattles Market
    by David Reilly
    The Wall Street Journal

    Mar 01, 2008
    Page: A1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB120432957846104273.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Financial Accounting, Financial Accounting Standards Board, Financial Analysis, Financial Reporting, Financial Statement Analysis, Standard Setting

    SUMMARY: "The massive write-downs that financial firms are posting have begun to spur a backlash among some investors and executives, who are blaming accounting rules for exaggerating the losses and are seeking new, more forgiving ways to value investments." The article quotes comments by Ben Bernancke to the Senate banking committee saying that he doesn't know how to "fix" this accounting issue and that accountants must "make the best judgment they can." Also quoted are comments by FASB Chairman, Bob Herz.

    CLASSROOM APPLICATION: Use the article to discuss the various influences on accounting standards setting: Economic consequences of accounting choices, the political pressures that can arise, and the desire to uphold qualitative characteristics in financial reporting. The related article is a 'Letter to the Editor' written by a Westport, CT, investment advisor with approximately $230 million in assets under management.

    QUESTIONS: 
    1.) Define the concept of "valuation" in accounting, the historical cost basis, and fair-value accounting. Provide examples in which each of these bases of reporting is used in financial statements.

    2.) How is fair value accounting potentially contributing to the effects of losses reported by financial institutions?

    3.) In responding to questions by the Senate banking committee, Federal Reserve Chairman Ben Bernanke says he does not know how to fix accounting issues arising from reporting on a fair-value basis and that "..accountants need to make the best judgment they can." What accountants are responsible for making judgments about whether to use the historical cost basis or fair-value basis for accounting valuations?

    4.) On what basis do accountants decide which is the appropriate model for valuation in financial statements? In your answer, define the conceptual framework in financial accounting and reporting and it's associated qualitative characteristics.

    5.) What are the economic consequences of accounting policy choice? List one argument made in the main article or the related one which exemplifies this concern with the economic consequences of accounting policy choice.

    6.) FASB Chairman Bob Herz acknowledges "the difficulty investors and companies are facing" but also argues that the alternative to fair-value reporting is to pretend "...that things aren't decreasing in value" and that company managements at times like these would "... say they think it's going to recover." Do you think that historical cost reporting works in this fashion?
     

    Reviewed By: Judy Beckman, University of Rhode Island


    IFRS (or maybe just the EU) Accounting Rule Flexibility in Action

    "Accounting Changes Help Deutsche Bank Avoid Loss," Reuters, The New York Times, October 30, 2008 --- Click Here

    New accounting rules allowed Deutsche Bank to dodge a loss in the third quarter, the company said Thursday as it also announced heavy losses in proprietary trading.

    Josef Ackermann, the chairman of Deutsche, which is Germany’s flagship bank and once was seen as having escaped the worst of the market turmoil, declared a year ago that the financial crisis for his bank was over.

    On Thursday, however, Mr. Ackermann departed from the optimism that had led him to declare seeing the light at the end of the tunnel several times over.

    “Conditions in equity and credit markets remain extremely difficult,” he said, warning that the bank could cut its dividend to shore up capital in a “highly uncertain environment.”

    Also Thursday, Germany’s finance minister, Peer Steinbrück, said that a number of German banks were expected to turn to Berlin for help. Mr. Steinbrück appeared to make a veiled reference to Deutsche Bank when he told a newspaper that those seeking help could include banks that had publicly opposed taking it in the past. Mr. Ackermann recently was quoted as saying he would be “ashamed” to take taxpayer money.

    Deutsche Bank made a pretax profit of 93 million euros ($118.5 million) in the third quarter, a result possible only because of changed accounting rules. These allowed it to cut write-downs by more than 800 million euros, to 1.2 billion euros, during the period.

    The new rules, sanctioned by Brussels lawmakers, soften the old system that demanded all assets reflect market prices.

    Deutsche Bank, for example, has more than 22 billion euros of leveraged loans — commitments often made to private equity investors to lend money to buy companies.

    Farming out these loans had become difficult as worried investors retreated to safe havens and their value had fallen. The new accounting rules allow Deutsche to hold some of these loans on their books at a fixed price.

    Like all other banks, Deutsche is grappling with a freeze in interbank lending. Banks around the world have largely stopped lending to one another after the Wall Street investment bank Lehman Brothers collapsed in mid-September.

    The crisis prompted the German government to start a rescue fund of 500 billion euros, under which it can give guarantees for banks seeking financing on this market or by issuing bonds, for example.

    November 3, 2008 reply from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    Beware, believing what's reported in the press as truth. Reporters generally do not study accounting as part of the academic experience.

    To the best of my knowledge, the recent change made by the IASB was to converge with US GAAP in permitting companies to re-classify financial assets from held for trading to available for sale. This move does not permit these assets to be held at other than fair value. It does report the change in fair value to equity, rather than in income.

    This change was made specifically to create a level playing field across Europe and the US. The same change was made in Canada for the same reason.

    Do I regret they made this change? Yes. I suspect they do too, but the alternative was to let the European Commission "do their own thing" in this crisis.

    Regards,
    Pat

    November 3, 2008 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    Pat,

    Actually, as I understand it the IASB change allows companies to reclassify securities out of the mark to market through income category (i.e., trading) to held to maturity in which case the securities will be carried at cost. Further, the change can be made retroactive to July 1 before most of the market disruption occurred. U.S rules allow this only in "rare" circumstances.

    See http://www.iasb.org/NR/rdonlyres/BE8B72FB-B7B8-49D9-95A3-CE2BDCFB915F/0/AmdmentsIAS39andIFRS7.pdf  which includes a dissent by Jim Leisenring and John Smith from the U.S.

    Denny Beresford

    November 3, 2008 reply from Bob Jensen

    Hi Pat and Denny,

    But isn’t it interesting banks are suddenly reclassifying their portfolios seemingly to avoid reporting losses? Is this good judgment based upon principles-based standards or earnings management under flexible accounting standards?

    Surely the reporters are all wrong and these reputable banks are merely using good judgments under principles-based standards. Certainly they would not use flexible accounting rules to manage earnings!

    Are we making a mockery out of accounting “standards?” What you are saying Pat is that the IASB would rather change an accounting standard under political pressure from the EU than to face up to another EU carve out of IFRS. Surely this is a mockery since the change in IFRS to suit the EU (and U.S.) affects all other nations using IFRS who are not in the EU and the U.S.

    What you are really telling us Pat is that IFRS adapts to threats from the EU when you stated:

    Do I regret they made this change? Yes. I suspect they do too, but the alternative
    was to let the European Commission "do their own thing”  . . .

    Pat Walters

    I call this making a mockery out of the conceptual framework that dictates that accounting standards are to be based upon what is the best accounting for investors. Instead the IASB acted in fear that the EU would “do-their-own-thing” accounting standards for banks. Of course there’s some history of this in the U.S., notably dry hole accounting for oil and gas. But the FASB has a better record of going nose-to-nose with Congress on FAS 133 and FAS 123-R.

    FASB standards are sometimes flexible to a fault as well. Surely Franklin Raines would not (ha, ha) reclassify just enough macro mortgage portfolios under FAS 133 rules to meet the e.p.s target (to the penny) to get his bonus before he was fired as CEO of Fannie Mae --- http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation 

    How can those of you teaching ethics and intermediate accounting and auditing look your students straight in the eye?

    Should accountancy be reclassified in the Literature Department since financial reports are becoming more flexible fiction than fact?

    Bob Jensen

    November 3, 2008 reply from Tom Selling [tom.selling@GROVESITE.COM]

    The following statement by Pat is not fully correct:

    “…the recent change made by the IASB was to converge with US GAAP in permitting companies to re-classify financial assets from held for trading to available for sale. This move does not permit these assets to be held at other than fair value. It does report the change in fair value to equity, rather than in income.”

    The revisions to IAS 39 (and FAS 133) permit loans and receivables that were being measured at fair value to be reclassified to “held to maturity”, if the entity does not intend to sell them in the “foreseeable future” (whatever the heck that means). Thus, fair value accounting would cease for these assets. Moreover, there would be a new rule for measuring impairment on these assets, which diverges from GAAP.

    Best,

    Tom Selling

    November 3, 2008 reply from Bob Jensen

    Hi Tom,

    What the reclassification to “held-to-maturity” means in these times is that nobody else (now not even our government) is foolish enough to buy this hopeless dog that the bank can’t possibly unload. Paulsen’s new bail out plan entails buying into bank equity rather than buying up the banks’dog/junk mortgages. The trick now is to get these dogs on the books at historical cost as “held-to-maturity” rather than, choke, fair value.

    Interestingly, this is precisely what Fannie Mae’s CEO, Franklin Raines, was doing when cherry picking which investments to designate as “held-to-maturity” in his earnings management scheme to pad his bonus --- http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation 

    Think of the irony. The good mortgages that perhaps increased in value with declining interest rates are marked upwards to fair value as “available-for-sale” or “trading” securities. The dogs that should be unloaded are instead designated as “held-to-maturity.”

    A clever professor here could design a case where all the good mortgages are sold for profit, the enormous executive bonuses are paid, and the shareholders are left with the “held-to-maturity” dog kennel that is grossly overvalued on the balance sheet. What’s even worse is that this is possible under FASB and IASB accounting standards. Our standard setters are now telling us there’s nothing wrong with being left with the dog kennel. The shareholders’ class action lawyers think otherwise.

    Is this what we call making investors our number one concern when setting accounting standards?

    My problem here is that in theory I can and do in my FAS 133 seminars make a darn good case for not marking up HTM securities to fair value. But then I never envisioned the dog kennel problem.

    I think the IASB is a bit tougher than the FASB on a decision to sell HTM investments before maturity. In IFRS it’s a bit like breaking the honor code. You may sell an insignificant sick puppy on occasion from the HTM dog kennel, but you must never sell a valuable dog before its maturity date without putting the other sick HTM dogs in the kennel up for sale as well. Selling them all might result in huge losses under the new IASB/FASB rulings allowing for the placement of very sick dogs in an HTM kennel to avoid recognizing huge losses in their value. Thus when Deutsche Bank put a lot of sick dogs in the HTM kennel to shore up 2008 reported earnings (actually to avoid a huge reported 2008 loss), Deutsche Bank better be prepared on its honor to keep virtually all of them in the kennel until they expire.

    The following is a direct quotation from IAS 39.

    B.19 Definition of held-to-maturity financial assets: 'tainting'

    In response to unsolicited tender offers, Entity A sells a significant amount of financial assets classified as held to maturity on economically favourable terms. Entity A does not classify any financial assets acquired after the date of the sale as held to maturity. However, it does not reclassify the remaining held-to-maturity investments since it maintains that it still intends to hold them to maturity. Is Entity A in compliance with IAS 39?

    No. Whenever a sale or transfer of more than an insignificant amount of financial assets classified as held to maturity (HTM) results in the conditions in IAS 39.9 and IAS 39.AG22 not being satisfied, no instruments should be classified in that category. Accordingly, any remaining HTM assets are reclassified as available-for-sale financial assets. The reclassification is recorded in the reporting period in which the sales or transfers occurred and is accounted for as a change in classification under IAS 39.51. IAS 39.9 makes it clear that at least two full financial years must pass before an entity can again classify financial assets as HTM.

    Bob Jensen

    Bob Jensen's threads on earnings management are at http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation

    Claims of IFRS Accounting Rule Flexibility --- http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting

     


    "Wave of Write-Offs Rattles Market:  Accounting Rules Blasted as Dow Falls; A $600 Billion Toll?" by David Reilly, The Wall Street Journal, March 1, 2008; Page A1 --- http://online.wsj.com/article/SB120432957846104273.html?mod=djem_jiewr_AC

    The massive write-downs that financial firms are posting have begun to spur a backlash among some investors and executives, who are blaming accounting rules for exaggerating the losses and are seeking new, more forgiving ways to value investments.

    The rules -- which last made headlines back in the Enron era -- require companies to value many of the securities they hold at whatever price prevails in the market, no matter how sharply those prices swing.

    Some analysts and executives argue this triggers a domino effect. The market falls, forcing banks to take write-offs, pushing the market lower, causing more write-offs.

    The rules' supporters, however, make a stark counter-argument: They can help prevent the U.S. from suffering the kind of malaise that gripped Japan in the 1990s -- as banks there sat on mountains of dud loans for years without writing them down.

    This debate gained new urgency Friday as the Dow Jones Industrial Average fell 315 points, or 2.5%. Driving stocks lower was insurance giant American International Group Inc.'s announcement of an $11.1 billion write-down that led the firm to post a $5.3 billion loss for the fourth quarter, the biggest loss in the firm's 89-year history.

    Also rattling investors was a report by UBS that said losses among financial institutions could top $600 billion as the turmoil in global credit markets continues to unfold.

    No one, including the chairman of the Federal Reserve, Ben Bernanke, knows with certainty what would be a better approach than using market prices for valuing holdings like these. "I don't know how to fix it," Mr. Bernanke said during testimony Thursday before the Senate banking committee. "I don't know what to do about it."

    Mr. Bernanke added that "I think the accountants need to make the best judgment they can."

    Despite the grim developments, many investors actually doubt that firms like AIG will suffer the full force of the losses they are now booking. Instead, these investors argue that the market has overreacted and will recover once the current panic subsides.

    Indeed, Martin Sullivan, AIG's chief executive, said Friday on the firm's conference call that he doesn't expect the losses to be permanent. "We are obviously witnessing and living through extraordinary market conditions," he said. "We are trying, as are many others, to value very complex instruments."

    Tumult also spread further in the normally staid market for municipal bonds -- debt issued by states and municipalities -- which is suffering one of its biggest crises in its history. Several hedge funds were hit with big losses after betting wrong on the direction of muni-bond prices, and as traders rushed to sell and exit their positions, portions of the market effectively froze.

    On Friday, muni-bond-prices fell for a 13th straight day, pushing yields significantly higher. (Bond yields move in the opposite direction as price.)

    For hundreds of muni-bond issuers, ranging from New York's Port Authority to the North Texas Tollway Authority, this tumult could cause borrowing costs to soar. That's a particular problem at a time when tax revenues are coming under strain from a slowing economy.

    AIG's argument that its write-downs were "unrealized" -- in other words, they may never actually result in a true charge to the company -- echoes points made by a number of other major financial firms. It's a sore point because companies feel they are being forced to take big financial hits on holdings that they have no intention of actually selling at current prices.

    The firms argue they are strong enough to simply keep the holdings in their portfolios until the crisis passes. Forcing companies to value securities based on what they would fetch if sold today "is an attempt to apply liquidation accounting to a going concern," said Charles Thayer of Chartwell Capital, a financial advisory.

    The market-value accounting approach is "exaggerating" the market turmoil, leading to write-downs that are "excessive," said Neal Soss, chief economist at Credit Suisse. "Many people would take the view that price and ultimately value have disconnected."

    Even analysts who are generally supportive of the market-value approach acknowledge it can make things tougher for investors in the current environment. It "increases the volatility of the accounts and it makes comparisons from quarter to quarter difficult," said Jeremy Perler of RiskMetrics Group, a research and strategy firm. "It certainly turns the world on end a little bit.

    Alternative accounting strategies don't offer much for markets to cling to. One alternative is to value a security based on what the buyer originally paid for it. However, that risks giving investors outdated information.

    The use of pricing models that don't pay heed to market values was discredited after Enron Corp. used them to book phantom profits earlier this decade.

    Enron, for example, would book a profit on a contract to buy or sell energy years in the future based on its own expectations of how much the contract would be worth over time. But Enron never tried to gauge what others in the market might think the contracts were worth.

    As the Fed chairman acknowledged in his recent Senate testimony, a move away from market values could in fact worsen current market turmoil. "The risk on other side is that if you do too much forbearance, or delay mark-to-market, that the suspicion will arise among investors that you're hiding something," Mr. Bernanke said.

    Buyers are already lacking trust and that has been a reason they have balked at buying securities that were typically seen as safe havens.

    But these market seizures are what have made market values so contentious. Robert Herz, chairman of the body that sets the accounting rules governing the use of market values, the Financial Accounting Standards Board, acknowledged the difficulty investors and companies are facing.

    "But you tell me what a better answer is," he said. "Is just pretending that things aren't decreasing in value a better answer? Should you just let everybody say they think it's going to recover?"

    Others who favor the use of market values say that for all its imperfections, it also imposes discipline on companies. "It forces you to realistically confront what's happening to you much quicker, so it plays a useful purpose," said Sen. Jack Reed (D., R.I.), a member of the Senate banking committee.

    Japan stands out as an example of how ignoring problems can lead to years-long stagnation. "Look at Japan, where they ignored write-downs at all their financial institutions when loans went bad," said Jeff Mahoney, general counsel at the Council for Institutional Investors.

    In addition, companies don't always have the luxury of waiting out a storm until assets recover the long-term value that executives believe exists. Sometimes market crises force their hands. Freddie Mac, for instance, sold $45 billion of assets last fall to help the company meet regulatory capital requirements.

    Investors can no longer take a firm's survival for granted in today's environment. Fed Chairman Bernanke in his testimony noted that it wouldn't be surprising if there were some bank failures due to the current market crisis.

     


    February 22, 2008 message from Tom Selling [tom.selling@GROVESITE.COM]

    On cost (replacement) versus (fair) value, Walter Teets and I have written a paper that we recently submitted to FAJ.  The basic thrust is that cost can be associated with principles-based accounting, and value cannot.  That’s why FAS 157 is rules based and filled with anomalies.  You can read the working paper here, or read my blog post that it was based on here.  Comments, especially on the working paper, would be much appreciated.

    Thomas I. Selling PhD, CPA
    602-228-4871 (M)
    602-952-9880 x205 (O)

    Website: www.tomselling.com 
    Weblog: www.accountingonion.com 
    Company: www.grovesite.com 


    Question
    What do CFO's think of Robert Herz's (Chairman of the FASB) radical proposed  format for financial statements that have more disaggregated financial information and no aggregated bottom line?

    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Before reading the article below you may want to first read about radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    "A New Vision for Accounting:  Robert Herz and FASB are preparing a radical new format for financial, CFO Magazine, by Alix Stuart, February 2008, pp. 49-53 --- http://www.cfo.com/article.cfm/10597001/c_10711055?f=home_todayinfinance

    Last summer, McCormick & Co. controller Ken Kelly sliced and diced his financial statements in ways he had never before imagined. For starters, he split the income statement for the $2.7 billion international spice-and-food company into the three categories of the cash-flow statement: operating, financing, and investing. He extracted discontinued operations and income taxes and placed them in separate categories, instead of peppering them throughout the other results. He created a new form to distinguish which changes in income were due to fair value and which to cash. One traditional ingredient, meanwhile, was conspicuous by its absence: net income.

    Kelly wasn't just indulging a whim. Ahead of a public release of a draft of the Financial Accounting Standards Board's new format for financial statements in the second quarter of 2008, the McCormick controller was trying out the financial statements of the future, a radical departure from current conventions. FASB's so-called financial statement presentation project is ostensibly concerned only with the form, or the "face," of financial statements, but it's quickly becoming clear that it will change and expand their content as well. "This is a complete redefinition of the financial statements as we know them," says John Hepp, a former FASB project manager and now senior manager at Grant Thornton.

    Some of the major changes under discussion: reconfiguring the balance sheet and the income statement to follow the three categories of the cash-flow statement, requiring companies to report cash flows with the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value changes. Companies will also likely have to report more about their segments, possibly down to the same level of detail as they currently report for the consolidated statements. Meanwhile, net income is slated to disappear completely from GAAP financial statements, with no obvious replacement for such commonly used metrics as earnings per share.

    FASB, working with the International Accounting Standards Board (IASB) and accounting standards boards in the United Kingdom and Japan, continues to work out the precise details of the new financial statements. "We are trying to set the stage for what financial statements will look like across the globe for decades to come," says FASB chairman Robert Herz. (Examples of the proposed new financial statements can be viewed at FASB's Website.) If the standard-setters stay their course, CFOs and controllers at every publicly traded company in the world could be following Kelly's lead as soon as 2010.

    It's too early to predict with confidence which changes will ultimately stick. But the mock-up exercise has made Kelly wary. He considers the direct cash-flow statement and reconciliation schedule among the "worst aspects" of the forthcoming proposal, and expects they would require "draconian exercises" from his finance staff, he says. And he questions what would result from the additional details: "If all of a sudden your income statement has 125 lines instead of 25, is that presentation more clarifying, or more confusing?"

    Other financial executives share Kelly's skepticism. In a December CFO survey of more than 200 finance executives, only 17 percent said the changes would offer any benefits to their companies or investors (see "Keep the Bottom Line" at the end of this article). Even some who endorsed the basic aim of the project and like the idea of standardizing categories across the three major financial statements were only cautiously optimistic. "It may be OK, or it may be excessive." says David Rickard, CFO of CVS/Caremark. "The devil will be in the details."

    Net Loss From the outset, corporate financial officers have been ambivalent about FASB's seven year-old project, which was originally launched to address concerns that net income was losing relevance amid a proliferation of pro forma numbers. Back in 2001, Financial Executives International "strongly opposed" it, while executives at Philip Morris, Exxon Mobil, Sears Roebuck, and Microsoft protested to FASB as well.

    (Critics then and now point out that FASB will have little control over pro forma reporting no matter what it does. Indeed, nearly 60 percent of respondents to CFO's survey said they would continue to report pro forma numbers after the new format is introduced.)

    Given the project's starting point, it's not surprising that current drafts of the future income statement omit net income. Right now that's by default, since income taxes are recorded in a separate section. But there is a big push among some board members to make a more fundamental change to eliminate net income by design, and promote business income (income from operations) as the preferred basis for investment metrics.

    "If net income stays, it would be a sign that we failed," says Don Young, a FASB board member. In his mind, the project is not merely about getting rid of net income, but rather about capturing all income-related information in a single line (including such volatile items as gains and losses on cash-flow hedges, available-for-sale securities, and foreign-exchange translations) rather than footnoting them in other comprehensive income (OCI) as they are now. "All changes in net assets and liabilities should be included," says Young. "Why should the income statement be incomplete?" He predicts that the new subtotals, namely business income, will present "a much clearer picture of what's going on."

    Board member Thomas Linsmeier agrees. "The rationale for segregating those items [in OCI] is not necessarily obvious, other than the fact that management doesn't want to be held accountable for them in the current period," he says.

    Whether for self-serving or practical reasons, finance chiefs are rallying behind net income. Nearly 70 percent of those polled by CFO in December said it should stay. "I understand their theories that it's not the be-all and end-all measure that it's put up to be, but it is a measure everyone is familiar with, and sophisticated users can adjust from there," says Kelly. Adds Rickard: "They're treating [net income] as if it's the scourge of the earth, which to me is silly. I think the logical conclusion is to make other things available, rather than hiding the one thing people find most useful."

    . . .

     

    Bob Jensen's threads on this proposed "radical change" in financial reporting are at http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay 

    Jensen Comment
    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Bob Jensen's threads on the radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

     


    Question
    Should your paycheck be impacted contractually by FAS 133?

    I was contacted by the representative of a major and highly reputable transportation company union concerning possible manipulation of FAS 133 accounting (one of the many tools for creative accounting) for purposes of lowering compensation payments to employees. He wanted to engage me on a consulting basis to examine a series of financial statements of the company. It would be great if I could inspire some public debate on the following issue. The message below follows an earlier message to XXXXX concerning how hedging ineffectiveness works under FAS 133 accounting rules --- http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Ineffectiveness

    _________________

    Hi XXXXX,

    You wrote:
    “Does the $502 million hedging ineffectiveness pique your interest?”

    My answer is most definitely yes since it fits into some research that I am doing at the moment. But the answers cannot be obtained from financial statements. Financial statements are (1) too aggregated (across multiple derivative hedging contracts) and (2) snapshots at particular points in time. Answers lie in tracing each contract individually (or at least a sampling of individual contracts) from inception to settlement. Results of effectiveness testing throughout the life of each hedging contract must be examined (on a sampling basis).

     

    Recall that there were enormous scandals concerning financial instruments derivatives that led up to FAS 133 and IAS 39. See http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
    The SEC pressured the FASB to come up with a new standard that would overcome the problem of so much unbooked financial liability risk due to derivative financial instruments. FAS 133 and IAS 39 got complicated when standard setters tried to book the derivative assets and liabilities on the balance sheet without impacting current earnings for qualified effective hedges of financial risk.

    When the FASB issued FAS 133, The FASB and the SEC were concerned about unbooked financial risk of every active derivative contract if the contract was settled on the interim balance sheet date. When a contract like an option is valued on a balance sheet date, its premature settlement value that day may well be deemed ineffective relative to the value of the hedged item. The reason is that derivative contracts are traded in different markets (usually more speculative markets) than commodities markets themselves (where buyers actually use the commodities). But the hedging contracts deemed ineffective on interim dates may not be ineffective at all across the long haul. Usually they are perfectly effective on hedging maturity dates.

    Temporal ineffectiveness more often than not works itself out such that all those gains and losses due to hedging ineffectiveness on particular interim dates exactly wash out such there is no ultimate cash flow gain or loss when the contracts are settled at maturity dates. I attached an Excel workbook that explains how some commodities hedges work out over time. The Graphing.xls file can also be downloaded from http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/
    Note in particular the “Hedges” spreadsheet in that file. These explain the outcomes at the settlement maturity dates that yield perfect hedges. But at any date before maturity (not pictured in the graphs), the hedges may not be perfect if settled prematurely on interim balance sheet dates.

    I illustrate the accounting for ineffective interim hedges in both the 03forfut.pps and 05options.ppt PowerPoint files at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
    The hedges may deemed ineffective under FAS 133 at interim balance sheet dates with gains and losses posted to current earnings. However, over time the gains and losses perfectly offset such that the hedges are perfectly effective when they are settled at maturity dates.

    The real problem with FAS 133 is that compensation contracts are generally tied to particular balance sheet dates where interim hedging contracts may be deemed ineffective and thereby affect paychecks. But some of those FAS 133 interim gains and losses may in fact never be realized in cash over the life of the each commodity hedging contract.

    What has to happen is for management to be very up front about how FAS 133 and other accounting standards may give rise to artificial gains and losses that are never realized unless the hedging contracts are settled prematurely on balance sheet dates. Compensation contracts should be hammered out with that thought in mind rather than blindly basing compensation contracts on bottom-line earnings that are mixtures of apples, oranges, toads, and nails due to accounting standards.

    Of course management is caught in a bind because investors follow bottom-line as the main indicator of performance of a company. The FASB recognizes this problem and is now trying to work out a new standard that will eliminate bottom-line reporting. The idea will be to provide information for analysts to derive alternative bottom-line numbers based upon what they want included and excluded in that bottom line. XBRL may indeed make this much easier for investors and analysts --- http://faculty.trinity.edu/rjensen/XBRLandOLAP.htm

    If I were working out a compensation contract based on accounting numbers, I would probably exclude FAS 133 unrealized gains and losses.

    In any case, back to your original question. I would love to work with management to track a sampling of fuel price hedging contracts from beginning to end. I would like to see what effectiveness tests were run on each reporting date and how gains and losses offset over the life of each examined contract. But this type of study cannot be run on aggregated financial statements.

    If I can study some of those individual hedging contracts over time I would be most interested. It will take your clout with management, however, to get me this data. I have such high priors on the integrity of your company's management that I seriously doubt that there is any intentional manipulation going on witth FAS 133 implementation. Rather I suspect that management is just trying to adhere as closely as possible with FAS 133 rules. What I would like to do is help enlighten the world about the bad things FAS 133 can do with compensation contracts and investment decisions by users of statements who really do not understand the temporal impacts of FAS 133 on bottom-line earnings.

    I fear that my study would, however, be mostly one of academic interest that I can report to the public. Only an inside whistleblower could pinpoint hanky-pank within a company, and I seriously doubt that your company is engaged in disreputable FAS 133 hanky-pank beyond that of possibly not fully explaining to unions how FAS 133 losses in general may be phantom losses over the long haul.

    Bob Jensen


    Questions
    How are auditors dealing with fair market value accounting and credit market issues?

    From The Wall Street Journal Accounting Weekly Review on October 19, 2007

    With New, United Voice, Auditors Stand Ground on How to Treat Crunch
    by David Reilly
    The Wall Street Journal

    Oct 17, 2007
    Page: C1
    Click here to view the full article on WSJ.com
     

    TOPICS: Audit Quality, Auditing, Auditing Services, Auditor Independence, Auditor/Client Disagreements, Banking, Fair Value Accounting

    SUMMARY: The article discusses three papers issued by the Center for Audit Quality on the recent issues in credit markets. The topics included the use of market prices for hard-to-trade securities and issues of banks' exposure to losses in off-balance-sheet entities. Organization of the Center for Audit Quality is discussed, along with reaction to the purpose of this entity from Lynn Turner, former Chief Accountant at the SEC, and an academic researcher at the University of Tennessee, Joseph Carcello.

    CLASSROOM APPLICATION: The article may be used to discuss the current credit market issues in an auditing class as well as a financial reporting class.

    QUESTIONS: 
    1.) Based on discussions in the article and on information at its web site (see http://thecaq.aicpa.org/) discuss the purpose and organization of the Center for Audit Quality.

    2.) What is self-regulation of the auditing profession? When did auditors lose the ability to self-regulate?

    3.) Some reactions described in this article are positive about the role that is being played by the Center for Audit Quality, while others are negative. Which view do you hold? Support your position.

    4.) Summarize concerns with the complexity of financial reporting guidance in the U.S. How might the work from the Center for Audit Quality contribute to that complexity? How might its work alleviate the issue of complexity in reporting standards?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Auditors to Street: Use Market Price
    by David Reilly and Randall Smith
    The Wall Street Journal
    Sep 18, 2007
    Page: C2
     

     

    Also see http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/

     


    May 17, 2006 message from Peter Walton

    I would like to take this opportunity to let you know about a forthcoming book from Routledge:

    The Routledge Companion to Fair Value and Financial Reporting --- Click Here

    Edited by Peter Walton

    May 2007: 246x174: 406pp

    Hb: 978-0-415-42356-4: £95.00 $170.00

    Jensen Comment
    Even though I have a paper published in this book, I will receive no compensation from sales of the book. And since I'm retired, lines on a resume no longer matter.


    A New Type of Intangible Investment (sort of not yet legal in the U.S.) --- Litigation
    How should it be booked and carried in financial statements?
    I say "sort of" since this intangible asset might be buried (as Purchased Goodwill") in acquisition prices when firms are purchased purchased or merged.

    The notion of litigation as a separate asset class is a novel one. It's hard to imagine fund managers one day allotting a bit of their portfolio to third-party lawsuits, alongside shares, bonds, property and hedge funds. But some wealthy investors are starting to dabble in lawsuit investment, bankrolling some or all of the heavy upfront costs in return for a share of the damages in the event of a win. The London-managed hedge fund MKM Longboat last month revealed plans to invest $100million (£50.5million) to finance European lawsuits. Today a new company, Juridica, floats on AIM, having raised £80million to make litigation bets.
    "The law is now an asset class," The London Times, December 21, 2007 --- http://business.timesonline.co.uk/tol/business/columnists/article3080766.ece

    Jensen Comment
    Under U.S. GAAP, intangible assets are generally booked only when purchased and are not conducive to fair value accounting afterwards. Probably the most serious problem in both accounting theory and practice is unbooked value (and in many cases undisclosed) of intangible assets and liabilities. Do the values of human capital and knowledge capital ring a bell? Does the cost retraining the world's workforce to use Office software other than Microsoft Office (Word, Excel, PowerPoint, etc.) ring a bell?

    Contingent liabilities (particularly pending lawsuits) are problematic until the amount of the liability is both reasonably measurable and highly probable. Until now, contingent litigation assets were not investment assets. Contingent liabilities were booked as current or past expenses. Now purchased litigation assets having future value? Horrors!

    In the past when a company purchased another company, some of the "goodwill" value above and beyond the traceable value to net tangible assets could easily have been the value of future litigation such as when Blackboard acquired WebCT and WebCT's patents on online education software. Patents and Copyrights may have value with respect to fending off future competition.

    But patents and copyrights may also have value in future litigation regarding past infringements. Now hedge funds might invest in bringing litigation to fruition.

    Intangible assets and liabilities are, and will forever remain, the largest problem in accounting theory and practice! In some cases, such as Microsoft Corporation, booked assets are so miniscule relative to unbooked intangible assets that the balance sheets are virtually a bad joke.

    An enormous problem, besides the fact that current value of intangibles cannot be counted, current value can change by enormous magnitudes overnight as new discoveries are made and new legislation is passed, to say nothing of court decisions. Tangible asset values can also change, but in general they are not as volatile.

    December 25, 2007 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    Bob,

    SFAS 141R (available on the FASB web site) substantially changes the accounting for both contingent assets and liabilities in connection with business combinations. In fact, 141R coupled with SFAS 160 on noncontrolling interests makes major changes to both the accounting for business combinations and the accounting for consolidation procedures. While the new rules can't be applied until 2009, anyone teaching advanced accounting or where ever else these topics are covered should throw out their old lesson plans and be prepared to enter into an entirely new world of accounting - not for the better in my humble opinion.

    By the way, another interesting thing to read on the FASB web site is the proposal to reduce the size of the FASB and make some other changes to improve the standard-setting process. We celebrated our family Christmas a few days ago because of travel plans and I'm working on my comment letter to the Financial Accounting Foundation today.

    Merry Christmas!

    Denny

    December 25, 2007 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]

    What I found interesting about 141R is the discussion in the appendices that showed both the FASB and IASB views and how the Boards reached convergence.

    141R also added a couple paragraphs to FIN 48 that result in goodwill no longer being adjusted if the contingent tax liability is increased or decreased. Instead the DR is to tax expense, which makes a lot more sense to me. If I read the statement correctly, the purchased assets and liabilities are stated at fair value under a recognition, then measurement principle. Taxes are exempt from those two principles; instead FAS 109/FIN 48 apply. What I couldn't tell is if the purchaser still has up to one year (the maximum measurement period) to get the tax contingent liability right before the DR goes to tax expense. Can anyone help me?

    Amy Dunbar
    UConn

    From the AccountingWeb on December 27, 2007 --- http://www.accountingweb.com/blogs/eva_lang_blog.html

    On December 4, 2007, the Financial Accounting Standards Board issued FASB Statements No. 141 (revised 2007), Business Combinations. The new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. The revision of 141 is part of the FASB's push toward "fair value," or mark-to market accounting.

    Financial Week (December 10, 2007) reports that Dennis Beresford, a former FASB chairman now serving on a Securities and Exchange Commission advisory committee that is studying the U.S. financial reporting system says “The rules will be difficult to apply and will require companies and analysts to relearn a lot of things.” The article goes on to say that the revisions to 141 “essentially extend the fair-value requirements to new areas. That will increase the valuation work required of corporate finance departments, and in some cases jack up the volatility of reported earnings as various assets and liabilities are marked to market.”

    Jensen Comment
    You can download FAS 141(R) from http://www.fasb.org/st/index.shtml#fas160

    December 31, 2007 reply from Gerald Trites [gtrites@ZORBA.CA]

    Warren Buffett referred to "mark to market" as "mark to myth", a comment that I think is right on the mark.

    Bob Jensen's threads on intangible/contingency asset asset and liability accounting are at
    http://faculty.trinity.edu/rjensen/Theory01.htm#TheoryDisputes 


    Introduction to Fair Value Accounting

    Bob Jensen's threads on fair value accounting are at various other links:

    I recently completed the first draft of a paper on fair value at http://faculty.trinity.edu/rjensen/FairValueDraft.htm
    Comments would be helpful.

    http://faculty.trinity.edu/rjensen/roi.htm

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm


    The "Unknown Professor's Financial Rounds Blog states the following on September 21, 2007 --- http://financialrounds.blogspot.com/ 

    And They Say Accounting Doesn't Make Sense

    As a person who's trained primarily in finance, accounting rules sometimes look like they were designed by Monty Python. Here's the latest installment - your company's credit rating drops, so the market value of your liabilities fall. As a result, you show a profit. This is what happened to some Wall Street firms recently. Read the whole story here. IMO, the best line in the article is:

    But Moody’s Investors Service said buyers should beware of gains booked when brokers mark down their own debt liabilities. “Moody’s does not consider such gains to be high-quality, core earnings,” it said in a report issued Friday.

    Ya think?

    This is why we make all our Finance students take four accounting classes before they graduate. That way, they'll see these things often enough that they won't break out laughing.

    Question
    Why am I not laughing? Is it because I taught accounting for 40 years?

    Actually the fact that a lowered credit rating can lead to a realized gain should make sense even to a finance professor. Consider the following scenario:

    1. I sell a bond and record a liability for $100,000 that matures in ten years.
    2. My credit rating gets lowered the next day.
    3. I buy back the bond for $90,000 (the market value of the bond declines because of my lowered credit rating)
    4. I've made a $10,000 cash profit in one day because of a lowered credit rating
    5. I wonder if a finance professor can comprehend that this is a gain.
    6. I wonder if Moody's can understand that this is a very high quality earnings since its cash in the bank.

    Now what if I don't sell the bond but adopt the fair value accounting option for financial instruments under FAS 159. I did not realize a cash profit if I still owe $100,000 when the bond eventually matures. But the reason I report an unrealized holding gain follows the same logic as if I bought back the bond today. That's what the "fair value option" under FAS 159 is all about.

    If Moody's does not treat unrealized holding gains and losses as high-quality, core earnings, more power to them.

    Finance students who've taken four courses in accounting may not laugh because they understand why sometimes credit rating gains are high quality and sometimes low quality will not laugh because they understand why. But they may not understand why their finance professor is laughing.

    Bob Jensen's tutorials on fair value accounting are at the following two links:

     


    From The Wall Street Journal Accounting Weekly Review on October 5, 2007

    Virtuous Losses
    by WSJ Editors; Review & Outlook Page
    The Wall Street Journal

    Oct 02, 2007
    Page: A16
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting, Accounting Theory, Advanced Financial Accounting, Bonds, Debt, Impairment

    SUMMARY: The editors laud UBS AG and Citigroup "for their announcements...that they'll soon take big writedowns for their mortgage bets." They react this way on the premise that "one question haunting the markets during the subprime meltdown has been where the financial bodies are buried." Similar reactions are evident for UBS and Citigroup shareholders; the companies' share prices both rose following the announcements. The editors conclude by offering evidence that credit markets are stabilizing and state that "by being forthright now, the banks can aid the process of bringing buyers back to the debt markets."

    CLASSROOM APPLICATION: This article can be used to cover write-downs due to impairment losses on mortgage assets as well as to discuss debtholders as users of financial markets. The situation also could be described as a "big bath" write-down to clean house now while times are bad in credit markets in general and, at least for UBS, while corporate leadership is new.

    QUESTIONS: 
    1.) In the opinion page article, the editors argue that "marking asset to market is...better for the financial system as a whole, rather than hiding losses on the balance sheet and hoping for a rebound." What does this statement mean? In your answer, define the terms "historical cost" and "mark to market." Also, address the notion that a loss could be included in a balance sheet account.

    2.) Refer to the related articles. What are the assets on which losses were taken at UBS and Citigroup?

    3.) Some might argue that the losses being recorded by Citigroup and UBS AG constitute a "big bath" to pave the way for improving reported results in the future. How does a current writedown help to improve reported results in the future? What current circumstances at each of these firms and in the general economy might allow for taking this approach to writedowns?

    4.) Refer again to the opinion page article's conclusion that reporting losses now "can aid the process of bringing buyers back to the debt markets." Should financial reporting have a specific outcome, such as improving numbers of credit market participants, as its objective? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     


    "The Finer Points of Fair Value," by Thomas A. Ratcliffe, Journal of Accountancy, December 2007 --- http://www.aicpa.org/pubs/jofa/dec2007/fair_value.htm

    EXECUTIVE SUMMARY
    To adopt FASB Statement no. 159, companies must comply with the requirements of Statement no. 157, Fair Value Measurements.

    Companies and their auditors must consider whether the use of fair value option accounting reflects a “substance over form” decision by management rather than an effort to gain an accounting result.

    FASB has raised the bar for disclosure required when the fair value option is in play so that financial statement users will be able to clearly understand the extent to which the option is utilized and how changes in fair values are being reflected in the financial statements.

    Companies are encouraged but not required to present the fair value option disclosures in combination with the fair value disclosures required in other accounting literature.

    The guidance must be implemented on an instrument-by-instrument basis and is irrevocable.


    From the FASB:  PROPOSED FASB STAFF POSITION No. FAS 157-a
    "Application of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive Accounting Pronouncements That Address Leasing Transactions" --- http://www.fasb.org/fasb_staff_positions/prop_fsp_fas157-a.pdf

    Objective

    1. This FASB Staff Position (FSP) amends FASB Statement No. 157, Fair Value Measurements, to exclude FASB Statement No. 13, Accounting for Leases, and its related interpretive accounting pronouncements that address leasing transactions.

    Background

    2. The Exposure Draft preceding Statement 157 proposed a scope exception for Statement 13 and other accounting pronouncements that require fair value measurements for leasing transactions. At that time, the Board was concerned that applying the fair value measurement objective in the Exposure Draft to leasing transactions could have unintended consequences, requiring reconsideration of aspects of lease accounting that were beyond the scope of the Exposure Draft.

    3. However, respondents to the Exposure Draft indicated that the fair value measurement objective for leasing transactions was generally consistent with the fair value measurement objective proposed by the Exposure Draft. Others in the leasing industry subsequently affirmed that view. Based on that input, the Board decided to include lease accounting pronouncements in the scope of Statement 157.

    4. Subsequent to the issuance of Statement 157, which changed in some respects from the Exposure Draft, constituents have raised issues stemming from the interaction

    Proposed FSP on Statement 157 (FSP FAS 157-a) 1 FSP FAS 157-a between the fair value measurement objective in Statement 13 and the fair value measurement objective in Statement 157.

    5. Constituents have noted that paragraph 5(c)(ii) of Statement 13 provides an example of the determination of fair value (an exit price) through the use of a transaction price (an entry price). Constituents also have raised issues about the application of the fair value measurement objective in Statement 157 to estimated residual values of leased property. These issues, as well as other issues related to the interaction between Statement 13 and Statement 157, would result in a change in lease accounting that requires considerations of lease classification criteria and measurements in leasing transactions that are beyond the scope of Statement 157 (for example, a change in lease classification for leases that would otherwise be accounted for as direct financing leases).

    6. The Board acknowledges that the term fair value will be left in Statement 13 although it is defined differently than in Statement 157; however, the Board believes that lease accounting provisions and the longstanding valuation practices common within the leasing industry should not be changed by Statement 157 without a comprehensive reconsideration of the accounting for leasing transactions. The Board has on its agenda a project to comprehensively reconsider the guidance in Statement 13 together with its subsequent amendments and interpretations.

     


    When do market investors become market makers?
    When "quants" become market makers instead of market players, it throws fair value accounting into a turmoil.

    November 23, 2007 message from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]

    The subprime crisis has captured my attention, and on the chance that others on this listserv are interested in this area, I am sending this email about the paper, What Happened to the Quants in August 2007?  I assumed the hedge funds went down because of subprime investments, but it appears that was just one of many possible causes.  I would love to hear what others think, particularly about the possibility of regulatory reform (mentioned at the end below) --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1015987

    The paper has 9011 abstract views and 4447 downloads.  Looks like a lot of people are interested in the hedge fund losses.

    The paper is fascinating.  Its objective is to suggest reasons for the hedge fund losses during the week of Aug 6,  2007.  The funds were quantitative, market-neutral funds. No major losses were reported in other hedge-fund sectors. The paper compares August 1998 (think LTCM collapse) with August 2007, and concludes the following:

     

    In August 1998, default of Russian government debt caused a flight to quality that ultimately resulted in the demise of LTCM and many other fixed-income arbitrage funds. This series of events caught even the most experienced traders by surprise because of the unrelated nature of Russian government debt and the broadly diversified portfolios of some of the most  successful fixed-income arbitrage funds. Similarly, the events of August 2007 caught some of the most experienced quantitative equity market-neutral managers by surprise. But August 2007 may be far more significant because it provides the first piece of evidence that problems in one corner of the financial system - possibly the sub-prime mortgage sector and related credit markets – can spill over so directly to a completely unrelated corner: long/short equity strategies. This is precisely the kind of ”shortcut" described in the theory of mathematical networks that generates the “small-world phenomenon" of Watts (1999) in which a small random shock in one part of the network can rapidly propagate throughout the entire network.

    The authors hypothesize an unwind of a large long/short equity portfolio, most likely a quantitative equity market-neutral portfolio.

    Likely factors contributing to the magnitude of the losses of this apparent unwind were: (a) the enormous growth in assets devoted to long/short equity strategies over the past decade and, more recently, to various 130/30 and other active-extension strategies; (b) the systematic decline in the profitability of quantitative equity market-neutral strategies, due to increasing competition, technological advances, and institutional and environmental changes such as decimalization, the decline in retail order flow, and the decline in equity-market volatility; (c) the increased leverage needed to maintain the levels of expected returns required by hedge-fund investors in the face of lower profitability; (d) the historical liquidity of U.S. equity markets and the general lack of awareness (at least prior to August 6, 2007) of just how crowded the long/short equity category had become; and (e) the unknown size and timing of new sub-prime-mortgage-related problems in credit markets, which created a climate of fear and panic, heightening the risk sensitivities of managers and investors across all markets and style categories.

    They also note that

     the timing of these losses - shortly after month-end of a very challenging month for many hedge-fund strategies - is also suggestive. The formal process of marking portfolios to market typically takes several business days after month-end, and August 7-9 may well be the first time managers and investors were forced to confront the extraordinary credit-related losses they suffered in July, which may have triggered the initial unwind of their more liquid investments, e.g., their equity portfolios, during this period.

    Question:  FAS 115 requires investment securities (actually only trading and available-for-sale securities) to be marked to market, but what is the driving force behind marking to market on a monthly basis?  Reporting to investors in the fund?

     Do the losses of August 2007 signal a breakdown in the basic economic relationships that yield attractive risk/reward profiles for such strategies, or is August 2007 an unavoidable and integral aspect of those risk/reward profiles? An instructive thought experiment is to consider a market-neutral portfolio strategy in which U.S. equities with odd-numbered CUSIP identifiers are held long and those with even-number CUSIPs are held short. Suppose such a portfolio strategy is quite popular and a

    number of large hedge funds have implemented it. Now imagine that one of these large hedge funds decides to liquidate its holdings because of some liquidity shock. Regardless of this portfolio's typical expected return during normal times, in the midst of a rapid and large unwind, all such portfolios will experience losses, with the magnitudes of those losses directly proportional to the size and speed of the unwind. Moreover, it is easy to see how such an unwind can generate losses for other types of portfolios, e.g., long-only portfolios of securities with prime-number CUSIPs, dedicated shortsellers that short only those securities with CUSIPs divisible by 10, etc. If a portfolio is of sufficient size, and it is based on a sufficiently popular strategy that is broadly implemented, then unwinding even a small fraction of it can cascade into a major market dislocation.

    . . .

    However, a successful investment strategy should include an assessment of the risk of ruin, and that risk should be managed appropriately. Moreover, the magnitude of tail risk should, in principle, be related to a strategy's expected return given the inevitable trade-off between risk and reward. Therefore, it is disingenuous to assert that “a strategy is successful except in the face of 25-standard-deviation events." Given the improbability of such events, we can only conclude that either the actual distribution of returns is extraordinarily leptokurtic, or the standard deviation is time-varying and exhibits occasional spikes.

    In particular, as Montier (2007) observed, risk has become “endogenous" in certain markets - particularly those that are recently flush with large inflows of assets - which is one of the reasons that the largest players can no longer assume that historical estimates of volatility and price impact are accurate measures of current risk exposures. Endogeneity is, in fact, an old economic concept illustrated by the well-known theory of imperfect competition: if an economic entity, or group of coordinated entities, is so large that it can unilaterally affect prices by its own actions, then the standard predictions of microeconomics under perfect competition no longer hold. Similarly, if a certain portfolio strategy is so popular that its liquidation can unilaterally affect the risks that it faces, then the standard tools of basic risk models such as Value-at-Risk and normal distributions no longer hold. In this respect, quantitative models may have failed in August 2007 by not adequately capturing the endogeneity of their risk exposures. Given the size and interconnectedness of the hedge-fund industry, we may require more sophisticated analytics to model the feedback implicit in current market dynamics.

     

    The authors commented several times on the lack of transparency in the hedge fund market. I found the authors’ comments on the need for  possible regulatory reform interesting.

    Given the role that hedge funds have begun to play in financial markets - namely, significant providers of liquidity and credit - they now impose externalities on the economy that are no longer negligible.  In this respect, hedge funds are becoming more like banks. The fact that the banking industry is so highly regulated is due to the enormous social externalities banks generate when they succeed, and when they fail. But unlike banks, hedge funds can decide to withdraw liquidity at a moment's notice, and while this may be benign if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.

    November 23, 2007 reply from Bob Jensen

    Hi Amy,

    Why do bankers resist expanding FAS 159 into required accounting for all financial instruments?
    Misleading Financial Statements:  Bankers Refusing to Recognize and Shed "Zombie Loans"

    One worrying lesson for bankers and regulators everywhere to bear in mind is post-bubble Japan. In the 1990s its leading bankers not only hung onto their jobs; they also refused to recognise and shed bad debts, in effect keeping “zombie” loans on their books. That is one reason why the country's economy stagnated for so long. The quicker bankers are to recognise their losses, to sell assets that they are hoarding in the vain hope that prices will recover, and to make markets in such assets for their clients, the quicker the banking system will get back on its feet.
    The Economist, as quoted in Jim Mahar's blog on November 10, 2007 --- http://financeprofessorblog.blogspot.com/

    But there are questions in theory about fair value accounting!
    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

     

    I personally think the driving forces behind FAS 115 were tendencies of banks to not recognize those "zombie" investments and adequately disclose highly likely losses. Firstly I might note that FAS 115 adjusts available-for-sale (AFS) securities to fair value without impacting earnings volatility except in the case of securities traders. According to Paragraph 86 of FAS 115, the FASB wanted to require fair value accounting for all financial securities but got hung up on debt instruments (such as mortgage debt) that more commonly are not AFS  and more difficult to mark-to-market (i.e. debt is often more difficult to value due to not being traded with unique covenants and is more likely to be HTM, held-to-maturity). The FASB justification for FAS 115 can be found in Paragraphs 39-43, although the elaborations in Paragraphs 86-100 are enlightening. IFRS requirements are similar, although penalties for violating HTM classification are somewhat more onerous.

    An interesting November 12 video on the “cascade theory” of what might be termed quantitative models, like lemmings, cascading over a cliff --- http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=593529134&fromSearch=n

    In that sense the comparison of the LTCM disaster in 1998 with the August 2007 downfall seems to hold some water. Although the big losers in both instances were big and sophisticated investors who’re well aware of the unique risks of unregulated hedge funds, the externalities affecting Main Street (read that CREF investors) are very real. The LTCM fiasco could well have brought down equity markets in all of Wall Street --- http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM 

    One of the hardcopy journals I read cover-to-cover each week is The Economist on October 25, 2007. The following is one of my favorite readable papers among the thousands of articles written about this controversy --- http://www.economist.com/finance/displaystory.cfm?story_id=10026288

    WHEN markets wobbled in August, almost all the media attention was focused on the credit crunch and the links to American mortgage loans. But at exactly the same time, another crisis was occurring at the core of the stockmarket.

    This crisis stemmed from the obscure world of quantitative, or quant-based, finance, which uses computer models to find attractive stocks and to identify overpriced shares. Suddenly, in August, the models went wrong.

    The incident revealed a problem at the heart of the financial system. In effect, the quant groups were acting as marketmakers, trading so often (some are aiming for transaction times in terms of milliseconds) that they set prices for everyone else. But unlike traditional marketmakers, quant funds are not obliged to make markets come rain or shine. And unlike marketmakers, they use a lot of leverage. This means that instead of providing liquidity in a crisis, the quants added to instability. There is a lesson there.

    In a way, the crisis stemmed from the quants' success. Many firms, such as the American hedge fund Renaissance Technologies, had done fantastically well and had been able to charge hefty fees. But if one firm can hire top mathematicians and use the latest technology, so can others. An arms race developed, with some trading faster and faster—even siting their computers closer to the exchanges in order to cut the time it took orders to travel down the wires.

    And as the computers sifted through the data, some strategies became overcrowded. A paper* by Amir Khandani and Andrew Lo of the Massachusetts Institute of Technology back-tested a proxy for a typical strategy, involving buying the previous day's losing stocks and selling the winners. Such a strategy would have delivered a daily return of 1.38% before (substantial) costs in 1995 but the return fell steadily to 0.15% a day last year.

    In the face of declining returns, the authors reckon, the natural response of managers would have been to increase leverage. But that, of course, increased their vulnerability when things went wrong.

    Both the MIT academics and a paper by Cliff Asness of AQR Capital Management, a leading quant group, agree that August's problems probably began when a diversified, or multi-strategy, hedge fund experienced losses in the credit markets. The fund sought to reduce its exposures but its credit positions were impossible to sell. So it cut its quant positions instead, since that merely involved selling highly liquid stocks.

    However, that selling pressure caused other quant funds to lose money as their favoured stocks fell in price. Those that were leveraged were naturally forced to reduce their positions as well. These waves of selling played havoc with the models. Quant investors thought they were aware of the risks of their strategy and had built diversified portfolios to avoid it. But the parts of the portfolio that were previously uncorrelated suddenly fell in tandem.

    In theory, quant funds could have been bold and borrowed more; after all, the stocks they thought were cheap had become even cheaper. The traders who took on the positions of Long-Term Capital Management (LTCM), after the hedge fund failed in 1998, ended up making money. But the example of LTCM, which went bust before it could be proved right, argued in favour of a more cautious approach. “We could have rolled the dice but that would have risked the business,” said one quant-fund manager. “I don't know of anyone that did so.”

    Avoiding that trap simply led quant investors into another. On August 10th, the stocks that quants had favoured suddenly rebounded. Those who had cut their positions most could not benefit from the rally. That category clearly included Goldman Sachs's Global Alpha hedge fund, which lost a remarkable 23% on the month.

    If it were just a few hedge funds, backed by rich people, losing money, it might not matter. But the funds had become too important: rather than adding stability, as marketmakers are supposed to do, they added volatility.

    Quants will adjust their models and clients will become more discerning; AQR's. Mr Asness says his firm will look harder for “unique” factors, that is, not used by other fund managers. But regulators should also reflect that markets are less stable than they assumed. The presence of leveraged traders such as quants at their heart means conditions can now turn, at the flick of a switch, from stability to panic.

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue
    When "quants" become market makers instead of market players, it throws fair value accounting into a turmoil.


    Question
    Will “Minsky Moments” become “Minsky Accounting?”

    As both the FASB in the U.S. and the IASB international standards boards march ever onward toward "fair value" accounting by replacing historical costs with current values (mark-to-market accounting), it will plunge corporate accountants and their CPA auditors ever deeper into current value estimation. Financial statements will become increasingly volatile and fictional with market movements. It is becoming clear that the efficient markets hypothesis that drives much of the theory behind fair value accounting is increasingly on shaky ground.

    Especially problematic are moments in time like now (2007) when the bubble burst on subprime mortgage borrowing and investing that has caused tremors throughout the world of banking and investing and risk sharing. And once again, the ghost of long departed John Maynard Keynes seems to have risen from the grave. There's material for a great Stephen King horror novel here.

    It is time for accounting standard setters who set such new standards as FAS 157 and FAS 159 to dust off some old economics books and seriously consider whether they understand the theoretical underpinnings of new and pending fair value standards moving closer to show time. You can read more fair value accounting controversies in my work-in-process PowerPoint file called 10FairValue.ppt at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

    Aside from badly mixing my metaphors here, the fundamental problem is that unrealized fair values painting rosy financial performance (as the speculative roller coaster rises with breath taking thrill toward the crest) become unrealized losses as the roller coaster swoops downward toward “Minsky Moments.” It's a fundamental problem in fair value accounting because an enormous portion of reported earnings on the way up become sheer Minsky mincemeat (before investments are sold and liabilities are not settled) and diabolical garbage on the way down. In other words in these boom/bust market cycles, financial statements (certified by independent auditors under new fair value accounting standards) become increasingly hypothetical fantasy replacing accustomed facts rooted in transactional accounting.

    Fair value standard setters are plunging accounting into the realm of economic theory that is itself less uncertain than astrology. It's time to rethink some of that Chicago School economic theory that we've taken for granted because of all the Nobel Prizes awarded to Chicago School economists.

     

    Question
    Did John Maynard Keynes rise from the grave?

    "In Time of Tumult, Obscure Economist Gains Currency:  Mr. Minsky Long Argued Markets Were Crisis Prone; His 'Moment' Has Arrived," by Justin Lahart, The Wall Street Journal, August 18, 2007; Page A1 --- http://online.wsj.com/article/SB118736585456901047.html?mod=todays_us_page_one

    The recent market turmoil is rocking investors around the globe. But it is raising the stock of one person: a little-known economist whose views have suddenly become very popular.

    Hyman Minsky, who died more than a decade ago, spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. At a time when many economists were coming to believe in the efficiency of markets, Mr. Minsky was considered somewhat of a radical for his stress on their tendency toward excess and upheaval.

    Today, his views are reverberating from New York to Hong Kong as economists and traders try to understand what's happening in the markets. The Levy Economics Institute of Bard College, where Mr. Minsky worked for the last six years of his life, is planning to reprint two books by the economist -- one on John Maynard Keynes, the other on unstable economies. The latter book was being offered on the Internet for thousands of dollars.

    Christopher Wood, a widely read Hong Kong-based analyst for CLSA Group, told his clients that recent cash injections by central banks designed "to prevent, or at least delay, a 'Minsky moment,' is evidence of market failure."

    Indeed, the Minsky moment has become a fashionable catch phrase on Wall Street. It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand.

    Mr. Minsky, who died in 1996 at the age of 77, was a tall man with unruly hair who wore unpressed suits. He approached the world as "one big research tank," says Diana Minsky, his daughter, an art history professor at Bard. "Economics was an integrated part of his life. It wasn't isolated. There wasn't a sense that work was something he did at the office."

    She recalls how, on a trip to a village in Italy to meet friends, Mr. Minsky ended up interviewing workers at a glove maker to understand how small-scale capitalism worked in the local economy.

    Although he was born in Chicago, Mr. Minsky didn't have many fans in the "Chicago School" of economists, who believed that markets were efficient. A follower of the economist John Maynard Keynes, he died just before a decade of financial crises in Asia, Russia, tech stocks, corporate credit and now mortgage debt, began to lend credence to his ideas.

    Following those periods of tumult, more investors turned to the investment classic "Manias, Panics, and Crashes: A History of Financial Crises," by Charles Kindleberger, a professor at the Massachusetts Institute of Technology who leaned heavily on Mr. Minsky's work.

    Mr. Kindleberger showed that financial crises unfolded the way that Mr. Minsky said they would. Though a loyal follower, Mr. Kindleberger described Mr. Minsky as "a man with a reputation among monetary theorists for being particularly pessimistic, even lugubrious, in his emphasis on the fragility of the monetary system and its propensity to disaster."

    At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.

    When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.

    "We are in the midst of a Minsky moment, bordering on a Minsky meltdown," says Paul McCulley, an economist and fund manager at Pacific Investment Management Co., the world's largest bond-fund manager, in an email exchange.

    The housing market is a case in point, says Investment Technology Group Inc. economist Robert Barbera, who first met Mr. Minsky in the late 1980s. When home buyers were expected to have a down payment of 10% or 20% to qualify for a mortgage, and to provide income documentation that showed they'd be able to make payments, there was minimal risk. But as home prices rose, and speculators entered the market, lenders relaxed their guard and began offering loans with no money down and little or no documentation.

    Once home prices stalled and, in many of the more-speculative markets, fell, there was a big problem.

    "If you're lending to home buyers with 20% down and house prices fall by 2%, so what?" Mr. Barbera says. If most of a lender's portfolio is tied up in loans to buyers who "don't put anything down and house prices fall by 2%, you're bankrupt," he says.

    Several money managers are laying claim to spotting the Minsky moment first. "I featured him about 18 months ago," says Jeremy Grantham, chairman of GMO LLC, which manages $150 billion in assets. He pointed to a note in early 2006 when he wrote that investors had become too comfortable that financial markets were safe, and consequently were taking on too much risk, just as Mr. Minsky predicted. "Guinea pigs of the world unite. We have nothing to lose but our shirts," he concluded.

    It was Mr. McCulley at Pacific Investment, though, who coined the phrase "Minsky moment" during the Russian debt crisis in 1998.

    Continued in article

    Bob Jensen's fair value PowerPoint show ---  http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

    August 18, 2007 reply from J. S. Gangolly [gangolly@CSC.ALBANY.EDU]

    Bob,

    I thought we could all enjoy the following Keynes quotes:

    1. "Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

    2. How prophetic he was:

    "The day is not far off when the economic problem will take the back seat where it belongs, and the arena of the heart and the head will be occupied or reoccupied, by our real problems / the problems of life and of human relations, of creation and behavior and religion."

    3. How wonderfully Keynes anticipated stuff in games played by Bayesian players and stuff in self-fulfilling equilibria (which yielded three "Nobel" prizes), all without introducing any mathematics or economic mumbo jumbo:

    "Successful investing is anticipating the anticipations of others."

    4. The accountics folks might enjoy the following:

    "The difficulty lies not so much in developing new ideas as in escaping from old ones."

    "If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid."

    "When the facts change, I change my mind. What do you do, sir?"

    5. This should thrill tax folks:

    "The avoidance of taxes is the only intellectual pursuit that still carries any reward."

    Jagdish

    August 20, 2007 reply from Paul Williams [Paul_Williams@NCSU.EDU]

    Apparently no economist ever dies -- they just come in and out of fashion. In George Akerlof's presidential address to the AEA in January 2006 ("The Missing Motivation in Macroeconomics") he concludes: "This lecture has shown that the early Keynesians got a great deal of the working of the economic system right in ways that are denied by the five neutralities (assumptions of the positivists).

    As quoted from Keynes earlier, they based their models on "our knowledge of human nature and from the detailed facts of experience."" Thus the recent interest in "norms" by Shyam Sunder and the urgency to provide "econonmic" explanations for "norms." So the very FIRST plenary speaker at the, Joe Henrich, at the Chicago 2007 AAA meeting, regaled us with his "evidence" that market integrated societies produce people who are more trusting and fair- minded because people from Missouri divide the spoils in a game that no one ever plays in their real lives more equitably than a hunter- gatherer from New Guinea for whom the game may have an entirely different meaning than someone from St.Louis (a synchresis, perhaps).

    Given that the integration of societies by "markets" represents the blink of an eye in evolutionary time (even for humans) one might consider that perhaps what makes Missourians different from hunter- gatherers is that they come from a Christian tradition that predates market integration by a couple thousand years (a tradition of Christian agape?).

    Linguists have long remarked that language is impossible without trust (how else can I believe that words mean what I am told they mean or how do I avoid starvation at birth unless I "trust" my mother? We are born trusting). Yet we get this facile rendering with regression equations of Adam Smith's argument stood completely on its head. For Smith markets were a possibility only within a society that was already integrated (in Smith's case by the kirk's dispositon of a stern Calvanist morality).

    Mike Royko (the columnist for the Chicago Tribune) once opined that he had finally figured out economic theory, to wit, "Economics says that almost anything can happen, and it usually does." The end of history? I bet not.

     


    May 17, 2006 message from Peter Walton

    I would like to take this opportunity to let you know about a forthcoming book from Routledge:

    The Routledge Companion to Fair Value and Financial Reporting --- Click Here

    Edited by Peter Walton

    May 2007: 246x174: 406pp

    Hb: 978-0-415-42356-4: £95.00 $170.00

    Jensen Comment
    Even though I have a paper published in this book, I will receive no compensation from sales of the book. And since I'm retired, lines on a resume no longer matter.


    FASB Statement No. 107
    Disclosures about Fair Value of Financial Instruments
    (Issue Date 12/91)
    [Full Text] [Summary] [Status]

    This Statement extends existing fair value disclosure practices for some instruments by requiring all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the statement of financial position, for which it is practicable to estimate fair value. If estimating fair value is not practicable, this Statement requires disclosure of descriptive information pertinent to estimating the value of a financial instrument. Disclosures about fair value are not required for certain financial instruments listed in paragraph 8.

    This Statement is effective for financial statements issued for fiscal years ending after December 15, 1992, except for entities with less than $150 million in total assets in the current statement of financial position. For those entities, the effective date is for fiscal years ending after December 15, 1995.

    FASB Statement No. 115
    Accounting for Certain Investments in Debt and Equity Securities
    (Issue Date 5/93)
    [Full Text] [Summary] [Status]

    This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows:

    Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

    Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

    Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

    This Statement does not apply to unsecuritized loans. However, after mortgage loans are converted to mortgage-backed securities, they are subject to its provisions. This Statement supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities, and related Interpretations and amends FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, to eliminate mortgage-backed securities from its scope.

    This Statement is effective for fiscal years beginning after December 15, 1993. It is to be initially applied as of the beginning of an enterprise's fiscal year and cannot be applied retroactively to prior years' financial statements. However, an enterprise may elect to initially apply this Statement as of the end of an earlier fiscal year for which annual financial statements have not previously been issued.

    FASB Statement No. 130
    Reporting Comprehensive Income

    (Issue Date 6/97)
    [Full Text] [Summary] [Status]

    This Statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. This Statement does not require a specific format for that financial statement but requires that an enterprise display an amount representing total comprehensive income for the period in that financial statement.

    This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

    This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required.

     

    FASB Statement No. 133 and Amendments in FAS 137, 138, 149, and 155
    Accounting for Derivative Instruments and Hedging Activities
    (Issue Date 6/98)
    [Full Text] [Summary] [Status]

    This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.

    For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value. For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

    This Statement applies to all entities. A not-for-profit organization should recognize the change in fair value of all derivatives as a change in net assets in the period of change. In a fair value hedge, the changes in the fair value of the hedged item attributable to the risk being hedged also are recognized. However, because of the format of their statement of financial performance, not-for-profit organizations are not permitted special hedge accounting for derivatives used to hedge forecasted transactions. This Statement does not address how a not-for-profit organization should determine the components of an operating measure if one is presented.

    This Statement precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation.

    This Statement amends FASB Statement No. 52, Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. It supersedes FASB Statements No. 80, Accounting for Futures Contracts, No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. It amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to include in Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105. This Statement also nullifies or modifies the consensuses reached in a number of issues addressed by the Emerging Issues Task Force.

    This Statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application of this Statement should be as of the beginning of an entity's fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of this Statement. Earlier application of all of the provisions of this Statement is encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after issuance of this Statement. This Statement should not be applied retroactively to financial statements of prior periods.


    Question
    How should you account for this one?
    Fair value accounting under FAS 141?   Yeah right!

    From The Wall Street Journal Accounting Weekly Review, January 18, 2008

    Behind Bank of America's Big Gamble
    by Valerie Bauerlein and James R. Hagerty
    The Wall Street Journal

    Jan 12, 2008
    Page: A1
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB120005404048583617.html?mod=djem_jiewr_ac
     

    TOPICS: Advanced Financial Accounting, Banking, Mergers and Acquisitions

    SUMMARY: The article describes the process of due diligence used by Bank of America and its ultimate reasoning in deciding to offer to acquire Countrywide Funding. "Terms of the deal call for Bank of America, the largest U.S. bank by market value, to give 0.1822 shares of Bank of America for each share of Countrywide. The deal could be renegotiated if Countrywide experiences a material change that adversely affects its business, but Mr. [Kenneth D.] Lewis [CEO of Bank America] said he does not anticipate that happening....Bank of America is buying a deeply troubled company, and it faces the risk that Countrywide's assets could continue deteriorating. As of Sept. 30, Countrywide's savings bank held about $79.5 billion of loans as investments. Three-quarters of those loans were second-lien home-equity loans...or option adjustable-rate mortgages....Overdue payments by Countrywide borrowers are surging....

    CLASSROOM APPLICATION: Introducing the acquisition process in business combinations, and the business combination as a solution to the problem of a struggling bank, is the best use of this article, though other topics such as the SEC's interest in Countrywide's loan loss reserves also are discussed.

    QUESTIONS: 
    1.) What is "due diligence"? How long did it take Bank of America to complete its due diligence prior to making an offer to Countrywide Financial Corp.?

    2.) How would Bank of America's analysts model how its portfolio of loans is likely to perform in the future? Describe the components of these models.

    3.) How do you think the results of analysts' modeling impact the negotiations between Bank of America and Countrywide? How do you think they impact the accounting for the transaction when it is completed later this spring?

    4.) How does fact that Countrywide has a book value of approximately $12 billion, triple the $4 billion price to Bank of America, provide a "cushion for potential damages, settlements and other litigation costs involving mortgages that went bad"?

    5.) Why is the SEC concerned with whether Countrywide has "...set aside enough reserves to cover potential losses on the loans on its books"? In your answer, define the term "reserves" as it is used in this quote and give other words preferred by accountants for this item.

    6.) What are the terms of the offer made by Bank of America? In your answer, be sure to address the issue of a contingency in the offer.

    7.) If the contingency described in the article were to come to pass, what would be its impact on the accounting for the business combination?

    8.) What other factors besides the performance of Countrywide's current loan portfolio are likely to impact the success of the acquisition and the mortgage lending operations in the future?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    No 'Fun': Bank of America Pulls Back
    by Valerie Bauerlein
    Jan 16, 2008
    Page: C3

     

    Tom Selling in his Accounting Onion Blog has a really nice piece on January 24, 2008 entitled "Peeling the Onion on the New Business Combination Standards: FAS 141R and FAS 160" ---

    This post examines the onion skin, if you will, of the new business combination standards. I'm going to explain the differences between the so-called 'purchase' method of accounting and the new 'acquisition' method. As is my habit, let's begin with a simple example.

    Assume that ParentCo acquires 70% of the outstanding shares of SubCo for $1,000. Additional facts are as follows:

    ParentCo estimates that the fair value of 100% of SubCo is $1,405: You should note that the fair value of SubCo may not ordinarily be calculated by extrapolating the purchase price paid to the remaining shares outstanding (i.e., $1,000/70% = $1,429 is not ordinarily the fair value). The reason is that a portion of the purchase price contains a payment for the ability to exercise control. In this case, the control premium would be $55, calculated as follows: ($1000 - .7($1405))/(1-.7) = $55

    It may be difficult to estimate the control premium, because it may have to be derived from an estimate of the full fair value of the acquired company, as above. But the new requirement to do so has not been controversial. That's because the larger the control premium, the lower will be goodwill. The book value of SubCo's assets and liabilities approximate their book value, except for one asset with a remaining useful life of 10 years. For that asset, the fair value exceeds the book value by $100.

    Tom then launches into a great analysis of this illustration.

    Bob Jensen's threads on intangibles and contingency issues on accountancy are at http://faculty.trinity.edu/rjensen/Theory01.htm#TheoryDisputes

    Bob Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

     

     


    FASB Statement No. 142
    Goodwill and Other Intangible Assets
    (Issue Date 6/01)
    [Full Text] [Summary] [Status]

    This Statement changes the subsequent accounting for goodwill and other intangible assets in the following significant respects:

    • Acquiring entities usually integrate acquired entities into their operations, and thus the acquirers' expectations of benefits from the resulting synergies usually are reflected in the premium that they pay to acquire those entities. However, the transaction-based approach to accounting for goodwill under Opinion 17 treated the acquired entity as if it remained a stand-alone entity rather than being integrated with the acquiring entity; as a result, the portion of the premium related to expected synergies (goodwill) was not accounted for appropriately. This Statement adopts a more aggregate view of goodwill and bases the accounting for goodwill on the units of the combined entity into which an acquired entity is integrated (those units are referred to as reporting units).

     

    • Opinion 17 presumed that goodwill and all other intangible assets were wasting assets (that is, finite lived), and thus the amounts assigned to them should be amortized in determining net income; Opinion 17 also mandated an arbitrary ceiling of 40 years for that amortization. This Statement does not presume that those assets are wasting assets. Instead, goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling.

     

    • Previous standards provided little guidance about how to determine and measure goodwill impairment; as a result, the accounting for goodwill impairments was not consistent and not comparable and yielded information of questionable usefulness. This Statement provides specific guidance for testing goodwill for impairment. Goodwill will be tested for impairment at least annually using a two-step process that begins with an estimation of the fair value of a reporting unit. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. However, if certain criteria are met, the requirement to test goodwill for impairment annually can be satisfied without a remeasurement of the fair value of a reporting unit.

     

    • In addition, this Statement provides specific guidance on testing intangible assets that will not be amortized for impairment and thus removes those intangible assets from the scope of other impairment guidance. Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair values of those assets with their recorded amounts.

     

    • This Statement requires disclosure of information about goodwill and other intangible assets in the years subsequent to their acquisition that was not previously required. Required disclosures include information about the changes in the carrying amount of goodwill from period to period (in the aggregate and by reportable segment), the carrying amount of intangible assets by major intangible asset class for those assets subject to amortization and for those not subject to amortization, and the estimated intangible asset amortization expense for the next five years.

     

    FASB Statement No. 155
    Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140
    (Issue Date 02/06)
    [Full Text] [Summary] [Status]
     

    This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.”

    This Statement:

    Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation

    Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133

    Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation

    Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives

    Amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

    Reasons for Issuing This Statement

    In January 2004, the Board added this project to its agenda to address what had been characterized as a temporary exemption from the application of the bifurcation requirements of Statement 133 to beneficial interests in securitized financial assets.

    Prior to the effective date of Statement 133, the FASB received inquiries on the application of the exception in paragraph 14 of Statement 133 to beneficial interests in securitized financial assets. In response to the inquiries, Implementation Issue D1 indicated that, pending issuance of further guidance, entities may continue to apply the guidance related to accounting for beneficial interests in paragraphs 14 and 362 of Statement 140. Those paragraphs indicate that any security that can be contractually prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment should be subsequently measured like investments in debt securities classified as available-for-sale or trading under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and may not be classified as held-to-maturity. Further, Implementation Issue D1 indicated that holders of beneficial interests in securitized financial assets that are not subject to paragraphs 14 and 362 of Statement 140 are not required to apply Statement 133 to those beneficial interests until further guidance is issued.

    How the Changes in This Statement Improve Financial Reporting

    This Statement improves financial reporting by eliminating the exemption from applying Statement 133 to interests in securitized financial assets so that similar instruments are accounted for similarly regardless of the form of the instruments. This Statement also improves financial reporting by allowing a preparer to elect fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. Providing a fair value measurement election also results in more financial instruments being measured at what the Board regards as the most relevant attribute for financial instruments, fair value.

    Effective Date and Transition

    This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of this Statement may also be applied upon adoption of this Statement for hybrid financial instruments that had been bifurcated under paragraph 12 of Statement 133 prior to the adoption of this Statement. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Provisions of this Statement may be applied to instruments that an entity holds at the date of adoption on an instrument-by-instrument basis.

    At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative-effect adjustment to beginning retained earnings. The cumulative-effect adjustment should be disclosed gross (that is, aggregating gain positions separate from loss positions) determined on an instrument-by-instrument basis. Prior periods should not be restated.

     

    FASB Statement No. 157
    Fair Value Measurements
    (Issue Date 09/06)
    [Full Text] [Summary] [Status]
     

    This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

    Reason for Issuing This Statement

    Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.

    Differences between This Statement and Current Practice

    The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

    The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

    This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

    This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.

    This Statement clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset. A fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset. That guidance applies for stock with restrictions on sale that terminate within one year that is measured at fair value under FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.

    This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

    This Statement affirms the requirement of other FASB Statements that the fair value of a position in a financial instrument (including a block) that trades in an active market should be measured as the product of the quoted price for the individual instrument times the quantity held (within Level 1 of the fair value hierarchy). The quoted price should not be adjusted because of the size of the position relative to trading volume (blockage factor). This Statement extends that requirement to broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.

    This Statement expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. The disclosures focus on the inputs used to measure fair value and for recurring fair value measurements using significant unobservable inputs (within Level 3 of the fair value hierarchy), the effect of the measurements on earnings (or changes in net assets) for the period. This Statement encourages entities to combine the fair value information disclosed under this Statement with the fair value information disclosed under other accounting pronouncements, including FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, where practicable.

    The guidance in this Statement applies for derivatives and other financial instruments measured at fair value under Statement 133 at initial recognition and in all subsequent periods. Therefore, this Statement nullifies the guidance in footnote 3 of EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” This Statement also amends Statement 133 to remove the similar guidance to that in Issue 02-3, which was added by FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments.

    How the Conclusions in This Statement Relate to the FASB’s Conceptual Framework

    The framework for measuring fair value considers the concepts in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. Concepts Statement 2 emphasizes that providing comparable information enables users of financial statements to identify similarities in and differences between two sets of economic events.

    The definition of fair value considers the concepts relating to assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements, in the context of market participants. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits).

    This Statement incorporates aspects of the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, as clarified and/or reconsidered in this Statement. This Statement does not revise Concepts Statement 7. The Board will consider the need to revise Concepts Statement 7 in its conceptual framework project.

    The expanded disclosures about the use of fair value to measure assets and liabilities should provide users of financial statements (present and potential investors, creditors, and others) with information that is useful in making investment, credit, and similar decisions—the first objective of financial reporting in FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises.

     

    FASB Statement No. 159
    The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115

    (Issue Date 02/07)
    [Full Text] [Summary] [Status]
     

     

    Why Is the FASB Issuing This Statement?

    This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the Board’s long-term measurement objectives for accounting for financial instruments.

    What Is the Scope of This Statement—Which Entities Does It Apply to and What Does It Affect?

    This Statement applies to all entities, including not-for-profit organizations. Most of the provisions of this Statement apply only to entities that elect the fair value option. However, the amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities. Some requirements apply differently to entities that do not report net income.

    The following are eligible items for the measurement option established by this Statement:

    Recognized financial assets and financial liabilities except:

    An investment in a subsidiary that the entity is required to consolidate

    An interest in a variable interest entity that the entity is required to consolidate

    Employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements, as defined in FASB Statements No. 35, Accounting and Reporting by Defined Benefit Pension Plans, No. 87, Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, No. 112, Employers’ Accounting for Postemployment Benefits, No. 123 (revised December 2004), Share-Based Payment, No. 43, Accounting for Compensated Absences, No. 146, Accounting for Costs Associated with Exit or Disposal Activities, and No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, and APB Opinion No. 12, Omnibus Opinion—1967

    Financial assets and financial liabilities recognized under leases as defined in FASB Statement No. 13, Accounting for Leases (This exception does not apply to a guarantee of a third-party lease obligation or a contingent obligation arising from a cancelled lease.)

    Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions

    Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including “temporary equity”). An example is a convertible debt security with a noncontingent beneficial conversion feature.

    Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments

    Nonfinancial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods or services

    Host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument.

    How Will This Statement Change Current Accounting Practices?

    The fair value option established by this Statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings (or another performance indicator if the business entity does not report earnings) at each subsequent reporting date. A not-for-profit organization shall report unrealized gains and losses in its statement of activities or similar statement.

    The fair value option:

    May be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method

    Is irrevocable (unless a new election date occurs)

    Is applied only to entire instruments and not to portions of instruments.

    How Does This Statement Contribute to International Convergence?

    The fair value option in this Statement is similar, but not identical, to the fair value option in IAS 39, Financial Instruments: Recognition and Measurement. The international fair value option is subject to certain qualifying criteria not included in this standard, and it applies to a slightly different set of instruments.

    What Is the Effective Date of This Statement?

    This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, Fair Value Measurements.

    No entity is permitted to apply this Statement retrospectively to fiscal years preceding the effective date unless the entity chooses early adoption. The choice to adopt early should be made after issuance of this Statement but within 120 days of the beginning of the fiscal year of adoption, provided the entity has not yet issued financial statements, including required notes to those financial statements, for any interim period of the fiscal year of adoption.

    This Statement permits application to eligible items existing at the effective date (or early adoption date).

     

    Many other U.S. and International Standards directly or indirectly impact on fair value accounting! In particular international IAS 32 and IAS 39 require fair value accounting in many circumstances.

     


    Introduction to Valuation

    Damodaran Online: A Great Sharing Site from a Finance Professor at New York University and Textbook Writer --- http://pages.stern.nyu.edu/%7Eadamodar/

    This site has great sections on corporate finance, investments, valuation, spreadsheets, research, etc. For example, take a look at the helpers on valuation --- http://pages.stern.nyu.edu/%7Eadamodar/

    You can pick the valuation approach that you would like to go to, to see illustrations, solutions and other supporting material.

       
      Discounted Cashflow Valuation
      Relative Valuation
      Option Pricing Approaches to Valuation
      Acquisition Valuation
      EVA, CFROI and other Value Enhancement Strategies

     

    Or you can pick the material that you are interested in.

           
    Spreadsheets Overheads Datasets References
    Problems & Solutions Derivations and Discussion Valuation Examples PowerPoint presentations

    Jim Mahar's finance sharing site (especially note his great blog link) --- http://financeprofessor.com/

    Financial Rounds from an anonymous finance professor --- http://financialrounds.blogspot.com/

    Bob Jensen's threads on valuation are at http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on fair value controversies in accounting are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    Bob Jensen's finance and investment helpers are at http://faculty.trinity.edu/rjensen/Bookbob1.htm


    From The Wall Street Journal Accounting Weekly Review on September 22, 2006

    TITLE: FASB to Issue Retooled Rule for Valuing Corporate Assets
    REPORTER: David Reilly
    DATE: Sep 15, 2006
    PAGE: C3
    LINK: http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac 
    TOPICS: Accounting, Advanced Financial Accounting, Fair Value Accounting

    SUMMARY: On 9/15/2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements. The standard "...provides enhanced guidance for using fair value to measure assets and liabilities. The standard also responds to investors' requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings." (Source: FASB News Release available on their web site at http://www.fasb.org/news/nr091506.shtml) This new standard must be used as guidance whenever reporting entities use fair value to measure value assets and liabilities as a required or acceptable method of applying GAAP.

    QUESTIONS:
    1.) What is the purpose of issuing Statement of Financial Accounting Standards No. 157? In your answer, describe how this standard should help to alleviate discrepancies in practice. To help answer this question, you may access the FASB's own news release about the standard, available at http://www.fasb.org/news/nr091506.shtml or the new standard itself, available on the FASB's web site.

    2.) From your own knowledge, cite an example in which fair value is used to measure an asset or liability in corporate balance sheets. Why is fair value an appropriate measure for including these assets and liabilities in corporate balance sheets?

    3.) What is the major difficulty with using fair values for financial reporting that is cited in the article?

    4.) Define the term "historical cost." Name two flaws with the use of historical costs, one cited in the article and one based on your own knowledge. Be sure to explain the flaw clearly.

    5.) How does this standard help to alleviate the issue described in answer to question 3? Again, you may access the FASB's web site, and the news release in particle, to answer this question.

    6.) The article closes with a statement that "The FASB hopes to counter some of [the issues cited in the article] by expanding disclosures required for all balance sheet items measure at fair value..." What could be the possible problem with that requirement?

    Reviewed By: Judy Beckman, University of Rhode Island

    "FASB to Issue Retooled Rule For Valuing Corporate Assets New Method Repeals Limits Spurred by Enron Scandal; Critics Worry About Abuses," by David Reilly,  The Wall Street Journal, September 15, 2006; Page C3 --- http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac

    Accounting rule makers have wrapped up an overhaul of a tricky but important method of valuing corporate assets, despite some critics' warning that the change could reopen the door to abuses like those seen at Enron Corp.

    The overhaul, contained in an accounting standard that could be issued as early as today, will repeal a ban put in place after Enron collapsed into bankruptcy court in late 2001 amid an array of accounting irregularities. The ban prohibited companies immediately booking gains or losses from complex financial instruments whose real value may not be known for years.

    The Financial Accounting Standards Board's new rule will require companies to base "fair" values for certain items on what they would fetch from a sale in an open market to a third party. In the past, firms often would use internal models to determine the value of instruments that didn't have a readily available price.

    FASB prohibited that practice after Enron used overly optimistic models to value multiyear power contracts in a bid to pad earnings. The ban was meant to give the board time to come up with a new approach to determining fair values.

    The accounting rule makers say the new standard will give companies, auditors and investors much needed, and more nuanced, guidance on how to measure market values. Companies will have to think, "it's not my own estimate of what something is worth to me, but what the market would demand for this," said Leslie Seidman, an FASB member. While clarifying how to come up with appropriate values for some instruments, the new standard doesn't expand the use of what is known as fair-value accounting.

    Critics say the new rule reopens the door to manipulation and possibly fraud by unscrupulous managers. Requiring market values for instruments where there isn't a ready price in a market can be "a license for management to invent the financial statements to be whatever they want them to be," Damon Silvers, associate general counsel for the AFL-CIO, said at a meeting of an FASB advisory group this spring.

    Jousting over the standard reflects a deep rift within accounting circles. For decades, accounting values were mostly based on historical cost, or what a company paid for a particular asset. In recent years, accounting rules have moved toward the use of market values, known as fair-value accounting. In some ways this reflects the shift in the U.S. from a manufacturing to a service economy, where intangible assets are more important than the plant and equipment that previously defined a company's financial strength.

    Starting in the mid-1980s, companies also began using ever-more-complicated financial instruments such as futures, options and swaps to manage interest-rate, currency and other risks. Such contracts often can't be measured based on their cost. This spurred the use of market values, thought to be more realistic. But these values can be tough to determine because many complex financial instruments are tailor-made and don't trade on open markets in the same way as stocks.

    Of course, valuations based on historical cost also have flaws. The savings-and-loan crisis of the late 1980s, for example, was prompted in part by thrifts carrying loans on their balance sheets at historical cost, even though the loans had plummeted in value.

    Robert Herz, the FASB's chairman, acknowledges the difficulty in coming up with a market, or fair, value for many instruments. In discussions, he often asks how a company could reasonably be expected to come up with a fair value for a 30-year swap agreement on the Thai currency, the baht, which is a bet on the future value of that currency against another.

    The answer, according to Mr. Herz and the FASB, is to base the value on what a willing third-party would pay in the market and possibly include a discount to reflect the uncertainty inherent in the approach.

    In an interview earlier this year, Mr. Herz said this valuation approach would reduce the likelihood of a recurrence of problems such as those seen at Enron. "The problem wasn't that Enron was using fair values, it was that they were using 'unfair' values," he said.

    Still, "the bottom line is that fair-value accounting is a great thing so long as you have market values," said J. Edward Ketz, an associate accounting professor at Pennsylvania State University, who is working on a book about the FASB's new standard. "If you don't, you get into some messy areas."

    The FASB hopes to counter some of these issues by expanding disclosures required for all balance-sheet items measured at fair value, the board's Ms. Seidman said.

    October 15, 2006 reply from Bob Jensen

    The original 157 Exposure Draft proposed a Fair Value Option (FVO) that would have allowed carrying of virtually any financial asset or liability at fair value rather than just limiting fair value accounting to selected items that are now required to be carried at fair value rather than historical cost. Business firms, and especially banks, generally are against fair value accounting (due to reporting instabilities that arise from fair value adjustments prior to contract settlements). The FASB backed off of the FVO when it issued FAS 157, thereby relegating FAS 157 to a standard that clarifies definitions of fair value in various circumstances. Hence FAS 157 is largely semantic and does not change the present fair value accounting rules.

    I asked Paul Pacter (at Deloitte in Hong Kong where he's still very active in helping to set IFRS and FASB standards) for an update on the FVO Project (commenced in 2004) that failed to impact the new FAS 157 standard. His reply is below.

    October 31 reply from Paul Pacter (CN - Hong Kong) [paupacter@deloitte.com.hk]

    Hi Bob,

    Yes, FASB's FV Option (FVO) t is very much active -- an ED on phase 1 was issued in January, and a final FAS is expected before year end.

    Thus phase 2 would go beyond IFRSs, though several IFRSs have FV options for individual types of assets. IAS 16 and IAS 38 allow it for PP&E and intangibles -- though the credit is to surplus, not P&L, no recycling, subsequent depreciation of revalued amounts. IAS 40 gives a FV option for investment property -- FV through P&L. IAS 41 isn't an option, it's a requirement for FV through P&L for agricultural assets.

    Phase 2 would commence in 2007.

    Re possible amendment to FAS 157, I don't think FASB plans to do that, though I suppose there might be some consequential amendment. But I don't think the FVO will change the definition of fair value that's in FAS 157.

    Here's FASB's web page: http://www.fasb.org/project/fv_option.shtml

    Warm regards,

    Paul

    Bob Jensen's threads on fair value accounting are at various other links:

    I recently completed the first draft of a paper on fair value at http://faculty.trinity.edu/rjensen/FairValueDraft.htm
    Comments would be helpful.

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    http://faculty.trinity.edu/rjensen/roi.htm

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

    Robert Walker's First Blog Entry is About Fair Value Accounting, October 27, 2006 --- http://www.robertbwalkerca.blogspot.com/

    Introduction
    I have decided to begin a commentary which expresses my views on accounting. As I begin to do this I envisage the source of my commentary to comprise three different sorts of writing in which I may engage:
    § Simple notes directly to the ‘blog’ such as this.
    § Formal submissions I may make to various bodies including the IASB.
    § Letters or reports I may write for one reason or another that I think might have some general readership.

    The expression of my views will stray from the subject matter of accounting per se to deal with matters of enormous significance to me such as corporate or public administration. Such expressions will not be too substantial a digression from the core subject matter because I believe that the foundation of good ‘corporate governance’, to use a vogue term, is accounting.

    Source of my ideas on accounting
    I would have to confess that the foundation upon which I base my philosophy of accounting is derivative, as much of human knowledge is of course. It is not for nothing that Newtown said that if he can see so far it is because he stands on the shoulders of giants. In my case, that ‘giant’ is Yuiji Ijiri. As I begin a detailed exposition of my views I shall return to the lessons I learned many years ago from Theory of Accounting Measurement, a neglected work that will still be read in 1,000 years or so long as humankind survives whichever is the shorter. As the depredations of the standard setting craze are visited upon us with ever increasing complexity, the message delivered by Ijiri will be heeded more an more.

    The basic structure of accounting
    Without wishing to be too philosophical about it, I need to begin by outlining what I mean by accounting. Accounting, in my mind, comprises three inter-related parts. These are:
    § Book-keeping.
    § Accounting.
    § Financial reporting.

    Book-keeping is the process of recording financial data elements in the underlying books of account. These financial data elements represent, or purport to represent, real world events. The heart of book-keeping is the double entry process. For instance at the most basic level a movement in cash will result in the surrender or receipt of an asset, the incurring or settlement of a liability and so on.

    I have no complete and coherent theory of the limits of book-keeping. Clearly cash movement (change of ownership) or the movement of commodity is the proper subject matter of book-keeping. Whether all forms of contract should be similarly treated is not clear to me. I am inclined to say yes. That is to adopt Ijiri’s theory of commitment accounting, but I can foresee that this leads me to conclusions that I may find unpalatable later on. Incidentally I say this because an epiphany I had, based on the notion of commitment accounting, some years ago is beginning to unravel.

    Book-keeping goes beyond recording to encompass control. That is the process by which the integrity of the centre piece of book-keeping – the general ledger expressing double entry – is ensured. I will not concern myself with such processes though this is not to say that they are unimportant.

    Accounting is the process by which sense is made of what is a raw record expressed in the general ledger. It is the process of distillation and summation that enables the accountant to gain on overview of what has happened to the entity the subject of the accounting. Accounting fundamentally assumes that the accountant is periodically capable of saying something useful about the real world using his or her special form of notation.

    Financial reporting is the process by which data is assembled into a comprehensive view of the world in accordance with a body of rules. It differs, in the ideal, from accounting in a number of ways. Most benignly it differs, for instance, by including ancillary information for the benefit of a reader beyond the mere abstraction from the general ledger. Again in the ideal there is an inter-relationship between the three levels in the accounting hierarchy. That is, the rules of financial reporting will, to some degree shape the order and format of the basic, book-keeping level so that the process of distillation and summation follows naturally to the final level of reporting without dramatic alteration.

    Perhaps what concerns me is that the sentiment expressed above can be seen, without much effort, to be only ideal and that in reality it does not arise. In short the golden strand that links the detailed recording of real world phenonmena to its final summation is broken.

    An example
    I was asked recently by a student of accounting to explain IAS 41, the IASB standard on agriculture. As I don’t deal in primary production at all, I had not thought about this subject for years.

    IAS 41 admonishes the accountant to apply ‘fair value’ accounting. Fair value accounting is the process by which current sale prices, or their proxies, are substituted for the past cost of any given item.

    For instance, you may have a mature vineyard. The vineyard comprises land, the vine and its fruit, the plant necessary to sustain the vine (support structures, irrigation channels etc.). Subsumed within the vine are the materials necessary for it to grow and start producing fruit. This will include the immature plant, the chemical supplements necessary to nurture and protect it, and the labour necessary to apply it.

    The book-keeping process will faithfully record all of these components. Suppose for example the plant, fertliser and labour cost $1000. In the books will be recorded:

    Dr Vineyard $1000
    Cr Cash $1000

    At the end of the accounting period, the accountant will summarise this is a balance statement. He or she will then obtain, in some way, the current selling price of the vine. Presumably this will be the future cash stream of selling the fruit, suitably discounted. Assume that this is $1200.

    The accountant will then make the following incremental adjustment:

    Dr Vineyard $200
    Cr Equity $200

    Looked like this there is a connection between the original book-keeping and the periodic adjustment at the end of the accounting period. This is an illusion. The incremental entry disguises what is really happening. It is as follows:

    Dr Equity $1000
    Cr Vineyard $1000

    And

    Dr Vineyard $1200
    Cr Equity $1200

    Considered from the long perspective, the original book-keeping has been discarded and a substitute value put in its place. This is the truth of the matter. The subject matter of the first phase of accounting was a set of events arising in a bank and in the entity undertaking accounting. The subject matter of the second phase is a set of future sales to a party who does not yet exist.

    From a perspective of solvency determination, a vital element of corporate governance, the view produced by the first phase is next to useless. However, the disquiet I had in my mind which I had suppressed until recently, relates to the shattering of the linkages between the three levels of accounting in the final reporting process. This disquiet has returned as I contemplate the apparently unstoppable momentum of the standard setting process.

    October 28, 2006 reply from Bob Jensen

    Hi Robert,

    I hope you add many more entries to your blog.

    The problem with "original book-keeping" is that it provides no answer how to account for risk of many modern day contracts that were not imagined when "original book-keeping" evolved in a simple world of transactions. For example, historical costs of forward contracts and swaps are zero and yet these contracts may have risks that may outweigh all the recorded debt under "original book-keeping." Once we opened the door to fair value accounting to better account for risk, however, we opened the door to misleading the public that booked fair value adjustments can be aggregated much like we sum the current balances of assets and liabilities on the balance sheet. Such aggregations are generally nonsense.

    I don't know if you saw my recent hockey analogy or not. It goes as follows:

    Goal Tenders versus Movers and Shakers
    Skate to where the puck is going, not to where it is.

    Wayne Gretsky (as quoted for many years by Jerry Trites at http://www.zorba.ca/ )

    Jensen Comment
    This may be true for most hockey players and other movers and shakers, but for goal tenders the eyes should be focused on where the puck is at every moment ---  not where it's going. The question is whether an accountant is a goal tender (stewardship responsibilities) or a mover and shaker (part of the managerial decision making team). This is also the essence of the debate of historical accounting versus pro forma accounting.

    Graduate student Derek Panchuk and professor Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed the most comprehensive, on-ice hockey study to determine where elite goalies focus their eyes in order to make a save. Simply put, they found that goalies should keep their eyes on the puck. In an article to be published in the journal Human Movement Science, Panchuk and Vickers discovered that the best goaltenders rest their gaze directly on the puck and shooter's stick almost a full second before the shot is released. When they do that they make the save over 75 per cent of the time.
    "Keep your eyes on the puck," PhysOrg, October 26, 2006 --- http://physorg.com/news81068530.html

    I have written a more serious piece about both theoretical and practical problems of fair value accounting. I should emphasize that this was written after the FASB Exposure Draft proposing fair value accounting as an option for all financial instruments and the culminating FAS 157 that is mainly definitional and removed the option to apply fair value accounting to all financial instruments even though it is still required in many instances by earlier FASB standards.

    My thoughts on this are at the following two links:

    http://faculty.trinity.edu/rjensen/FairValueDraft.htm

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    Bob Jensen

    October 30, 2006 reply from Robert B Walker [walkerrb@ACTRIX.CO.NZ]

    Bob

    Thanks for the support. I have answered you in my second installment ( www.robertbwalkerca.blogspot.com ).

    I shall continue to write if for no other reason than for myself. I have had it in mind to write a book. I shall begin doing so this way.

    Robert

    October 30, 2006 reply from Bob Jensen

    I have difficulty envisioning forward contracts as “executory contracts.” These appear to be to be executed contracts that are terminated when the cash finally flows.

    Fair value appears to be the only way to book forward contracts if they are to be booked at all, although fair value on the date they are signed is usually zero.

    Once you are in the fair value realm, you have all the aggregation problems, blockage problems, etc. that are mentioned at http://faculty.trinity.edu/rjensen/FairValueDraft.htm 

    I guess what I’d especially like you to address is the problem of aggregation in a balance sheet or income statement based upon heterogeneous measurements.

    Bob Jensen

    Bob Jensen's threads on fair value accounting are at various other links:

    I recently completed the first draft of a paper on fair value at http://faculty.trinity.edu/rjensen/FairValueDraft.htm
    Comments would be helpful.

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    http://faculty.trinity.edu/rjensen/roi.htm

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

    http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

    http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm


    Fair value is the estimated best disposal (exit, liquidation) value in any sale other than a forced sale.  It is defined as follows in Paragraph 540 on Page 243 of FAS 133:

    The amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option- pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.  Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring forward contracts, such as foreign currency forward contracts, at fair value by discounting estimated future cash flows, an entity should base the estimate of future cash flows on the changes in the forward rate (rather than the spot rate). In measuring financial liabilities and nonfinancial derivatives that are liabilities at fair value by discounting estimated future cash flows (or equivalent outflows of other assets), an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

    This is old news, but it does provide some questions for students to ponder.  The main problem of fair value adjustment is that many ((most?) of the adjustments cause enormous fluctuations in earnings, assets, and liabilities that are washed out over time and never realized.  The main advantage is that interim impacts that “might be” realized are booked.  It’s a war between “might be” versus “might never.”  The war has been waging for over a century with respect to booked assets and two decades with respect to unbooked derivative instruments, contingencies, and intangibles.

    CFA analysts' group favors full fair value reporting
    The CFA Centre for Financial Market Integrity – a part of the CFA Institute – has published a new financial reporting model that, they believe, would greatly enhance the ability of financial analysts and investors to evaluate companies in making investment decisions. The Comprehensive Business Reporting Model proposes 12 principles to ensure that financial statements are relevant, clear, accurate, understandable, and comprehensive (See below).
    "Analysts' group favours full fair value reporting," IAS Plus, October 31, 2005 --- http://www.iasplus.com/index.htm

     

    CFA Institute Centre for Financial Market Integrity
    Comprehensive Business Reporting Model – Principles

    • 1. The company must be viewed from the perspective of a current investor in the company's common equity.
    • 2. Fair value information is the only information relevant for financial decision making.
    • 3. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone.
    • 4. All economic transactions and events should be completely and accurately recognized as they occur in the financial statements.
    • 5. Investors' wealth assessments must determine the materiality threshold.
    • 6. Financial reporting must be neutral.
    • 7. All changes in net assets must be recorded in a single financial statement, the Statement of Changes in Net Assets Available to Common Shareowners.
    • 8. The Statement of Changes in Net Assets Available to Common Shareowners should include timely recognition of all changes in fair values of assets and liabilities.
    • 9. The Cash Flow Statement provides information essential to the analysis of a company and should be prepared using the direct method only.
    • 10. Changes affecting each of the financial statements must be reported and explained on a disaggregated basis.
    • 11. Individual line items should be reported based upon the nature of the items rather than the function for which they are used.
    • 12. Disclosures must provide all the additional information investors require to understand the items recognized in the financial statements, their measurement properties, and risk exposures.

    Standards of Value: Theory and Applications
    Standards of Value covers the underlying assumption in many of the prominent standards of value, including Fair Market Value, investment value, and fair value. It discusses the specific purposes of the valuation, including divorce, shareholders' oppression, financial reporting, and how these standards are applied.
    Standards of Value: Theory and Applications, by Jay E. Fishman, Shannon P. Pratt, William J. Morrison Wiley:  ISBN: 0-471-69483-5 Hardcover 368 pages November 2006 US $95.00) --- http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471694835.html


    "Will Fair Value Fly? Fair-value accounting could change the very basis of corporate finance," by Ronald Fink, CFO Magazine September 01, 2006 --- http://www.cfo.com/article.cfm/7851757/c_7873404?f=magazine_featured

    Much has changed in financial reporting since Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and WorldCom, respectively, brought disgrace upon themselves, their employers, and, to a degree, their profession. Regulators and investors have pressed companies to be more open and forthcoming about their results — and companies have responded. According to a new CFO magazine survey, 82 percent of public-company finance executives disclose more information in their financial statements today then they did three years ago. But that positive finding won't quell calls for further accounting reform.

    The U.S. reporting system "faces a number of important and difficult challenges," Robert Herz, chairman of the Financial Accounting Standards Board, told the annual conference of the American Institute of Certified Public Accountants in Washington, D.C., last December. Chief among those, said Herz, is "the need to reduce complexity and improve the transparency and overall usefulness" of information reported to investors. ad

    Critics contend that generally accepted accounting principles (GAAP) remain seriously flawed, even as companies have beefed up internal controls to comply with the Sarbanes-Oxley Act. "We've done very little but play defense for the last five to six years," charges J. Michael Cook, chairman and CEO emeritus of Deloitte & Touche LLP. "It's time to play offense."

    Cook, a respected elder statesman in the accounting community, goes so far as to pronounce financial statements almost completely irrelevant to financial analysis as currently conducted. "The analyst community does workarounds based on numbers that have very little to do with the financial statements," says Cook. "Net income is a virtually useless number."

    How can financial statements become more relevant and useful? Many reformers, including Herz, believe that fair-value accounting must be part of the answer. In this approach, which FASB increasingly favors, assets and liabilities are marked to market rather than recorded on balance sheets at historical cost. Fair-value accounting, say its advocates, would give users of financial statements a far clearer picture of the economic state of a company.

    "I know what an asset is. I can see one, I can touch one, or I can see representations of one. I also know what liabilities are," says Thomas Linsmeier, a Michigan State University accounting professor who joined FASB in June. On the other hand, "I believe that revenues, expenses, gains, and losses are accounting constructs," he adds. "I can't say that I see a revenue going down the street. And so for me to have an accounting model that captures economic reality, I think the starting point has to be assets and liabilities."

    More than any other regulatory change, fair value promises to end the practice of earnings management. That's because a company's earnings would depend more on what happens on its balance sheet than on its income statement (see "The End of Earnings Management?" at the end of this article).

    But switching from historical cost would require enormous effort from overworked finance departments. Valuing assets in the absence of active markets could be overly subjective, making financial statements less reliable. Linsmeier's confidence notwithstanding, disputes could arise over the very definition of certain assets and liabilities. And using fair value could even distort a company's approach to deal-making and capital structure.

    A Familiar Concept Fair value is by no means unfamiliar to corporate-finance executives, as current accounting rules for such items as derivatives (FAS 133 and 155), securitizations (FAS 156), and employee stock option grants (FAS 123R) use it to varying degrees when recording assets and liabilities. So does a proposal issued last January for another rule, this one for accounting for all financial instruments. FASB's more recent proposals to include pensions and leases on balance sheets also embrace fair-value measurement (see "Be Careful What You Wish For" at the end of this article).

    While both Herz and Linsmeier are careful to note that they don't necessarily favor the application of fair value to assets and liabilities that lack a ready market, they clearly advocate its application where there's sufficient reason to believe the valuations are reliable. Corporate accounting, Herz says, is the only major reporting system that doesn't use fair value as its basis, and he points to the Federal Reserve's use of it in tracking the U.S. economy as sufficient reason for companies to adopt it.

    The corporate world, however, must grapple with its own complexities. For one, fair value could make it even more difficult to realize value from acquisitions. Take the question of contingent considerations, wherein the amount that acquirers pay for assets ultimately depends on their return. Under current GAAP, the balance-sheet value of assets that are transferred through such earnouts may reflect only the amount exchanged at the time the deal is completed, because the acquirer has considerable leeway in treating subsequent payments as expenses.

    Under fair value, the acquirer would also include on its balance sheet the present value of those contingent payments based on their likelihood of materializing. Since the money may never materialize, some finance executives contend those estimates could be unreliable and misleading. "I disagree with [this application of fair value] on principle," James Barge, senior vice president and controller for Time Warner, said during a conference on financial reporting last May. ad

    Barge cites the acquisition of intangible assets that a company does not intend to use as a further example of fair value's potentially worrisome effects. Under current GAAP, their value is included in goodwill and subject to annual impairment testing for possible write-off. But if, as FASB is contemplating, the value of those assets would be recorded on the balance sheet along with that of the associated tangible assets that were acquired, Barge worries that an immediate write-off would then be required — even though it would not reflect the acquiring company's economics.

    Fair value's defenders say such concerns are misplaced. The possibility that a contingent consideration won't materialize, for starters, is already reflected in an acquirer's bid, says Patricia McConnell, a Bear Stearns senior managing director who chairs the corporate-disclosure policy council of the CFA Institute, a group for financial analysts. "It's in the price," she says.

    As for intangibles that are acquired and then extinguished, the analyst says a write-off would not in fact be required under fair value if the transaction strengthens the acquirer's market position. That position would presumably be reflected in the value of the assets associated with those intangibles as recorded on the balance sheet under fair-value treatment.

    "It may be in buying a brand to gain monopolistic position that you don't have an expense," McConnell explains, "but rather you have the extinguishment of one asset and the creation of another." Yet McConnell, among others, admits that accounting for intangibles is an area that would need improvement even if FASB adopted fair value.

    Deceptive Debt? Another area of concern involves capital structure, with Barge suggesting that fair value may make it more difficult to finance growth with debt. He contends that marking a company's debt to market could make a company look more highly exposed to interest-rate risk than it really is, noting during the May conference that Time Warner's debt was totally hedged.

    Barge also cited as problematic the hypothetical case of a company whose creditworthiness is downgraded by the rating agencies. By marking down the debt's value on its balance sheet, the company would realize more income, a scenario Barge called "nonsensical." He warned of a host of such effects arising under fair value when a company changes its capital structure.

    Proponents find at least some of the complaints about fair value and corporate debt to be misplaced. Herz notes fair value would require the company to mark the hedge as well as the debt to market, so that if a company is hedging interest-rate risk effectively, its balance sheet should accurately reflect its lack of any exposure.

    What's more, fair value could also improve balance sheets in some cases. When, for instance, a company owns an interest in another whose results it need not consolidate, the equity holder's proportion of the other company's assets and liabilities is currently carried at historical cost. If, however, the other company's assets have gained value and were marked to market, the equity holder's own leverage might decrease.

    A real-life case in point: If the chemical company Valhi marked to market its 39 percent stake in Titanium Metals, Valhi's own ratio of long-term debt to equity would fall from 90 percent (at the end of 2005) to 56 percent, according to Jack T. Ciesielski, publisher of The Analyst's Accounting Observer newsletter. ad

    Still, even some fair-value proponents share Barge's concern about credit downgrades. As Ciesielski, a member of FASB's Emerging Issues Task Force, wrote last April in a report on the board's proposal for the use of fair value for financial instruments, it is "awfully counterintuitive" for a company to show rising earnings when its debt-repayment capacity is declining.

    Herz and other fair-value proponents disagree, noting that the income accrues to the benefit of the shareholders, not to bondholders. "It's not at all counterintuitive," asserts Rebecca McEnally, director for capital-markets policy of the CFA Institute Centre for Financial Market Integrity, citing the fact that the item is classified under GAAP as "income from forgiveness of indebtedness." But Ciesielski says investors are unlikely to understand that, and that fair value, in this case at least, may not produce useful results.

    Resolving the Issues Even some of FASB's critics agree, however, that the current system needs improvement, and that fair value can help provide it. "Fair value in general is more relevant than historical cost and can lead to reduced complexity and greater transparency," Barge admits, though he has noted that the use of fair value may also lead to "soft" results that "you can't audit."

    For much the same reason, Colleen Cunningham, president and CEO of Financial Executives International (FEI), expressed concern in testimony before Congress last March that "overly theoretical and complex standards can result in financial reporting of questionable accuracy and can create a significant cost burden, with little benefit to investors." In an interview, she explains that her biggest concern is that FASB is pushing ahead with fair-value-based rules without sufficient input from preparers. "Let's resolve the issues" before proceeding, she insists.

    Herz concedes that numerous issues surrounding fair value need to be addressed. But important users of financial statements are pressing him to move forward on fair value without delay. As a comment letter that the CFA Institute sent to FASB put it: "All financial decision-making should be based on fair value, the only relevant measurement for assets, liabilities, revenues, and expenses."

    Meanwhile, Herz isn't waiting for the conceptual framework to be completed before enacting new rules that embrace fair value. "In the end, we're not going to get everybody agreeing," Herz says. "So we have to make decisions" despite lingering disagreement.

    Ironically, one fair-value-based proposal that FASB issued recently may have created an artful means of defusing opposition. The Board's proposal for financial instruments gives preparers of financial reports the choice of using historical cost or fair value in recording the instruments on their balance sheets. That worries some people, who say giving companies a choice of methods will make it harder to compare their results, even when they're in the same industry.

    Continued in article


    Capital Structure --- http://en.wikipedia.org/wiki/Capital_Structure
    Modigliani-Miller theorem --- http://en.wikipedia.org/wiki/Modigliani-Miller_theorem

  • The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

  • Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

  • Miller was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

    Capital Structure plus M&M Theory --- http://en.wikipedia.org/wiki/Capital_Structure

    "Capital Structure Decisions Around the World:  Which Factors are Reliably Important? by Ozde Oztekin, University of Kansas, SSRN --- March 5, 2009 --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1464471

    Abstract:
    This paper examines which leverage factors are consistently important for capital structure decisions of firms around the world. The most reliable determinants are past leverage, tangibility, firm size, research and development, depreciation expenses, industry median leverage, and liquidity. The signs of the reliable determinants give consistent support to the dynamic trade off theory. The impact of leverage factors on capital structure are systematically driven by cross-country differences in the quality of institutions that affect bankruptcy costs, agency costs, tax benefits of debt, agency costs of equity, and information asymmetry costs.

    Bob Jensen's threads on debt versus equity --- http://faculty.trinity.edu/rjensen/theory01.htm#FAS150

    The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them. My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.
    Michael Milken, "Why Capital Structure Matters Companies that repurchased stock two years ago are in a world of hurt," The Wall Street Journal, April 21, 2009 --- http://online.wsj.com/article/SB124027187331937083.html

  • Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, "I'll never own a stock again!" Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.

  • If that all sounds familiar today, it's worth remembering that 1974 was also a turning point. With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

  • The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles.

  • This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity. These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.

  • The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them.

  • My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

  • Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's happening again.

  • Overleveraging in many industries -- especially airlines, aerospace and technology -- started in the late 1960s. As the perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply. But by using the capital markets to deleverage -- by paying off these securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt -- most companies avoided default and saved jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which it was retired.)

  • Issuing new equity can of course depress a stock's value in two ways: It increases the supply, thus lowering the price; and it "signals" that management thinks the stock price is high relative to its true value. Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

  • Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

  • The decision to increase or decrease leverage depends on market conditions and investors' receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late '80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.

  • In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years. As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance sheets. That has helped save jobs.

  • The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market's recent fall. These purchases peaked at more than $700 billion in 2007 near the market top -- and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world's largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

  • Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

  • The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality. The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of the time.

  • History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

  • It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.

  • Michael Milken is chairman of the Milken Institute.

     

    April 22, 2009 reply from David Albrecht [albrecht@PROFALBRECHT.COM]

    The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them. My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

    Bob, is the above passage your statement? If so, AECMers will no doubt be alarmed to hear that once again I agree with you. Oh, I don't agree to the extent that I've been teaching it 40 years (after all, you are older than I), but I have been teaching it for ten years or so.

    When I teach the right side of the balance sheet, as well as the non-operating part of the income statement), I run students through a review of capital structure. The right hand side of the balance sheet starts with current liabilities (20-30% of assets on average), then the remaining 70-80% is split between long-term liabilities and common equity. It is easy to see the industry risk effect on the relative composition of this large remainder. Companies that are inherently risky due to being built on easy to disappear intellectual property have very little in the way long-term liabilities. Examples are Internet/software companies like Google or Microsoft, and pharmaceuticals like Merck. Companies that are mostly riskless due to permanence of their assets can bear much in the way of long-term liabilities. I used to cite commercial banks as an example, because the legal system and federal guarantees protects some of the liabilities.

    I for one champion the move to value liabilities at fair value, as it can be a useful benchmark for analysts to judge the relative proportion of debt to equity in the capital structure.

    However, there is a lot of criticism of fair value applied to the right side of the balance sheet. I've received a handful of comments that oppose right-hand side fair valuation in severe downturns just like we have experienced. Because bank assets take a hit, the survivability of the bank is at question. This means that if a higher or riskier interest rate were applied to value right-hand side liabilities, there would be a gain that could swamp the losses from the asset side. There are some that don't like a company reporting a neutral income statement when the company is going down the tubes. Consequently, they call for scaling back the fair value rule to the asset side only.

    David Albrecht

     

    April 22, 2009 reply from Bob Jensen

    Hi David,

    That passage was written by Mike Milken, which is why I had it in italics and a different color.

    I don’t think Milken was thinking about accounting rules when he wrote this article. He probably was thinking more in terms of held-to-maturity debt under FAS 115 rules where HTM debt is not marked-to-market with changing capital structure levels that are actually hypothetical.

    The problem with fair value adjustments of long term debt is that these adjustments are poorly correlated with cash flows and can change capital structure in misleading ways for firms not intending to buy back debt. There are many reasons firms will not buy back debt even when there are gains to be realized from declines in interest rates. One of the big barriers is the transaction cost of buying back debt which makes it take a pretty large drop in interest rates to make buy-backs worthwhile.

    Another factor is that debt holders often will not sell unless forced to do so in call back clauses of debt contracts, but the call back penalties may be very high and add to the transactions costs. For this reason debt is commonly classified as HTM and not adjusted to fair value.

    Another reason firms do not commonly buy back debt is that FAS 125 ended the practice of in-substance defeasance for getting around call back fees and transactions costs for live debt that was being removed, before FAS 125, with defeasance accounting.

    In-substance defeasance used to be a ploy to take debt off the balance sheet. It was invented by Exxon in 1982 as a means of capturing the millions in a gain on debt (bonds) that had gone up significantly in value due to rising interest rates. The debt itself was permanently "parked" with an independent trustee as if it had been cancelled by risk free government bonds also placed with the trustee in a manner that the risk free assets would be sufficient to pay off the parked debt at maturity. The defeased (parked) $515 million in debt was taken off of Exxon's balance sheet and the $132 million gain of the debt was booked into current earnings --- http://www.bsu.edu/majb/resource/pdf/vol04num2.pdf 

    Defeasance was thus looked upon as an alternative to outright extinguishment of debt until the FASB passed FAS 125 that ended the ability of companies to use in-substance defeasance to remove debt from the balance sheet. Prior to FAS 125, defeasance became enormously popular as an OBSF ploy.

    The bottom line is that I think long-term debt should not be adjusted for fair value although fair value trends should be disclosed in footnotes.

    As with CAPM, the MM assumptions are unrealistic. However, much empirical evidence (of the accountics variety) points to evidence that the MM theory is relatively robust. However, this empirical support also makes limiting assumptions in testing models that test the MM theory. The MM theorem has been used over and over again in practice to justify adding leverage.

    Certainly the MM Theorem has not gone unchallenged. Probably the best known critic is Myron Gordon Gordon, Myron J. (1989). "Corporate Finance Under the MM Theorems". Financial Management 18 (2): 19–28

    I think most finance courses have tended to treat it the MM theorem as a given. The theorem has been expanded to include taxation.

    Yale’s finance/economics professor Robert Shiller has a video lecture on MM theory at http://www.youtube.com/watch?v=Wj1GnT8xlj4 

    Bob Jensen


    "Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8, 2006 ---
    http://www.iasplus.com/index.htm

    Deloitte & Touche (USA) has updated its book of guidance on FASB Statement No. 123(R) Share-Based Payment: A Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards (PDF 2220k). This second edition reflects all authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes over 60 new questions and answers, particularly in the areas of earnings per share, income tax accounting, and liability classification. Our interpretations incorporate the views in SEC Staff Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as subsequent clarifications of EITF Topic No. D-98 "Classification and Measurement of Redeemable Securities" (dealing with mezzanine equity treatment). The publication contains other resource materials, including a GAAP accounting and disclosure checklist. Note that while FAS 123 is similar to IFRS 2 Share-based Payment, there are some measurement differences that are Described Here.

    Bob Jensen's threads on employee stock options are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm


    Fair Value Accounting Book Review (Meeting the New FASB Requirements)

    From SmartPros on May 1, 2006
    Fair Value for Financial Reporting by Alfred King highlights the accounting and auditing requirements for fair value information and offers a detailed explanation of how the FASB is going to change "fair value," from determining the fair value of intangible assets to selecting and working with an appraiser --- http://accounting.smartpros.com/x35458.xml

    Fair Value for Financial Reporting: Meeting the New FASB Requirements
    by Alfred M. King
    ISBN: 0-471-77184-8
    Hardcover 352 pages April 2006

     

    Click to Download the Comprehensive Business Reporting Model from the CFA Institute website.
    Click here for Press Release (PDF 26k).

    As you can see below, the war is not over yet.  In fact it has intensified between corporations (especially banks) versus standard setters versus members of the academy.

    From The Wall Street Journal Accounting Educators' Review on April 2, 2004

    TITLE: As IASB Unveils New Rules, Dispute With EU Continues 
    REPORTER: David Reilly 
    DATE: Mar 31, 2004 
    PAGE: A2 LINK: http://online.wsj.com/article/0,,SB108067939682469331,00.html  
    TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider trading, International Accounting, International Accounting Standards Board

    SUMMARY: Despite controversy with the European Union (EU), the International Accounting Standards Board (IASB) is expected to release a final set of international accounting standards. Questions focus on the role of the IASB, controversy with the EU, and harmonization of the accounting standards.

    QUESTIONS: 
    1.) What is the role of the IASB? What authority does the IASB have to enforce standards?

    2.) List three reasons that a country would choose to follow IASB accounting standards. Why has the U.S. not adopted IASB accounting standards?

    3.) Discuss the advantages and disadvantages of harmonization of accounting standards throughout the world. Why is it important the IASB reach a resolution with the EU over the disputed accounting standards?

    4.) What is fair value accounting? Why would fair value accounting make financial statements more volatile? Is increased volatility a valid argument for not adopting fair value accounting? Does GAAP in the United States require fair value accounting? Support your answers.

    There are a number of software vendors of FAS 133 valuation software.

    One of the major companies is Financial CAD --- http://www.financialcad.com/ 

    FinancialCAD provides software and services that support the valuation and risk management of financial securities and derivatives that is essential for banks, corporate treasuries and asset management firms. FinancialCAD’s industry standard financial analytics are a key component in FinancialCAD solutions that are used by over 25,000 professionals in 60 countries.

    See software.

    Fair value accounting politics in the revised IAS 39

    From Paul Pacter's IAS Plus on July 13, 2005 --- http://www.iasplus.com/index.htm
    Also see http://faculty.trinity.edu/rjensen//theory/00overview/IASBFairValueFAQ.pdf

     
    The European Commission has published Frequently Asked Questions – IAS 39 Fair Value Option (FVO) (PDF 94k), providing the Commission's views on the following questions:
    • Why did the Commission carve out the full fair value option in the original IAS 39 standard?
    • Do prudential supervisors support IAS 39 FVO as published by the IASB?
    • When will the Commission to adopt the amended standard for the IAS 39 FVO?
    • Will companies be able to apply the amended standard for their 2005 financial statements?
    • Does the amended standard for IAS 39 FVO meet the EU endorsement criteria?
    • What about the relationship between the fair valuation of own liabilities under the amended IAS 39 FVO standard and under Article 42(a) of the Fourth Company Law Directive?
    • Will the Commission now propose amending Article 42(a) of the Fourth Company Directive?
    • What about the remaining IAS 39 carve-out relating to certain

    On June 23, 2005, the Financial Accounting Standards Board issued an Exposure Draft (ED) entitled "Fair Value Measurements."  The original ED can be downloaded free at
    http://www.fasb.org/draft/ed_fair_value_measurements.pdf

    "Response to the FASB's Exposure Draft on Fair Value Measurements," AAA Financial Standards Committee, Accounting Horizons, September 2005, pp. 187-195 --- http://aaahq.org/pubs/electpubs.htm

    RESPONSES TO SPECIFIC ISSUES

    The FASB invited comment on all matters related to the ED, but specifically requested comments on 14 listed issues.  The Committee's comments are limited to those issues for which empirical research provides some insights, or those sections of the ED that are conceptually inconsistent or unclear.  The Committee has previously commented on other fair-value-related documents issued by the FASB and other standard-setting bodies.  This letter reiterates comments expressed in those letters to the extent they are germane to the measurement issues contained in the ED.  However, to better understand our perspective on reporting fair value information in the financial statements and related notes, we refer readers to those comment letters (i.e., AAA FASC 1998, 2000).

    Issue 1: Definition of Fair Value

    The Committee believes that the ED contains some conceptual inconsistencies between the definition and application of the fair value measurement attribute.  The ED proposes a definition of fair value that is relatively independent of the entity-specific use of the assets held or settlement of the liabilities owed.  In contrast, the proposed standard and related implementation guidance includes measurement that is, at times, directly determined by the entity-specific use of the asset or settlement of the liability in question.

    Some of the inconsistencies with respect to fair value measurement might be attributable to the attempt to apply general, high-level fair value guidance to the idiosyncratic attributes of specific accounts and transactions.  In some cases, application to specific accounts and transactions requires deviation from an entity-independent notion of fair value to one that includes consideration of the specific types and uses of assets held or liabilities owed by companies.  For example, as we note in our discussion of Issue 6 (below), one of the examples in the ED suggests that the fair value of a machine should include an adjustment of quoted market prices (based on comparable machines) for installation costs.  However, such an adjustment is dependent on the individual circumstances of the company that purchases the equipment.  That is, installation costs are included in the fair value of an asset only when the firm intends to use that asset for income producing activities.  Alternatively, if the firm intends to sell the asset, then installation costs are ignored.

    Some members of the Committee, however, do not perceive an inconsistency between the definition and application of the fair value measurement attribute.  These members view the definition of fair value and the context within which it is applied (i.e., the valuation premise) to be distinct, albeit related, attributes.  Although the definition of fair value can be entity-independent, the valuation premise (e.g., value-in-use or value-in-exchange) cannot.  Further, these members argue that ignoring the valuation premise in determining fair value could lead to unsatisfactory outcomes.  For example, if installation costs are ignored regardless of the valuation premise, then immediately after purchasing an asset for use in income-producing activities, firms would suffer impairment losses equal to the installation costs incurred to prepare the assets for use.

    The Committee raises the example of machinery installation costs to illustrate the confusion we experienced trying to reconcile the high-level (seemingly entity-independent) definition of fair value with the contextually determined application standards.  We note that the Introduction of the Ed suggests that the intent of the proposed guidance in the ED is to establish fair value measures that would be referenced in other authoritative accounting to establish fair value measures that would be referenced in other authoritative accounting pronouncements.  Presumably, these other pronouncements would also establish reasonable deviations from the entity-independent notion of fair value.  The Committee believes the most effective general purpose fair value measurement standard would adopt a general notion of fair value that is consistent across the definition of fair value, the accounting standard, and the implementation guidance.  To the extent the Board generally believes that fair value is an entity-specific concept, the high-level definition should reflect this as well.

    Issues 4 and 5: Valuation Premise and Fair Value Hierarchy

    Related to our previous comments, some members of the Committee perceive a contradiction between the definition of fair value in paragraphs 4 and 5 of the ED and the valuation premise described in paragraph 13.  The definition of fair value provided in paragraph 5 suggests a pure value-in-exchange perspective where fair value is determined by the market price that would occur between willing parties.  In contrast, the valuation premise described in paragraph 13 suggests that the fair value estimate can follow either a value-in-use perspective or a value-in-exchange perspective.

    Moreover, the fair value hierarchy described in the ED gives the highest priority to fair value measurements based on market inputs regardless of the valuation premise.  Some members of the Committee believe that quoted market prices are not necessarily an appropriate measure of fair value when a value-in-use premise is being considered.  This is especially true when a quoted price for an identical asset in an active reference market (i.e., a Level 1 estimate) exists, but is significantly different from a value-in-use estimate computed by taking the present value of the firm-specific future cash flows expected to be generated by the asset (i.e., a Level 3 estimate).  In such instances, following the fair value hierarchy might lead to a fair value estimate more in character with a value-in-exchange premise than a value-in-use premise.

    In summary, the Committee believes that: (1) integrating the two valuation premises (i.e., value-in-use and value-in-exchange) into the definition of fair value itself and (2) elaborating on the differences between the two premises would help ensure more consistent application of the standard.

    Issue 6: Reference Market

    Some members of the Committee are confused by the guidance related to determining the appropriate reference market.  With respect to the Level 1 reference market, the ED states that when multiple active markets exist, the most advantageous market should be used.  The most advantageous market is determined by comparing prices across multiple markets net of transactions costs.  However, the ED requires that transactions costs be ignored subsequently in determining the fair value measurement.  In our view, ignoring transactions costs is problematic because we believe such costs are an ordinary and predictable part of executing a transaction.

    In Example 5 (paragraph B9 (b) of the ED) where two markets, A and B, are considered, the price in Market B ($35) is more advantageous than the price in Market A ($25), ignoring transaction costs.  However, the fair value estimate is determined using the price in Market A because the transactions cost in Market B ($20) is much higher than in Market A ($5).  The guidance is less clear if we modify the example by reducing the transaction costs for Market B to $15.  In this instance, neither market is advantageous in a "net" sense, but Market B would yield the highest fair value estimate (ignoring transactions costs), which provides managers an opportunity to pick the most desirable figure based on their reporting objectives.

    Omitting transactions costs from the fair value estimate in Example 5 contrasts sharply with Example 3 (Appendix B, paragraph B7 (a)) where the value-in-use fair value estimate of a machine is determined by adjusting the quoted market price of a comparable machine by installation costs.  Installation costs are ignored only if the firm intends to dispose of the asset (Appendix B, paragraph B7 (b)).  Thus, managerial intent plays an integral role in determining whether fair value is computed with or without installation costs, but the same does not hold for transaction costs.  Since transaction costs are not relevant unless management intends to dispose of the asset, the Committee agrees that ignoring transaction costs is justified when a value-in-use premise is appropriate, but the Committee questions the appropriateness of ignoring transaction costs when a value-in-exchange premise is adopted.

    Issue 7: Pricing in Active Dealer Markets

    The ED requires that the fair value of financial instruments traded in active dealer markets where bid and asked prices are readily available be estimated using bid prices for assets and asked prices for liabilities.  Some Committee members believe that this requirement is inconsistent with the general concept of fair value and seems to be biased toward valuing assets and liabilities at value-in-exchange instead of value-in-use.  Limiting our discussion to the asset case, if a buyer establishes a long position through a dealer, the buyer must pay the asked price.  By purchasing the asset at the asked price, the buyer clearly expects to earn an acceptable rate of return on the investment in the asset (at the higher price).  Moreover, if after purchasing the asset, the buyer immediately applies the ED's proposed fair value measurement guidance (i.e., bid price valuation), the buyer would incur a loss on the asset equal to the bid-ask spread.

    In general, the bid price seems relevant only if the holder wishes to liquidate his/her position.  Although the Committee is not largely in favor of managerial intent-based fair value measures, we are uncomfortable with a bias toward a value-in-exchange premise for assets in-use.  If the Board decides to retain bid-based (ask-based) accounting for dealer traded assets (liabilities) in the final standard, then we propose that the final standard more clearly describe the conceptual basis for liquidation basis asset and liability valuation.

    Issue 9: Level 3 Estimates

    Level 3 estimates require considerable judgment in terms of both the selection and application of valuation techniques.  As a result, estimates using different valuation techniques with different assumptions will likely yield widely varying fair value estimates.  Examples 7 and 8 in Appendix B of the ED illustrate the wide variance in fair value estimates obtained with different valuation techniques.  The ED allows considerable latitude in both the valuation technique and inputs used.  Due to their incentives, managers might use the flexibility afforded by the proposed standard to produce biased and unreliable estimates.  The measurement guidance proposed in the ED is similar to the unstructured and imprecise category of standards analyzed by Nelson et al.  (2002).  They find that managers are more likely to attempt (and auditors are less likely to question) earnings management under such standards compared to more precise standards.

    The income approach to determining a Level 3 fair value estimate encompasses a basket of valuation techniques including two different present value techniques--the discount rate adjustment technique and the expected present value technique.4  The ED conjectures that these two techniques should produce the same fair values (see paragraphs A12, A13 and FN 17).  But, from an application perspective, this conjecture is not consistent with empirical results from studies of human judgment and decision making.5  In particular, psychology research repeatedly shows that people are very poor intuitive statisticians (e.g., people consistently make axiomatic violations when estimating probabilistic outcomes).  In light of these findings, statements such as "the estimated fair values should be the same" provide preparers, auditors, and users with an unfounded (and descriptively false) belief that the techniques suggested in the ED will produce the same fair value estimates.

    Some members of the Committee believe that the ED should explicitly caution preparers, auditors, and users by stating that individuals consistently make these judgment errors.  Further, these Committee members recommend that the ED require companies (when practicable) to (1) independently use the discount rate adjustment and expected present value techniques if they decide to use a present value approach to determine fair value and (2) reconcile the results of the two techniques in a meaningful fashion and document the reconciliation so it can be audited for reasonableness.  Moreover, the application of the present value techniques should be independent of suggested or existing fair value figures when practicable (e.g., the fair value amount recorded in the previous year's financial statements), because psychology research finds that preconceived targets and legacy amounts unduly influence current judgments and decisions (e.g., through "anchoring" and insufficient adjustment).

    Although the disclosures required under paragraph 25 of the ED provide some information regarding the potential reliability of a Level 3 estimate, they do not provide alternative benchmark models that the firm may have considered in determining those fair value estimates.  Hence, the Committee also recommends that the FASB consider requiring firms to disclose (1) fair value estimates under alternative valuation techniques, and (2) sensitivity of fair value estimates to the specific assumptions and inputs used.

    Issue 11: Fair Value Disclosures

    As mentioned previously, the Committee believes that the proposed fair value measurement disclosures are not complete.  The Committee believes that when a firm uses alternative valuation methods to determine fair value, information regarding the alternative techniques and inputs employed should be provided.  Furthermore, users of financial statements would get a better understanding of the reliability of fair value estimates if the financial statements provide detailed disclosures related to (1) fair value estimates produced by alternative valuation techniques and reasons for selecting a preferred estimate, and (2) information about the sensitivity of fair value estimates to changes in assumptions and inputs.

    The Committee also notes that the ED requires the expanded set of reliability related disclosures only for fair value estimates reported in the balance sheet (paragraph 25).  A complete set of financial statements also includes many fair value estimates reported in the notes to the financial statements.  Some members of the Committee believe that financial statement users would also benefit from receiving the reliability related disclosures for fair values disclosed in the footnotes.  Moreover, application of the fair value hierarchy has implications for the reliability of the unrealized gains and losses reported in net (or comprehensive) income.  Accordingly, some members recommend that firms be required to disclose a breakdown of unrealized gains or losses based on how the related fair value amounts were determined (i.e., quoted prices of identical items, quoted prices of similar items, valuation models with significant market inputs, or valuation models with significant entity inputs.)

    CONCLUSION

    The Committee supports the formulation of a single standard that provides guidance on fair value measurement.  We believe that such a standard would improve the consistency of fair value measurement across the many standards that require fair value reporting and disclosure.  In this comment letter, we identify some potential inconsistencies between fair value definitions and fair value determination, and suggest ways to improve disclosures so that users of financial statements can better appreciate the reliability (or lack thereof) of fair value estimates.

    Although the Committee recognizes that the ED is intended to provide fair value measurement guidance, we wish to caution against promulgating pronouncements that completely eliminate historical cost information from the financial statements.  Evidence reported in Dietrich et al. (2000) suggests that historical cost information is incrementally informative even after fair value information is included in regression analyses.


    4    FASB Concept Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, describes these techniques, albeit using different terminology.  In that Concepts Statement, traditional present value refers to the discount rate adjustment technique, while expected cash flow approach refers to the expected present value technique.

    5    Probability-related judgments and decisions are among the oldest branches of psychology and decision-science research.  Two excellent resources that catalogue the problems that individuals have with probability judgments and statistical reasoning are Baron (2000) and Goldstein and Hogarth (1997).

     

    What are the advantages and disadvantages of requiring fair value accounting for all financial instruments as well as derivative financial instruments?

    Advantages:

     

    1. Eliminate arbitrary FAS 115 classifications that can be used by management to manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
    2. Reduce problems of applying FAS 133 in hedge accounting where hedge accounting is now allowed only when the hedged item is maintained at historical cost.
    3. Provide a better snap shot of values and risks at each point in time.  For example, banks now resist fair value accounting because they do not want to show how investment securities have dropped in value.

     

    Disdvantages:

     

    1. Combines fact and fiction in the sense that unrealized gains and losses due to fair value adjustments are combined with “real” gains and losses from cash transactions.  Many, if not most, of the unrealized gains and losses will never be realized in cash.  These are transitory fluctuations that move up and down with transitory markets.  For example, the value of a $1,000 fixed-rate bond moves up and down with interest rates when at expiration it will return the $1,000 no matter how interest rates fluctuated over the life of the bond.
    2. Sometimes difficult to value, especially OTC securities.
    3. Creates enormous swings in reported earnings and balance sheet values.
    4. Generally fair value is the estimated exit (liquidation) value of an asset or liability.  For assets, this is often much less than the entry (acquisition) value for a variety of reasons such as higher transactions costs of entry value, installation costs (e.g., for machines), and different markets  (e.g., paying dealer prices for acquisition and blue book for disposal).  For example, suppose Company A purchases a computer for $2 million that it can only dispose of for $1 million a week after the purchase and installation.  Fair value accounting requires expensing half of the computer in the first week even though the computer itself may be utilized for years to come.  This violates the matching principle of matching expenses with revenues, which is one of the reasons why fair value proponents generally do not recommend fair value accounting for operating assets. 
       

    "Derivatives and hedging:  An Analyst's Response to US FAS 133," by Frank Will, Corporate Finance Magazine, June 2002, http://www.corporatefinancemag.com/pdf/122341.pdf 

    However, FAS 133 still needs further clarification and improvement as the example of Fannie Mae shows. Analysts focus more on the economic value of a company and less on unrealised gains and losses.  Much of the FAS 133 volatility in earnings and in equity does not consistently reflect the economic situation.  This makes it difficult to interpret the figures.  Therefore, analysts welcome the decision of some companies voluntarily to disclose a separate set of figures excluding the effect of FAS 133.

    For more on Frank Will's analysis of FAS 133, Fair Value Accounting, and Fannie Mae, go to http://faculty.trinity.edu/rjensen/caseans/000index.htm 

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory.htm 

    You can read more about fair value at http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms 

    Forwarded on May 11, 2003 by Patrick E Charles [charlesp@CWDOM.DM

    Mark-to-market rule should be written off

    Richard A. Werner Special to The Daily Yomiuri

    Yomiuri

    Since 1996, comprehensive accounting reforms have been gradually introduced in Japan. Since fiscal 2000, the valuation of investment securities owned by firms has been based on their market value at book-closing. Since fiscal 2001, securities held on a long-term basis also have been subjected to the mark-to-market rule. Now, the Liberal Democratic Party is calling for the suspension of the newly introduced rule to mark investments to market, as well as for a delay in the introduction of a new rule that requires fixed assets to be valued at their market value.

    The proponents of so-called global standards are up in arms at this latest intervention by the LDP. If marking assets to market is delayed, they argue, the nation will lag behind in the globalization of accounting standards. Moreover, they argue that corporate accounts must be as transparent as possible, and therefore should be marked to market as often and as radically as possible. On the other hand, opponents of the mark-to-market rule argue that the recent slump in the stock market, which has reached a 21-year low, can at least partly be blamed on the new accounting rules.

    What are we to make of this debate? Let us consider the facts. Most leading industrialized countries, such as Britain, France and Germany, so far have not introduced mark-to-market rules. Indeed, the vast majority of countries currently do not use them.

    Nevertheless, there is enormous political pressure to utilize mark-to-market accounting, and many countries plan to introduce the standard in 2005 or thereafter.

    Japan decided to adopt the new standard ahead of everyone else, based on the advice given by a few accountants--an industry that benefits from the revision of accounting standards as any rule change guarantees years of demand for their consulting services.

    However, so far there has not been a broad public debate about the overall benefits and disadvantages of the new standard. The LDP has raised the important point that such accounting changes might have unintended negative consequences for the macroeconomy.

    Let us first reflect on the microeconomic rationale supporting mark-to-market rules. They are said to render company accounts more transparent by calculating corporate balance sheets using the values that markets happen to indicate on the day of book- closing. Since book-closing occurs only once, twice or, at best, four times a year, any sudden or temporary move of markets on these days--easily possible in these times of extraordinary market volatility--will distort accounts rather than rendering them more transparent.

    Second, it is not clear that marking assets to market reflects the way companies look at their assets. While they know that market values are highly volatile, there is one piece of information about corporate assets that have an undisputed meaning for

    firms: the price at which they were actually bought.

    The purchase price matters as it reflects actual transactions and economic activity. Marking to market, on the other hand, means valuing assets at values at which they were never transacted. The company has neither paid nor received this theoretical money in exchange for the assets. This market value is hence a purely fictitious value. Instead of increasing transparency, we end up increasing the part of the accounts that is fiction.

    While the history of marking to market is brief, we do have some track record from the United States, which introduced mark-to-market accounting in the 1990s.

    Did the introduction increase accounting transparency? The U.S. Financial Accounting Standards Board last November concluded that the new rule of marking to market allowed Enron Energy Services Inc. to book profits from long-term energy contracts immediately rather than when the money was actually received.

    This enabled Enron executives to create the illusion of a profitable business unit despite the fact that the truth was far from it. Thanks to mark-to-market accounting, Enron's retail division managed to hide significant losses and book billions of dollars in profits based on inflated predictions of future energy prices. Enron's executives received millions of dollars in bonuses when the energy contracts were signed.

    The U.S. Financial Accounting Standards Board task force recognized the problems and has hence recommended the mark-to-market accounting rule be scrapped. Since this year, U.S. energy companies will only be able to report profits as income actually is received.

    Marking to market thus creates the illusion that theoretical market values can actually be realized. We must not forget that market values are merely the values derived on the basis of a certain number of transactions during the day in case.

    Strictly speaking, it is a false assumption to extend the same values to any number of assets that were not actually transacted at that value on that day.

    When a certain number of the 225 stocks constituting the Nikkei Stock Average are traded at a certain price, this does not say anything about the price that all stocks that have been issued by these 225 companies would have traded on that day.

    As market participants know well, the volume of transactions is an important indicator of how representative stock prices can be considered during any given day. If the index falls 1 percent on little volume, this is quickly discounted by many observers as it means that only a tiny fraction of shares were actually traded. If the market falls 1 percent on record volume, then this may be a better proxy of the majority of stock prices on that day.

    The values at which U.S. corporations were marked to market at the end of December 1999, at the peak of a speculative bubble, did little to increase transparency. If all companies had indeed sold their assets on that day, surely this would have severely depressed asset prices.

    Consider this: If your neighbor decides to sell his house for half price, how would you feel if the bank that gave you a mortgage argued that, according to the mark-to- market rule, it now also must halve the value of your house--and, as a result, they regret to inform you that you are bankrupt.

    We discussed the case of traded securities. But in many cases a market for the assets on a company's books does not actually exist. In this case, accountants use so-called net present value calculations to estimate a theoretical value. This means even greater fiction because the theoretical value depends crucially on assumptions made about interest rates, economic growth, asset markets and so on.

    Given the dismal track record of forecasters in this area, it is astonishing to find that serious accountants wish corporate accounts to be based on them.

    There are significant macroeconomic costs involved with mark-to-market accounting. As all companies will soon be forced to recalculate their balance sheets more frequently, the state of financial markets on the calculation day will determine whether they are still "sound," or in accounting terms, "bankrupt." While book value accounting tends to reduce volatility in markets to some extent, the new rule can only increase it. The implications are especially far-reaching in the banking sector since banks are not ordinary businesses, but fulfill the public function of creating and providing the money supply on which economic growth depends.

    U.S. experts warned years ago that the introduction of marking to market could create a credit crunch. As banks will be forced to set aside larger loan-loss reserves to cover loans that may have declined in value on the day of marking, bank earnings could be reduced. Banks might thus shy away from making loans to small or midsize firms under the new rules, where a risk premium exists and hence the likelihood of marking losses is larger. As a result, banks would have a disincentive to lend to small firms. Yet, for all we know, the small firm loans may yet be repaid in full.

    If banks buy a 10-year Japanese government bond with the intention to hold it until maturity, and the economy recovers, thus pushing down bond prices significantly, the market value of the government bonds will decline. Banks would thus be forced to book substantial losses on their bond holdings despite the fact that, by holding until maturity, they would never actually have suffered any losses. Japanese banks currently have vast holdings of government bonds. The change in accounting rules likely will increase problems in the banking sector. As banks reduce lending, economic growth will fall, thereby depressing asset prices, after which accountants will quickly try to mark down everyone's books.

    Of course, in good times, the opposite may occur, as we saw in the case of Enron. During upturns, marking to market may boost accounting figures beyond the actual state of reality. This also will boost banks' accounts (similar to the Bank for International Settlements rules announced in 1988), thus encouraging excessive lending. This in turn will fuel an economic boom, which will further raise the accounting values of assets.

    Thus does it make sense to mark everything to fictitious market values? We can conclude that marking to market has enough problems on the micro level to negate any potential benefits. On the macro level, the disadvantages will be far larger as asset price volatility will rise, business cycles will be exacerbated and economic activity will be destabilized.

    The world economy has done well for several centuries without this new rule. There is no evidence that it will improve anything. To the contrary, it is likely to prove harmful. The LDP must be lauded for its attempt to stop the introduction of these new accounting rules.

    Werner is an assistant professor of economics at Sophia University and chief economist at Tokyo-based investment adviser Profit Research Center Ltd.


    Measuring the Business Value of Stakeholder Relationships – all about social capital and how high-trust relationships affect the bottom line. Plus a new measurement tool for benchmarking the quality of stakeholder relationships --- www.cim.sfu.ca/newsletter 

    Trust, shared values and strong relationships aren't typical financial indicators but perhaps they should be. A joint study by CIM and the Schulich School of Business is examining the link between high trust stakeholder relationships and business value creation. The study is sponsored by the Canadian Institute of Chartered Accountants (CICA).

    The research team is looking at how social capital can be applied to business. The aim of this project is to better understand corporate social capital, measure the quality of relationships, and provide the business community with ways to improve those relationships and in turn improve their bottom line.

    Because stakeholder relationships all have common features, direct comparisons of the quality of relationships can be made across diverse stakeholder groups, companies and industries.

    Social capital is “the stock of active connections among people; the trust, mutual understanding, and shared values and behaviors that bind the members of human networks and communities and make cooperative action possible” (Cohen and Prusak, 2000).

    So far the research suggests that trust, a cooperative spirit and shared understanding between a company and its stakeholders creates greater coherence of action, better knowledge sharing, lower transaction costs, lower turnover rates and organizational stability. In the bigger picture, social capital appears to minimize shareholder risk, promote innovation, enhance reputation and deepen brand loyalty.

    Preliminary results show that high levels of social capital in a relationship can build upon themselves. For example, as a company builds reputation among its peers for fair dealing and reliability in keeping promises, that reputation itself becomes a prized asset useful for sustaining its current alliances and forming future ones.

    The first phase of the research is now complete and the study moves into its second phase involving detailed case studies with six companies that have earned a competitive business advantage through their stakeholder relationships. Click here for a full report

    Bob Jensen's discussion of valuation and aggregation issues can be found at http://faculty.trinity.edu/rjensen/FraudConclusion.htm 


    That scenario isn't as farfetched as you might think. It's called a prediction market, based on the notion that a marketplace is a better organizer of insight and predictor of the future than individuals are. Once confined to research universities, the idea of markets working within companies has started to seep out into some of the nation's largest corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are bringing the market inside, with workers trading futures contracts on such "commodities" as sales, product success and supplier behavior. The concept: a work force contains vast amounts of untapped, useful information that a market can unlock. "Markets are likely to revolutionize corporate forecasting and decision making," says Robin Hanson, an economist at George Mason University, in Virginia, who has researched and developed markets. "Strategic decisions, such as mergers, product introductions, regional expansions and changing CEOs, could be effectively delegated to people far down the corporate hierarchy, people not selected by or even known to top management."
    Barbara Kiviat (See below)

    "The End Of Management? by Barbara Kiviat, Time Magazine, July 12, 2004, pp. 88-92 --- http://www.time.com/time/insidebiz/printout/0,8816,1101040712-660965,00.html 

    The end of management just might look something like this. You show up for work, boot up your computer and log onto your company's Intranet to make a few trades before getting down to work. You see how your stocks did the day before and then execute a few new orders. You think your company should step up production next month, and you trade on that thought. You sell stock for the production of 20,000 units and buy stock that represents an order for 30,000 instead. All around you, as co-workers arrive at their cubicles, they too flick on their computers and trade.

    Together, you are buyers and sellers of your company's future. Through your trades, you determine what is going to happen and then decide how your company should respond. With employees in the trading pits betting on the future, who needs the manager in the corner office?

    That scenario isn't as farfetched as you might think. It's called a prediction market, based on the notion that a marketplace is a better organizer of insight and predictor of the future than individuals are. Once confined to research universities, the idea of markets working within companies has started to seep out into some of the nation's largest corporations. Companies from Microsoft to Eli Lilly and Hewlett-Packard are bringing the market inside, with workers trading futures contracts on such "commodities" as sales, product success and supplier behavior. The concept: a work force contains vast amounts of untapped, useful information that a market can unlock. "Markets are likely to revolutionize corporate forecasting and decision making," says Robin Hanson, an economist at George Mason University, in Virginia, who has researched and developed markets. "Strategic decisions, such as mergers, product introductions, regional expansions and changing CEOs, could be effectively delegated to people far down the corporate hierarchy, people not selected by or even known to top management."

    To understand the hype, take a look at Hewlett-Packard's experience with forecasting monthly sales. A few years back, HP commissioned Charles Plott, an economist from the California Institute of Technology, to set up a software trading platform. A few dozen employees, mostly product and finance managers, were each given about $50 in a trading account to bet on what they thought computer sales would be at the end of the month. If a salesman thought the company would sell between, say, $201 million and $210 million worth, he could buy a security — like a futures contract — for that prediction, signaling to the rest of the market that someone thought that was a probable scenario. If his opinion changed, he could buy again or sell.

    When trading stopped, the scenario behind the highest-priced stock was the one the market deemed most likely. The traders got to keep their profits and won an additional dollar for every share of "stock" they owned that turned out to be the right sales range. Result: while HP's official forecast, which was generated by a marketing manager, was off 13%, the stock market was off only 6%. In further trials, the market beat official forecasts 75% of the time.

    Intrigued by that success, HP's business-services division ran a pilot last year with 14 managers worldwide, trying to determine the group's monthly sales and profit. The market was so successful (in one case, improving the prediction 50%) that it has since been integrated into the division's regular forecasts. Another division is running a pilot to see if a market would be better at predicting the costs of certain components with volatile prices. And two other HP divisions hope to be using markets to answer similar questions by the end of the year. "You could do zillions of things with this," says Bernardo Huberman, director of the HP group that designs and coordinates the markets. "The idea of being able to forecast something allows you to prepare, plan and make decisions. It's potentially huge savings."

    Eli Lilly, one of the largest pharmaceutical companies in the world, which routinely places multimillion-dollar bets on drug candidates that face overwhelming odds of failure, wanted to see if it could get a better idea of which compounds would succeed. So last year Lilly ran an experiment in which about 50 employees involved in drug development — chemists, biologists, project managers — traded six mock drug candidates through an internal market. "We wanted to look at the way scattered bits of information are processed in the course of drug development," says Alpheus Bingham, vice president for Lilly Research Laboratories strategy. The market brought together all the information, from toxicology reports to clinical results, and correctly predicted the three most successful drugs.

    What's more, the market data revealed shades of opinion that never would have shown up if the traders were, say, responding to a poll. A willingness to pay $70 for a particular drug showed greater confidence than a bid at $60, a spread that wouldn't show if you simply asked, Will this drug succeed? "When we start trading stock, and I try buying your stock cheaper and cheaper, it forces us to a way of agreeing that never really occurs in any other kind of conversation," says Bingham. "That is the power of the market."

    The current enthusiasm can be traced in part, oddly enough, to last summer's high-profile flop of a market that was supposed to help predict future terrorist attacks. A public backlash killed that Pentagon project a few months before its debut, but not before the media broadcast the notion that useful information embedded within a group of people could be drawn out and organized via a marketplace. Says George Mason's Hanson, who helped design the market: "People noticed." Another predictive market, the Iowa Electronic Markets at the University of Iowa, has been around since 1988. That bourse has accepted up to $500 from anyone wanting to wager on election results. Players buy and sell outcomes: Is Kerry a win or Bush a shoo-in? This is the same information that news organizations and pollsters chase in the run-up to election night. Yet Iowa outperforms them 75% of the time.

    Inspired by such results, researchers at Microsoft started running trials of predictive markets in February, finding the system inexpensive to set up. Now they're shopping around for the market's first real use. An early candidate: predicting how long it will take software testers to adopt a new piece of technology. Todd Proebsting, who is spearheading the initiative, explains, "If the market says they're going to be behind schedule, executives can ask, What does the market know that we don't know?" Another option: predicting how many patches, or corrections, will be issued in the first six months of using a new piece of software. "The pilots worked great, but we had little to compare it to," he says. "You can reason that this would do a good job. But what you really want to show is that this works better than the alternative."

    Ultimately, "you may someday see someone in a desk job or a manufacturing job doing day trading, knowing that's part of the job," says Thomas Malone, a management professor at M.I.T. who has written about markets. "I'm very optimistic about the long-term prospects."

    But no market is perfect. Economists are still unsure of the human factor: how to get people to play and do their best. In the stock market or even the Iowa prediction market, people put up their own money and trade to make more. That incentive ensures that people trade on their best information. But a company that asks employees to risk their own money raises ethical questions, so most corporate markets use play money to trade and small bonuses or prizes for good traders. "Though this may look like God's gift to business, there are problems with it," says Plott, who ran the first HP experiments. Tokyo-based Dentsu, one of the world's largest advertising firms, is still grappling with incentives for an ad forecasting market it will launch later this year with the help of News Futures, a U.S. consultancy.

    And even if companies can figure out how to make their internal markets totally efficient, there are plenty of reasons that corporate America isn't about to jump wholesale onto the markets bandwagon. For one thing, markets, based on individuals and individual interests, could threaten the kind of team spirit that many corporations have struggled to cultivate. Established hierarchies could be threatened too. After all, a market implies that the current data crunching and decision-making process may not be as good as a gamelike system that often includes lower-level employees. In a sense, an internal market's success suggests that if upper managers would just give up control, things would run better. Lilly, which is considering using a market to forecast actual drug success, is still grappling with the potential ramifications. "We already have a rigorous process," says Lilly's Bingham. "So what do you do if you use a market and get different data?" Throw it out? Or say that the market was smarter, impugning the tried-and-true system?

    There could be risks to individual workers in an internal trading system as well. If you lose money in the market, does that mean you're not knowledgeable about something you should be? "You have to get people used to the idea of being accountable in a very different way," says Mary Murphy-Hoye, senior principal engineer at Intel, which has been experimenting with internal markets. "I can now tell if planners are any good, because they're making money or they're not making money."

    Continued in article


    Robert Walker's First Blog Entry is About Fair Value Accounting, October 27, 2006 --- http://www.robertbwalkerca.blogspot.com/

    Introduction
    I have decided to begin a commentary which expresses my views on accounting. As I begin to do this I envisage the source of my commentary to comprise three different sorts of writing in which I may engage:
    § Simple notes directly to the ‘blog’ such as this.
    § Formal submissions I may make to various bodies including the IASB.
    § Letters or reports I may write for one reason or another that I think might have some general readership.

    The expression of my views will stray from the subject matter of accounting per se to deal with matters of enormous significance to me such as corporate or public administration. Such expressions will not be too substantial a digression from the core subject matter because I believe that the foundation of good ‘corporate governance’, to use a vogue term, is accounting.

    Source of my ideas on accounting
    I would have to confess that the foundation upon which I base my philosophy of accounting is derivative, as much of human knowledge is of course. It is not for nothing that Newtown said that if he can see so far it is because he stands on the shoulders of giants. In my case, that ‘giant’ is Yuiji Ijiri. As I begin a detailed exposition of my views I shall return to the lessons I learned many years ago from Theory of Accounting Measurement, a neglected work that will still be read in 1,000 years or so long as humankind survives whichever is the shorter. As the depredations of the standard setting craze are visited upon us with ever increasing complexity, the message delivered by Ijiri will be heeded more an more.

    The basic structure of accounting
    Without wishing to be too philosophical about it, I need to begin by outlining what I mean by accounting. Accounting, in my mind, comprises three inter-related parts. These are:
    § Book-keeping.
    § Accounting.
    § Financial reporting.

    Book-keeping is the process of recording financial data elements in the underlying books of account. These financial data elements represent, or purport to represent, real world events. The heart of book-keeping is the double entry process. For instance at the most basic level a movement in cash will result in the surrender or receipt of an asset, the incurring or settlement of a liability and so on.

    I have no complete and coherent theory of the limits of book-keeping. Clearly cash movement (change of ownership) or the movement of commodity is the proper subject matter of book-keeping. Whether all forms of contract should be similarly treated is not clear to me. I am inclined to say yes. That is to adopt Ijiri’s theory of commitment accounting, but I can foresee that this leads me to conclusions that I may find unpalatable later on. Incidentally I say this because an epiphany I had, based on the notion of commitment accounting, some years ago is beginning to unravel.

    Book-keeping goes beyond recording to encompass control. That is the process by which the integrity of the centre piece of book-keeping – the general ledger expressing double entry – is ensured. I will not concern myself with such processes though this is not to say that they are unimportant.

    Accounting is the process by which sense is made of what is a raw record expressed in the general ledger. It is the process of distillation and summation that enables the accountant to gain on overview of what has happened to the entity the subject of the accounting. Accounting fundamentally assumes that the accountant is periodically capable of saying something useful about the real world using his or her special form of notation.

    Financial reporting is the process by which data is assembled into a comprehensive view of the world in accordance with a body of rules. It differs, in the ideal, from accounting in a number of ways. Most benignly it differs, for instance, by including ancillary information for the benefit of a reader beyond the mere abstraction from the general ledger. Again in the ideal there is an inter-relationship between the three levels in the accounting hierarchy. That is, the rules of financial reporting will, to some degree shape the order and format of the basic, book-keeping level so that the process of distillation and summation follows naturally to the final level of reporting without dramatic alteration.

    Perhaps what concerns me is that the sentiment expressed above can be seen, without much effort, to be only ideal and that in reality it does not arise. In short the golden strand that links the detailed recording of real world phenonmena to its final summation is broken.

    An example
    I was asked recently by a student of accounting to explain IAS 41, the IASB standard on agriculture. As I don’t deal in primary production at all, I had not thought about this subject for years.

    IAS 41 admonishes the accountant to apply ‘fair value’ accounting. Fair value accounting is the process by which current sale prices, or their proxies, are substituted for the past cost of any given item.

    For instance, you may have a mature vineyard. The vineyard comprises land, the vine and its fruit, the plant necessary to sustain the vine (support structures, irrigation channels etc.). Subsumed within the vine are the materials necessary for it to grow and start producing fruit. This will include the immature plant, the chemical supplements necessary to nurture and protect it, and the labour necessary to apply it.

    The book-keeping process will faithfully record all of these components. Suppose for example the plant, fertliser and labour cost $1000. In the books will be recorded:

    Dr Vineyard $1000
    Cr Cash $1000

    At the end of the accounting period, the accountant will summarise this is a balance statement. He or she will then obtain, in some way, the current selling price of the vine. Presumably this will be the future cash stream of selling the fruit, suitably discounted. Assume that this is $1200.

    The accountant will then make the following incremental adjustment:

    Dr Vineyard $200
    Cr Equity $200

    Looked like this there is a connection between the original book-keeping and the periodic adjustment at the end of the accounting period. This is an illusion. The incremental entry disguises what is really happening. It is as follows:

    Dr Equity $1000
    Cr Vineyard $1000

    And

    Dr Vineyard $1200
    Cr Equity $1200

    Considered from the long perspective, the original book-keeping has been discarded and a substitute value put in its place. This is the truth of the matter. The subject matter of the first phase of accounting was a set of events arising in a bank and in the entity undertaking accounting. The subject matter of the second phase is a set of future sales to a party who does not yet exist.

    From a perspective of solvency determination, a vital element of corporate governance, the view produced by the first phase is next to useless. However, the disquiet I had in my mind which I had suppressed until recently, relates to the shattering of the linkages between the three levels of accounting in the final reporting process. This disquiet has returned as I contemplate the apparently unstoppable momentum of the standard setting process.

    October 28, 2006 reply from Bob Jensen

    Hi Robert,

    I hope you add many more entries to your blog.

    The problem with "original book-keeping" is that it provides no answers about how to account for risk of many modern day contracts that were not imagined when "original book-keeping" evolved in a simple world of transactions. For example, historical costs of forward contracts and swaps are zero and yet these contracts may have risks that may outweigh all the recorded debt under "original book-keeping." Once we opened the door to fair value accounting to better account for risk, however, we opened the door to misleading the public that booked fair value adjustments can be aggregated much like we sum the current balances of assets and liabilities on the balance sheet. Such aggregations are generally nonsense.

    I don't know if you saw my recent hockey analogy or not. It goes as follows:

    Goal Tenders versus Movers and Shakers
    Skate to where the puck is going, not to where it is.

    Wayne Gretsky (as quoted for many years by Jerry Trites at http://www.zorba.ca/ )

    Jensen Comment
    This may be true for most hockey players and other movers and shakers, but for goal tenders the eyes should be focused on where the puck is at every moment ---  not where it's going. The question is whether an accountant is a goal tender (stewardship responsibilities) or a mover and shaker (part of the managerial decision making team). This is also the essence of the debate of historical accounting versus pro forma accounting.

    Graduate student Derek Panchuk and professor Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed the most comprehensive, on-ice hockey study to determine where elite goalies focus their eyes in order to make a save. Simply put, they found that goalies should keep their eyes on the puck. In an article to be published in the journal Human Movement Science, Panchuk and Vickers discovered that the best goaltenders rest their gaze directly on the puck and shooter's stick almost a full second before the shot is released. When they do that they make the save over 75 per cent of the time.
    "Keep your eyes on the puck," PhysOrg, October 26, 2006 --- http://physorg.com/news81068530.html

    I have written a more serious piece about both theoretical and practical problems of fair value accounting. I should emphasize that this was written after the FASB Exposure Draft proposing fair value accounting as an option for all financial instruments and the culminating FAS 157 that is mainly definitional and removed the option to apply fair value accounting to all financial instruments even though it is still required in many instances by earlier FASB standards.

    My thoughts on this are at the following link:

    http://faculty.trinity.edu/rjensen/FairValueDraft.htm

    Bob Jensen

     


    E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE The International Federation of Accountants (IFAC) invites comments on two new exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and Electronic Commerce: Using the Internet or Other Public Networks - Effect on the Audit of Financial Statements. Comments on both EDs, developed by IFAC's International Auditing Practices Committee (IAPC), are due by January 15, 2002. See http://accountingeducation.com/news/news2213.html  

    The IFAC link is at http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151 

    The purpose of this International Standard on Auditing (ISA) is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, this ISA addresses audit considerations relating to the valuation, measurement, presentation and disclosure for material assets, liabilities and specific components of equity presented or disclosed at fair value in financial statements. Fair value measurements of assets, liabilities and components of equity may arise from both the initial recording of transactions and later changes in value.

     
    Download
    "Auditing Fair Value Measurements And Disclosures"
    in MS Word format.

    File Size: 123 Kbytes
    Download
    "Auditing Fair Value Measurements And Disclosures"
    in Adobe Acrobat format.

    File Size: 209 Kbytes


    Loan Losses and Bad Debts

    "Loan Accounting: It’s High Time for the SEC to Step Up to the Plate," by Tom Selling, The Accounting Onion, August 2, 2014 ---
    http://accountingonion.com/2014/08/time-for-the-sec-to-step-up-to-the-plate.html

    Jensen Comment
    I'm just not as confident in the profession of "independent valuation experts." You get ten such experts to give you a number, and you will get ten possibly widely divergent numbers to a point that management and/or auditors can selectively manage earnings by using carefully chosen valuation "experts." Most such valuations rely upon crucial assumptions that are highly uncertain, especially in the case of foreign debt like Argentine bonds.

    Secondly, I'm not certain about the benefit-cost of such valuations of banks having a lot of branches spread across the USA. This is the Ole-versus-Sven debate that I've used with Tom too often already --- See Below


    Does Fair Value Accounting Provide More Useful Financial Statements than Current GAAP for Banks?

     The Accounting Review
    Article Volume 93, Issue 6 (November 2018)
    https://aaajournals.org/doi/full/10.2308/accr-52007

    John M. McInnis

    Yong Yu
    The University of Texas at Austin

    Christopher G. Yust
    Texas A&M University


     

    ABSTRACT

    Standard setters contend that fair value accounting yields the most relevant measurement for financial instruments. We examine this claim by comparing the value relevance of banks' financial statements under fair value accounting with that under current GAAP, which is largely based on historical costs. We find that the combined value relevance of book value of equity and income under fair value is less than that under GAAP. We also find that fair value income is less value-relevant than GAAP income because of the inclusion of transitory unrealized gains and losses in fair value income. More surprisingly, we find that book value of equity under fair value is not more value-relevant than under GAAP, due both to divergence between exit value and value-in-use and to measurement error in fair value estimates. Overall, our results suggest that financial statements under fair value accounting provide less relevant information for bank valuation than financial statements under current GAAP.

    Keywords: fair value, historical cost, financial instrument, bank, value relevance


    From the CFO Journal's Morning Ledger on May 1, 2015

    FASB Finalizing Credit Impairment Guidance

    The FASB is finalizing amendments to its guidance on the impairment of financial instruments, which would introduce a new impairment model based on expected losses rather than incurred losses. The proposed model aims to provide more timely recognition of credit losses and reduce the complexity of U.S. GAAP by decreasing the number of credit impairment models used. Deloitte’s “Heads Up” newsletter discusses the new proposed amendments and provides related comparisons and illustrative examples. Continue »

    Read more Deloitte Insights »

    FASB Finalizing Credit Impairment Guidance ---
    http://deloitte.wsj.com/cfo/2015/05/01/fasb-finalizing-credit-impairment-guidance/

    Deloitte’s Heads Up newsletter provides a comprehensive summary of the FASB’s proposed changes to the credit impairment guidance under current U.S. GAAP, which are reflected in the Board’s December 2012 proposed ASU³ and subsequent tentative decisions.⁴ In addition, the full newsletter contains several appendixes. Appendix A compares the impairment models under current U.S. GAAP, the FASB’s tentative approach, and the IASB’s recently amended IFRS 9, respectively. Appendix B, in the full Heads Up newsletter, gives an overview of the existing impairment models under U.S. GAAP for loans and debt securities. Appendix C and Appendix D provide illustrative examples of how an entity might apply the CECL model to purchased credit-impaired (PCI) assets and trade receivables, respectively.

    The CECL Model

    Scope

    The CECL model would apply to most⁵ debt instruments (other than those measured at fair value through net income (FVTNI)), trade receivables, lease receivables, reinsurance receivables that result from insurance transactions, financial guarantee contracts,⁶ and loan commitments. However, available-for-sale (AFS) debt securities would be excluded from the model’s scope and would continue to be assessed for impairment under ASC 320⁷ (the FASB has proposed limited changes to the impairment model for AFS debt securities).

    Recognition of Expected Credit Losses

    Unlike the incurred loss models in existing U.S. GAAP, the CECL model does not specify a threshold for the recognition of an impairment allowance. Rather, an entity would recognize an impairment allowance equal to the current estimate of expected credit losses (i.e., all contractual cash flows that the entity does not expect to collect) for financial assets as of the end of the reporting period. Credit impairment would be recognized as an allowance—or contra-asset—rather than as a direct write-down of the amortized cost basis of a financial asset. However, the carrying amount of a financial asset that is deemed uncollectible would be written off in a manner consistent with existing U.S. GAAP.

    Measurement of Expected Credit Losses

    Under the proposed amendments, an entity’s estimate of expected credit losses represents all contractual cash flows that the entity does not expect to collect over the contractual life of the financial asset. When determining the contractual life of a financial asset, the entity would consider expected prepayments but would not be allowed to consider expected extensions unless it “reasonably expects that it will execute a troubled debt restructuring with the borrower.”⁸

    The entity would consider all available relevant information in making the estimate, including information about past events, current conditions, and reasonable and supportable forecasts and their implications for expected credit losses. That is, while the entity would be able to use historical charge-off rates as a starting point in determining expected credit losses, it would have to evaluate how conditions that existed during the historical charge-off period differ from its current expectations and accordingly revise its estimate of expected credit losses. However, the entity would not be required to forecast conditions over the contractual life of the asset. Rather, for the period beyond the period for which the entity can make reasonable and supportable forecasts, the entity would revert to an unadjusted historical credit loss experience.

    Unit of Account

    The CECL model would not prescribe a unit of account (e.g., an individual asset or a group of financial assets) in the measurement of expected credit losses. However, an entity would be required to evaluate financial assets within the scope of the model on a collective (i.e., pool) basis when similar risk characteristics are shared. If a financial asset does not share similar risk characteristics with the entity’s other financial assets, the entity would evaluate the financial asset individually. If the financial asset is individually evaluated for expected credit losses, the entity would not be allowed to ignore available external information such as credit ratings and other credit loss statistics.

    Continued in article


    The Interaction of the IFRS 9 Expected Loss Approach with Supervisory Rules and Implications for Financial Stability
    SSRN, August 5, 2016

    Accounting in Europe (Forthcoming)

    Author

    Zoltán Novotny-Farkas
    Lancaster University - Management School

    Abstract

    This paper examines the interaction of the IFRS 9 expected credit loss (ECL) model with supervisory rules and discusses potential implications for financial stability in the European Union. Compared to the incurred loss approach of IAS 39, the IFRS 9 ECL model incorporates earlier and larger impairment allowances and is more closely aligned with regulatory expected loss. The earlier recognition of credit losses will reduce the build-up of loss-overhangs and the overstatement of regulatory capital. In addition, extended disclosure requirements are likely to contribute to more effective market discipline. Through these channels IFRS 9 might enhance financial stability. However, due to the reliance on point-in-time estimates of the main input parameters (probability of default and loss given default) IFRS 9 ECLs will increase the volatility of regulatory capital for some banks. Furthermore, the ECL model provides significant room for managerial discretion. Bank supervisors might play an important role in the implementation of IFRS 9, but too much supervisory intervention bears the risk of introducing a prudential bias into loan loss accounting that compromises the integrity of financial reporting. Overall, the potential benefits of the standard will crucially depend on its proper and consistent application across jurisdictions.


    Collateralized Debt Obligation --- http://en.wikipedia.org/wiki/Collateralized_debt_obligation

    New Rules for CDOs
    "Statement at Open Meeting: Asset-Backed Securities Disclosure and Registration," by Commissioner Kara M. Stein, SEC, August 27, 2014 ---
    http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370542772431#.VBgvYBZS7rx

    I begin my remarks by echoing others and commending the work of the team that has been working on this rule, including Rolaine Bancroft, Hughes Bates, Michelle Stasny, Kayla Florio, Heather Mackintosh, Silvia Pilkerton, Robert Errett, Max Rumyantsev, and Kathy Hsu. 

    Heather and Sylvia have been working on the data tagging and preparing EDGAR to accept this new data.  This is no small endeavor. 

    I want to give a special thank you to Paula Dubberly, who retired last year from the SEC and is in the audience today.  She has been a champion for investors through her leadership on asset-backed securities regulation from the development of the initial Reg AB proposal through the rules that are being considered today.

    This rule is an important step forward in completing the mandated Dodd-Frank Act rulemakings.[1]  The financial crisis revealed investors’ inability to actually assess pools of loans that had been sliced and diced, sometimes multiple times, by being securitized, re-securitized, or combined in a dizzying array of complex financial instruments.  The securitization market was at the center of the financial crisis.  While securitization structures provided liquidity to nearly every sector in the U.S. economy, they also exposed investors to significant and non-transparent risks due to poor lending practices and poor disclosure practices. 

    As we now know, offering documents failed to provide timely and complete information for investors to assess the underlying risks of the pool of assets.[2]   Without sufficient and accurate loan level details, analysts and investors could not gauge the quality of the loans – and without an ability to distinguish the good from the bad, the secondary market collapsed.

    Congress responded and required the Commission to promulgate rules to address a number of weaknesses in the securitization process.[3]

    Six years after the financial crisis, the securitization markets continue to recover.  While certain asset classes have rebounded, others continue to struggle.

    The rule the Commission issues today partially addresses the Congressional mandate.  In effect, today’s rules provide investors with better information on what is inside the securitization package.  The rules today do for investors what food and drug labeling does for consumers – provide a list of ingredients.

    This rule also addresses certain critical flaws that became apparent in the securitization process, including a dearth of quality information and insufficient time to make informed assessments of the underlying investments.  This rule is an important step toward providing investors with tools and data to better understand the underlying risks and appropriately price the securities. 

    There are several important and laudable aspects of today’s rule that merit specific mentioning.

    First, the rule requires the underlying loan information to be standardized and available in a tagged XML format to ensure maximum utility in analysis.[4]   As noted in the Commission’s 2010 Proxy Plumbing Release: “If issuers provided reportable items in interactive data format, shareholders may be able to more easily obtain information about issuers, compare information across different issuers, and observe how issuer-specific information changes over time as the same issuer continues to file in an interactive format.”[5]  The same is true for underlying loan information.  Investors can unlock the value and efficiency that standardized, machine readable data allows. 

    Today’s rule also improves disclosures regarding the initial offering of securities and significantly, for the first time, requires periodic updating regarding the loans as they perform over time.  This information will provide a more nuanced and evolving picture of the underlying assets in a portfolio to investors.

    The rule also requires that the principal executive officer of the ABS issuer certify that the information in the prospectus or report is accurate.  These kinds of certifications provide a key control to help ensure more oversight and accountability.

    As for the privacy concerns that prompted a re-proposal, the staff has worked hard to balance investor needs for loan level data with concerns that the data could lead to identification of individual borrowers.   I believe the rule achieves a workable balance between these two competing needs, while still providing invaluable public disclosure.

    Finally, I believe that the new disclosure rule will provide investors with the necessary tools to see what is “under the hood” on auto loan securitizations.  In its latest report on consumer debt and credit, the Federal Reserve Bank of New York noted a recent spike in subprime auto lending.  As the report shows, although consumer auto debt balances have risen across the board, the real growth has been in riskier loans.[6] The disclosure and reporting changes that the Commission is adopting today will help investors see the quality of the loans in a portfolio and the performance of those loans over time. 

    While today’s rules are an important step forward, more work needs to be done regarding conflicts of interest.   We now know that many firms who were structuring securitizations before the financial crisis were also betting against those same securitizations. 

    In April 2010, the Commission charged the U.S broker-dealer of a large financial services firm for its role in failing to disclose that it allowed a client to select assets for an investment portfolio while betting that the portfolio would ultimately lose its value.  Investors in the portfolio lost more than $1 billion.[7]  

    In October 2011, the Commission sued the U.S broker-dealer of a large financial services firm for among other things, selling investment products tied to the housing market and then, for their own trading, betting that those assets would lose money.  In effect, the firm bet against the very investors it had solicited.  An experienced collateral manager commented internally that a particular portfolio was “horrible.”  While investors lost virtually all of their investments in the portfolio, the firm pocketed over $160 million from bets it made against the securitization it created.[8]

    The Dodd-Frank Act directed the Commission to adopt rules prohibiting placement agents, underwriters, and sponsors from engaging in a material conflict of interest for one year following the closing of a securitization transaction. Those rules were required to be issued by April 2011.[9]   The Commission initially proposed these rules in September 2011, and still has not completed them.[10]  We need to complete these rules as soon as possible, hopefully, by the end of this year.  These rules will provide investors with additional confidence that they are not being hoodwinked by those packaging and selling those financial instruments. 

    Unfortunately, the Commission has put on hold its work to provide investors with a software engine to aid in the calculation of waterfall models.  Although the final rule provides for a preliminary prospectus at least three business days before the first sale, this is reduced from the proposal, which provided for a five-day period.   With only three days to conduct due diligence and make an investment determination, such a software engine could be an important and much needed tool for investors to use in analyzing the flow of funds.  Such waterfall models can help investors assess the cash flows from the loan level data.  We should return to this important initiative to provide investors with the mathematical logic that forms the basis for the narrative disclosure within the prospectus. 

    The rule today impacts some significant sectors of the securitization market, however, the Commission should continue to work in making improvements that will provide investors with the disclosures they need regarding other asset classes, such as student loans, equipment loans and leases, and others as appropriate.      

    Finally, it is vitally important that the Commission continue to work with our fellow regulators to establish important provisions for risk retention, also required by the Dodd-Frank Act. 

    In conclusion, I appreciate the staff’s hard work both with me and my staff over these past several months.  But much work remains to be done.  I am committed to working with the staff and my fellow Commissioners to continue to move forward with Dodd-Frank rulemakings and specifically rulemakings to improve the strength and resiliency of securitization markets. 

    A stable securitization market efficiently brings investors and issuers together.  Thus far, the return of capital to securitization markets has been disappointing, and I am hopeful that this rule and others that will follow will provide incentives for both issuers and investors to return with confidence to this once vibrant marketplace.     

    The new tools and protections provided in today’s rule should help restore trust in a market that was at the heart of the worst financial crisis since the Great Depression.  But removing this black cloud is going to require continuing focus and effort from all of us. 

    Thank you.  I
     


     

    [1]           The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010). 

     

    [2]           See Sheila Bair, Bull by The Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself at 52 (2012) (investors in asset-backed securities lacked detailed loan level information and adequate time to analyze the information before making an investment decision). 
    [3]           The Dodd-Frank Wall Street Reform and Consumer Protection Act imposed new requirements on the ABS process and required the Commission to promulgate rules in a number of areas.  Section 621 prohibits an underwriter, placement agent, initial purchaser, sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security from engaging in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity for a period of one year after the date of the first closing of the sale of the asset-backed security.  Section 941 requires the Commission, the Federal banking agencies, and, with respect residential mortgages, the Secretary of Housing and Urban Development and the Federal Housing Finance Agency to prescribe rules to require that a securitizer retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells, or conveys to a third party. The chairperson of the Financial Stability Oversight Council is tasked with coordinating this regulatory effort.  Section 942 contains disclosure and Exchange Act reporting requirements for ABS issuers.  Section 943 requires the Commission to prescribe regulations on the use of representations and warranties in the ABS market.  Section 945 requires the Commission to issue rules requiring an asset-backed issuer in a Securities Act registered transaction to perform a review of the assets underlying the ABS, and disclose the nature of such review.   See also H.R. Rep. No. 4173 (2010) (Dodd-Frank Conference Report)

     

    [4]           See Statement of Former Federal Reserve Governor Randall S. Kroszner at the Federal Reserve System Conference on Housing and Mortgage Markets, Washington, DC, December 4, 2008, available at  http://www.federalreserve.gov/newsevents/speech/kroszner20081204a.htm.

     

    [5]           See Concept Release on the U.S. Proxy System, Exchange Act Release No. 62495 (July 14, 2010), available at http://www.sec.gov/rules/concept/2010/34-62495.pdf.

     

     

    [6]           See Quarterly Report on Household Debt and Credit, August 14, 2014, Federal Reserve Bank of New York, available at http://www.newyorkfed.org/microeconomics/hhdc.html#/2014/q2.

      

    [7]           See SEC v. Goldman, Sachs & Co. and Fabrice Tourre, 10 Civ. 3229 (BJ) (S.D.N.Y. filed April 16, 2010) available at http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf.

     

    [8]           See SEC v. Citigroup Global Markets, 11 Civ. 7387. (Rakoff, J.) (S.D.N.Y. filed Oct. 19, 2011)., available at http://www.sec.gov/litigation/complaints/2011/comp-pr2011-214.pdf.

     

     

    [9]           Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, § 621, 124 Stat. 1376, 1632 (2010).

     

    [10]          See SEC Release No. 34-65355, Prohibition against Conflicts of Interest in Certain Securitizations, September 19, 2011; SEC Release No. 34-65545, October 12, 2011 (extending the comment period from December 19, 2011 to January 13, 2012); and SEC Release No. 34-66058, October 12, 2011 (extending the comment period end date from January 13, 2012 to February 13, 2012).

    The Impact of Fair Value Measurement for Bank Assets on Information Asymmetry and the Moderating Effect of Own Credit Risk Gains and Losses

    The Accounting Review
    Article Volume 93, Issue 6 (November 2018) N
    https://aaajournals.org/doi/full/10.2308/accr-52070

     

    Joana C. Fontes
    UCP–Catolica Lisbon School of Business and Economics

    Argyro Panaretou

    Kenneth V. Peasnell
    Lancaster University

     

    ABSTRACT

    We examine whether the use of fair value measurement (FVM) for bank assets reduces information asymmetry among equity investors (bid-ask spread) and how this is affected by the recognition of own credit risk gains and losses (OCR). Our findings show that FVM of assets is associated with noticeably lower information asymmetry, and that this reduction is more than twice as large when banks also recognize OCR. In addition, we find that the bid-ask spread is incrementally lower for banks that provide more detailed narrative disclosures on OCR. The findings also indicate that the effects of asset FVM and OCR recognition on the bid-ask spread do not simply capture the differences in the characteristics of the banks and the quality of their information environments.

    Data Availability: All data are available from public sources.

    Keywords: mixed-attribute model, own credit risk, fair value option, financial instruments, IAS 39, banks


    "Banks Outside U.S. Get New Rules on Accounting for Bad Loans:  IASB's Changes on Recording Losses Will Make It Harder to Compare Banks Inside and Outside the U.S.," by Michael Rapoport, The Wall Street Journal, July 24, 2014 ---
    http://online.wsj.com/articles/iasb-gives-non-u-s-banks-a-loan-accounting-overhaul-1406203202?mod=WSJ_LatestHeadlines

    European banks and other banks outside the U.S. will have to record losses on bad loans more quickly and set aside more reserves for loan losses under an overhaul of finance-accounting rules that global rule makers made final on Thursday.

    Under the new standard, non-U.S. banks will have to book loan losses based on their expectation that future losses will occur, beginning in 2018. That is expected to speed up the booking of losses and require greater loan-loss reserves.

    Currently, banks don't record losses until they have actually happened, but many observers believe that method led banks to be too slow in taking losses during the financial crisis.

    The move by the London-based International Accounting Standards Board, which has been in the works for years, could create a conundrum for the banking industry: Because U.S. and global rule makers haven't been able to agree on the same accounting approach for writing off bad loans, it could become more difficult to compare U.S. banks and those outside the U.S.

    U.S. and global rule makers have been striving for years to eliminate differences between their rules in some major areas of accounting, including loans and other financial instruments, but the effort has been plagued by problems and delays. The two systems have gotten more similar in some areas, but on this banking issue, some analysts say they are growing more different.

    The Financial Accounting Standards Board, the U.S. accounting rule-setter, has proposed U.S. banks switch from the incurred-loss model that both use now to the expected-loss approach, too. But the two disagree on just how rapidly banks should book their loan losses.

    The IASB will require non-U.S. banks to immediately book only those losses based on the probability that a loan will default in the next 12 months. If the loan's quality gets significantly worse, other losses would be recorded in the future. The IASB move will affect all financial assets on non-U.S. companies' balance sheets, but the treatment of bank loans is particularly important due to the role that soured loans and credit losses play in their businesses.

    The change "will enhance investor confidence in banks' balance sheets and the financial system as a whole," said Hans Hoogervorst, chairman of IASB, which sets accounting rules for most countries outside the U.S.

    The Institute of Chartered Accountants in England and Wales, a London-based accountants' group, estimated that the IASB changes will increase banks' loan-loss provisions by about 50% on average. Iain Coke, head of ICAEW's financial-services faculty, said the new rule, combined with tougher regulatory-capital requirements, may force banks to hold more capital for the same risks. "This may make banks safer but may also make them more costly to run," he said.

    The FASB proposal, however, would require all losses expected over the lifetime of a loan to be booked up front—so if it is enacted, U.S. banks would record more losses immediately than banks in other countries, and might have to set aside more reserves, hurting their current financial results and making them look worse compared with foreign banks, many banking and accounting observers believe. The FASB hasn't completed its proposed changes, though it hopes to do so by year-end.

    "It's unfortunate that we do have a different standard being issued," said Tony Clifford, a partner with Big Four accounting firm EY.

    The IASB said in documents laying out its proposal Thursday that although it and the FASB had made "every effort" to agree on the same approach, "ultimately those efforts have been unsuccessful."

    Christine Klimek, a FASB spokeswoman, said the FASB believes its approach "best serves the interests of investors in U.S. capital markets because it better reflects the credit risks of loans on an institution's balance sheet." IASB's approach likely would lead to lower loan-loss reserves than FASB's at U.S. banks, she said, "which would have been counterintuitive to the lessons learned during the recent financial crisis."

    In addition, Mr. Clifford said, the new IASB rule requires banks to use their own judgment to a greater extent than existing rules when determining their expected losses, and that could lead to differences between individual banks that could make it harder for investors to compare them.

    Among other provisions of the new rule the IASB issued Thursday, non-U.S. banks will no longer have to record gains to net income when their own creditworthiness declines, and losses when their creditworthiness improves—a counterintuitive practice known in the U.S. as "debt/debit valuation adjustments," or DVA. Those gains and losses will be stripped out of the banks' net income and be placed into "other comprehensive income," a separate measurement that doesn't affect the main earnings number tracked by most investors. Banks can adopt that change separately, before the rest of the IASB rule.

    The FASB has proposed a similar move for U.S. banks but has yet to enact it.


    "Boards (FASB and IASB) Discuss Constituent Feedback on (Credit) Impairment Proposals," CFO Journal, August 23, 2013 ---
    http://deloitte.wsj.com/cfo/2013/08/23/boards-discuss-constituent-feedback-on-impairment-proposals/

    . . .

    Overview of Feedback

    Constituents disagreed with one another on numerous aspects of the models, including the following:

    Aspects of the proposals on which constituents generally agreed include the following:

    Next Steps

    The FASB and IASB will most likely begin redeliberations in September of this year. Give the disparate feedback and the general preference by constituents of each board for that board’s own model, it is unclear whether the boards can fully converge their respective standards. Final guidance is not expected until 2014. No effective date has been set, but feedback generally indicated that constituents would need at least two to three years to implement a final standard (i.e., if a standard is finalized in 2014, it should be effective no earlier than 2017).


    Teaching Case
    From The Wall Street Journal Accounting Weekly Review on December 6, 2013

    Skepticism on China Nonperforming Loans
    by: Cynthia Koons
    Dec 04, 2013
    Click here to view the full article on WSJ.com
     

    TOPICS: Allowance For Doubtful Accounts, Bad Debts, Banking, Disclosure, Financial Ratios

    SUMMARY: According to reported numbers in their financial statements, Chinese banks' nonperforming loans are only .9% of total bank loans, bested only by Luxembourg at .4% and Canada at .6%. The U.S. rate is 3.9%. Also, "China's economic slowdown has started to hurt industries like shipbuilding, steel and solar power, as well as the more developed east coast...." So Chinese banks' declining price-to-book ratios tell a different story than do the financial statement ratios: "'People are very skeptical about the [non-performing loan] ratios,' said Jim Antos, a banking analyst at Mizuho Securities. 'The market is saying: We just don't trust the credit-quality trends in China.'" The banks roll over troubled loans without disclosing data on the restructured loans. While the banks "need a reason to justify rolling over a loan..there are ways around the hurdle." One Fitch analyst sees high corporate debt burdens as a result of these practices.

    CLASSROOM APPLICATION: The article may be used in an international accounting class, a class covering accounting by banking institutions, or to introduce an interesting analysis of allowances for bad debts.

    QUESTIONS: 
    1. (Advanced) What is a nonperforming loan?

    2. (Advanced) What is the problem with reporting of nonperforming loans by Chinese banks? Include in your answer a definition of the term "troubled debt restructuring."

    3. (Advanced) What is the price-to-book ratio? In general, how does this ratio reflect stock market sentiment about the book value of a business and its growth opportunities not yet shown in its financial statements?

    4. (Introductory) What has been the trend in price-to-book ratios for Chinese banks? According to the article, what does that trend indicate?

    5. (Introductory) How are Chinese banks working with companies who "can demonstrate other banks are willing to provide loans to repay" original bank loans that become troubled?

    6. (Introductory) How has one Fitch Ratings analyst identified information on the extent of problem debt levels in China?

    7. (Advanced) Define the concept of representational faithfulness. Explain how that qualitative characteristic of financial reporting is apparently being violated in published financial statements of Chinese banks.
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Skepticism on China Nonperforming Loans," by Cynthia Koons, The Wall Street Journal, December 4, 2013 ---
    http://online.wsj.com/news/articles/SB10001424052702304355104579235084041750444?mod=djem_jiewr_AC_domainid

    Nonperforming loans account for less than 1% of total loans, a ratio that has been falling in recent years and is now one of the lowest in the world, according to World Bank data. Despite this, price-to-book values of the country's leading banks have been declining over the past few years, reflecting worries about deteriorating credit quality in China.

    "People are very skeptical about the [nonperforming-loan] ratios," said Jim Antos, a banking analyst at Mizuho Securities. "The market is saying: 'We just don't trust the credit-quality trends in China.'"

    The reason China's bad-debt levels are so low boils down to the tendency of the country's banks to routinely extend or restructure loans to borrowers, or sell them, rather than admit they have gone bad and record a loss in their accounts, analysts say. While the tactic is also used in the West and was a major source of concern during the financial crisis, it is increasingly prevalent in China, where lending has been booming over the past five years. In the U.S., bad loans are 3.9% of total loans.

    "There is a culture of rolling things over when they come due at least once, often more," said Charlene Chu, an analyst at Fitch Ratings. In rolling over a loan, a bank can renew the debt or push out the repayment deadline. "In fact, one of the main functions of China's shadow finance system is to provide temporary credit to facilitate rollovers and interest payments," she added.

    China's Yingli Green Energy Holding Co., the world's biggest solar- panel maker by sales, is confident it will be able to roll over its debt with Chinese lenders this year, a spokesman said. There is no suggestion that the company is unable to meet its obligations, but it has recorded losses for more than two years as solar-panel prices have fallen amid a glut. Yingli had $1.2 billion in short-term debt outstanding at the end of September, and rolled over about $1.3 billion of debt that was due in 2012, most of which was owed to Chinese banks, according to filings.

    The country's regulators discourage banks from rolling over troubled loans, in an effort to ensure that asset-quality data accurately reflects reality. But the sheer volume of loans this year indicates much of the debt in the system is being rolled over, according to Ms. Chu. In China's banking system, 9.5 trillion Chinese yuan ($1.6 trillion) of new loans will have been given out this year, even after repayments are taken into account, by Fitch's estimates.

    Fitch predicts that this year, more than 10 trillion yuan of additional credit will be extended through shadow banking, a system of loosely regulated nonbank lenders like trust companies and pawnbrokers. Banks don't disclose data on rolled-over loans.

    Banks need a reason to justify rolling over a loan, particularly if a company can't repay it. But there are ways around the hurdle. "If you can demonstrate other banks are willing to provide the loans to repay yours, then that's a justification for a bank to continue giving a loan," Barclays analyst May Yan said.

    When they do roll over loans, Chinese banks sometimes do it in creative ways. To skirt restrictions on rolling over loans, banks cooperate with informal lenders that provide bank customers with short-term loans with high interest rates. That borrowing is used to repay a bank loan on the understanding that the bank will issue a new loan two or three weeks later. Such behavior can, in some instances, lead to bigger corporate-debt burdens.

    "You look at the data and it just starts to get ridiculous how high some of the debt burdens are and that can't go on into infinity," Fitch's Ms. Chu said. "But over the short term there's nothing to say that this has to end right now and a lot of it comes down to banks' willingness to continue to extend and rollover credit."

    China's economic slowdown has started to hurt industries like shipbuilding, steel and solar power, as well as the more developed east coast, home to cities like Beijing and Shanghai. Nonperforming loans in the first six months of 2013 rose 22% on the east coast from the final six months of 2012, while nonperforming loans in the rest of China declined 5%, according to Bernstein Research.

    Nonperforming loan ratios have fallen from 22.4% in 2000, but bad debts are rising, as Bernstein's numbers indicate. This comes as the government is working to rein in lending: In October, net local-currency loans extended in China totaled $83 billion, down 36% from September and the lowest monthly figure all year.

    Continued in article


    PwC's Appeal to Upgrade the Shameful Valuation Profession Smitten With Non-independence and Unreliability

    Jensen Comment
    Tom Selling repeatedly assumes there is a valuation profession of men and women in white robes and gold halos who can be called upon to reliably and independently valuate such things as troubled loan investments having no deep markets. Bob Jensen argues that the valuation profession is one of the least-independent and least-reliable professions in the world, especially in the USA as evidenced in part by the shameful valuations of mortgage collateral on tens of millions of properties, thereby enabling subprime mortgages that never should have been granted in the first place. Furthermore credit rating agencies that value securities participated wildly in overvaluing poisoned CDO bonds that brought down some of the big investment banks of Wall Street like Bear Sterns, Merrill Lynch, and Lehman Bros.

    In the article below, PwC calls the valuation profession shameful and calls for major upgrades that, while falling short of issuing white robes with gold halos, would go a long way toward improving a rotten profession.

    "PwC Calls for New Approach to Valuations," by Tammy Whitehouse, Compliance Week, November 26, 2013 ---
    http://www.complianceweek.com/pwc-calls-for-new-approach-to-valuations/article/322671/

    The largely unregulated valuation profession could use a shake-up, in the view of some who rely on valuations to achieve regulatory compliance.

    PwC recently published two white papers calling on the valuation profession to up their game in terms of unifying themselves under a single professional framework and improving their standards. The financial reporting world needs greater quality and consistency, the Big 4 firms says, as financial reporting grows increasingly reliant on valuations to help prepare and audit financial statements steeped in fair value measurements. One paper focuses on the need for the valuation profession to unify itself under a single professional infrastructure, while the other addresses the need for better valuation standards.

    The message is consistent with one delivered earlier by Paul Beswick, now chief accountant at the Securities and Exchange Commission. “The fragmented nature of the profession creates an environment where expectation gaps can exist between valuators, management, and auditors, as well as standard setters and regulators,” he said at a 2011 accounting conference. The SEC and the Public Company Accounting Oversight Board both have called on preparers and auditors to pay closer attention to the valuations they are relying on and not simply accept them at face value.

    “Historically, the valuation profession hasn't been front and center in capital markets,” says John Glynn, U.S. valuation services leader for PwC. “The accounting model didn't have as many pieces measured at fair value as we have today. Some of the questions about the professional infrastructure that didn't matter previously have become more apparent.”

    The valuation profession is governed by a number of different professional organizations, PwC says, each with different credentialing and membership requirements and none of them specific to the needs of capital markets. “To maintain its professional standing in an increasingly rigorous environment and promote greater confidence in its work, the valuation profession needs to address questions about the quality, consistency, and reliability of its valuations, particularly those performed for financial reporting purposes,” PwC writes. “A key element to successfully addressing such questions is having a leading global standard setter that issues technical valuation standards governing the performance of valuations for financial reporting purposes.”

    The answer is not necessarily a new regulatory channel, says Glynn. “We need to give the valuation profession a way to build a self-regulatory mechanism,” he says. “One or or more of the professional organizations need to agree to build something that is focused on building a high-quality infrastructure to support the valuation professionals that are working in public capital markets, particularly around financial reporting.” That should include education requirements, accreditations, certifications, as well as professional standards and performance standards developed under a robust system of due process, he says. The International Valuations Standards Council is showing potential to become a leader in driving the profession to a unified, global valuation approach, Glynn says.


    Hi Pat,

    Tom Selling writes that:


    It has been my position throughout that the FASB has come to realize that their own individual interests, as opposed to the public interest, requires that any changes they make to GAAP must be acceptable to Wall Street and the bankers.

    . . .

    At this point, the object of the exercise should be painfully obvious.  Compared to current values, even the best possible version of amortized cost accounting that bankers could use to save their hides (a la Mr. Shabudin), or feather their nests (a la the bankers who remain at large) is nothing more than a straw man.

    More at
    http://accountingonion.com/2013/09/hank-paulson-says-another-financial-crisis-is-inevitable-the-fasb-is-working-to-prove-him-right.html

    What Tom does not point out the inconsistency of the above argument in light of the fact that the bankers are lobbying against the amortized cost accounting change in the three-bucket fair value standard for loan losses, the fair value standard that's served them so well in managing their earnings since fair value of unique troubled loans often have no value in the market or a fire-sale value that's inappropriate.

    It's not surprising industry is lobbying against the proposed credit loss and loan loss (bad debts) accounting model proposed by the FASB that will beef up bad debt reserves ---
    http://www.elfaonline.org/issues/accounting/pdfs/ELFACreditLossesCommentLtr.pdf

    I would contend that he should be taking on the IASB more than the FASB. The IASB has proven that when it comes to recognizing losses on debt like Greek Bonds, the IASB is allowing European bankers and EU lawmakers to dictate accounting standards for loan impairments.


    Question
    Why do banks hate the new loan loss (bad debt estimation) model proposed by the FASB in place of the prior fair value estimation model?

    "U.S. banks push back on change in loan loss accounting," by Dena Aubin, Fox Business, May 13, 2013 ---
    http://www.foxbusiness.com/news/2013/05/13/us-banks-push-back-on-change-in-loan-loss-accounting/ 

    More than a dozen of the biggest U.S. banks have questioned a proposed accounting change meant to boost reserves for risky loans, saying the results would be vastly different from those of a similar rule being developed by global standard-setters.

    A key reform arising out of the 2007-08 global financial crisis, the proposal would require banks to look ahead and reserve for expected losses on the day a loan is made.

    Currently, banks do not have to reserve for risky loans until there are signs of a loss.

    Reserves were criticized as being "too little, too late" during the global crisis, when major banks were buffeted by defaults on loans and other debt. Many had to be bailed out because they had not set aside enough for losses.

    Numerous banking regulators have called for more timely reserves, though critics have also warned that proposed accounting changes would make quarterly earnings more volatile as banks adjust their expectations for losses.

    In a letter to accounting rule-makers, banks suggested that trying to predict losses too far ahead would be unreliable.

    Banks signing the letter included Bank of America Corp, Citigroup Inc, JPMorgan Chase & Co and Morgan Stanley. Spokesmen for the banks either declined to comment or did not respond to requests for comment.

    The letter, dated May 10, was addressed to the Connecticut-based Financial Accounting Standards Board, which sets U.S. accounting standards, and the London-based International Accounting Standards Board, which sets international rules.

    FASB is seeking comment on its proposal through May 31, and its details may change. Analysts said it would likely not be effective before 2015. A separate rule on loan losses was proposed by the IASB in March.

    50 PCT JUMP IN RESERVES POSSIBLE

    The letter intensified pressure on the two boards to align their rules. U.S. companies use FASB's generally accepted accounting principles, or GAAP. Much of the rest of the world uses IASB's international financial reporting standards (IFRS).

    The two boards have been working for over a decade to merge their standards. Financial accounting has been a key focus since the global crisis, but the boards parted ways on loan loss accounting last year.

    "Relative to the IASB's proposal, the FASB's proposal would generally require entities to recognize allowances for credit losses sooner and in larger amounts," said Bruce Pounder, director of professional programs at Loscalzo Associates, a Shrewsbury, New Jersey-based accounting education company.

    The balance sheets of U.S. banks could look significantly worse than that of banks using international standards, even in identical economic conditions, he said.

    Continued in article

    Will bad loans look worse under U.S. GAAP versus IFRS?
    How Bad is a Bad Bank Loan:  Rule Split to Put U.S. Banks at a Loss

    From the CFO Morning Ledger on February 28, 2013

    How bad is a bad bank loan?
    Accounting regulators in the U.S. and Europe disagree on the standards for how banks book loan losses, and their rift could lead to tens of billions of dollars being carved off U.S. lenders’ current profits, writes the WSJ’s Michael Rapaport. The FASB and the IASB have separate proposals in the works that would require banks to record losses on soured loans earlier than they do now. But the U.S. proposal goes a step further and would force American banks to accelerate even more losses more quickly than foreign banks would. If U.S. and overseas banks end up using different models for booking losses, that could create an apples-to-oranges situation that would make it more difficult for investors to tell how they stack up against one another
    .

    "Rule Split to Put U.S. Banks at a Loss," by Michael Rapoport, The Wall Street Journal, February 27, 2013 --- Click Here
    http://professional.wsj.com/article/SB10001424127887323293704578330490452665994.html?mod=ITP_moneyandinvesting_0&mg=reno64-wsj

    How bad is a bad bank loan? Accounting regulators in the U.S. and Europe disagree, and their rift could lead to tens of billions of dollars being carved off U.S. lenders' current profits.

    American and global rule makers have separate proposals in the works that would require banks to record losses on soured loans earlier than they do now. The plans aim to give investors a more accurate picture of banks' health, after many critics felt banks, both in the U.S. and abroad, took losses too slowly during the financial crisis.

    But the U.S. proposal goes a step further: In a split with their overseas counterparts, U.S. rule makers would force American banks to accelerate even more losses more quickly than foreign banks would.

    That could severely crimp current results for U.S. banks, some observers believe—an example of how a host of regulatory actions on both sides of the Atlantic may cause disparities. It also could hurt how investors perceive the health and performance of U.S. banks versus their competitors.

    "If overseas banks don't have to record losses as early as U.S. banks, I think that puts [the U.S. banks] at a disadvantage," said Patrick Dolan, a finance and securitization attorney with Dechert LLP.

    The gap between the two proposals is "a big difference," said Donna Fisher, a senior vice president at the American Bankers Association. Banks "all agreed globally that we want one standard" for booking losses, she said.

    If U.S. and overseas banks end up using different models for booking losses, that could create an apples-to-oranges situation that would make it more difficult for investors to tell how they stack up against one another.

    "They will be harder to compare than they are at present," said Peter Elwin, head of European pensions, valuation and accounting research for J.P. Morgan JPM +3.41% Cazenove, part of J.P. Morgan Chase & Co.

    The changes aren't imminent. The plans from both the U.S.'s Financial Accounting Standards Board and International Accounting Standards Board, its London-based global counterpart, are still in the early stages: The IASB proposal hasn't even been formally issued yet, and both boards will listen to public comment on their plans before making a final decision. No changes are expected to take effect before 2015.

    But FASB has suggested that some large U.S. banks might have to increase bad-loan reserves by 50% in some areas of their business. U.S. industry-wide reserves were $162 billion at the end of 2012, according to the Federal Deposit Insurance Corp. Currently, banks wait to record loan losses until there is evidence that losses have actually occurred.

    During the financial crisis, net loan charge-offs booked by U.S. banks didn't peak until late 2009, according to FDIC data, more than a year after the heart of the crisis.

    That left banks carrying huge piles of bad loans even after it was apparent they were souring in droves, making the banks appear healthier to investors than they really were and delaying the banks' reckoning with the crisis's impact.

    Banks charged off $189 billion in bad loans in 2009 and $187 billion in 2010, according to the FDIC—much of which arguably should have been charged off earlier. (Charge-offs were $100 billion in 2008 and only $44 billion in 2007.)

    Both FASB and IASB now want to change that system, so that projections of future losses would be the standard for booking loan losses. That is expected to speed up recognition of bad loans.

    Until last summer, the two panels also had agreed on the details of how and when to book the losses: Largely, only those losses based on events expected over the following 12 months would be booked upfront. But FASB pulled away from that method, saying that it had heard concerns from some banks, investors and regulators that it was too complex.

    Now, the FASB proposal, issued in December, calls for all losses banks expect over the life of a loan to be booked upfront. If that expectation changes, so will the recorded amount of losses.

    Continued in article

    Bob Jensen's threads on fair value accounting and bad debts ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValueFails

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

     


    Multi-Column Earnings and OCI reporting

    "New Black Box Metrics Challenge Accountants' Creativity and Investor Intelligence," by Anthony H. Catanach Jr., Grumpy Old Accountants Blog, February 15, 2013 ---
    http://grumpyoldaccountants.com/blog/2013/2/15/new-black-box-metrics-challenge-accountants-creativity-and-investor-intelligence

    According to Merriam Webster, a black box is broadly defined as “anything that has mysterious or unknown internal functions or mechanisms.”  How appropriate that Jonathan Weil called our attention to an “unconventional profitability metric” used by Black Box (the Company) to report third quarter performance in its January 29th press release (Form 8-K, Exhibit 99.1).   As usual, Jon got right to the point, and suggested that using the term “adjusted Ebitda (as adjusted)” was just another ploy to make “earnings look better.”  While I generally agree with Jon’s conclusion, I am particularly stunned by the lack of creativity exhibited by the Company’s accountants in naming their performance metrics.  After all, even a bean counter should be able to come up with something better.  As a grumpy old accountant, I'd recommend using Lynn Turner’s “everything but bad stuffEBS title (coined over a decade ago)…now that might have been more appropriate!  But why did Black Box’s accountants just give up?  Well, after a bit of digging, I think I know why.  I also discovered that this was just one of five non-GAAP measures used by the Company in its press release, but not in its current 10-Q or 10-K.  And finally, Black Box omitted a very important income statement disclosure in its press release that was included in its 10-Q and prior year 10-K.  All of this raises questions about the transparency of the Company’s most recent financial disclosures, and what is prompting the recent move to non-GAAP metrics.

    But first, even though I have little or no respect for most performance based non-GAAP metrics, I must confess that Black Box’s “unconventional profitability metric” appears to comply with the policies of the U.S. Securities and Exchange Commission (SEC). The SEC outlines its rules for such measures in its Final Rule on Non-GAAP Financial Measures, as well as its Compliance and Disclosure Interpretations on Non-GAAP Financial Measures.  In fact, the Company’s cumbersome EBITDA moniker is likely due to SEC guidance to use the word “adjusted” when reconciling net income to a non-standard definition of EBITDA.  However, Black Box adopted two separate non-GAAP EBITDA metrics: EBITDA as adjusted and the hilarious “adjusted EBITDA (as adjusted)” term, the two of which differed only by stock compensation expense.  The table below shows how these two non-GAAP measures relate to each other, as well as to the more traditional notion of EBITDA.  The first column reflects income statement data for the Company’s nine months of operations for the current fiscal year (3QYTD13) as reported in the January 29th press release (8-K, Exhibit 99.1, page 10), while the other three columns reflect related P&L data from prior Company 10-K’s.

    . . .

    In summary, the Company’s “adjusted Ebitda (as adjusted)” metric appears to be the tip of a financial reporting iceberg. Instead of improving financial reporting transparency, Black Box may really be a Pandora’s Box of non-GAAP metrics that obfuscate “true” performance.

    Continued in article

    This is remotely related to OCI reporting where earnings are adjusted for non-recurrent and unrealized value changes.

     

    From PwC on February 5, 2013
    Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income
    On February 5, 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This guidance is the culmination of the board's redeliberation on reporting reclassification adjustments from accumulated other comprehensive income. The new requirements will take effect for public companies in interim and annual reporting periods beginning after December 15, 2012 (the first quarter of 2013 for public, calendar-year companies).
    http://www.pwc.com/en_US/us/cfodirect/assets/pdf/in-brief/in-brief-2013-05-fasb-other-comprehensive-income.pdf

     

    "Academic Research and Standard-Setting: The Case of Other Comprehensive Income," by Lynn L. Rees and Philip B. Shane, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 789-815. ---
    http://aaajournals.org/doi/full/10.2308/acch-50237 

    This paper links academic accounting research on comprehensive income reporting with the accounting standard-setting efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). We begin by discussing the development of reporting other comprehensive income, and we identify a significant weakness in the FASB's Conceptual Framework, in the lack of a cohesive definition of any subcategory of comprehensive income, including earnings. We identify several attributes that could help allocate comprehensive income between net income, other comprehensive income, and other subcategories. We then review academic research related to remaining standard-setting issues, and identify gaps in academic research where hypotheses could be developed and tested. Our objectives are to (1) stimulate standard-setters to better conceptualize what is meant by other comprehensive income and to distinguish it from earnings, and (2) stimulate researchers to develop and test hypotheses that might help in that process.

    . . .

    Potential Alternative Definitions of Earnings

    Table 1 summarizes and categorizes various standard-setting issues related to reporting comprehensive income, and provides the organizing structure for our literature review later in the paper. The most important of these issues is the definition of earnings, or what makes up earnings and how it is distinguished from OCI. This is a “cross-cutting” issue because it arises when the Boards deliberate on various topics. The Boards cooperatively initiated the financial statement presentation project intending, in part, to solve the comprehensive income composition problem, but the project was subsequently delayed.

    Table 2 presents a list of the specific comprehensive income components under current U.S. GAAP that require recognition as OCI. The second column presents the statement that provided financial reporting guidance for the OCI component, along with its effective date. The effective dates provide an indication as to how the OCI components have expanded over time. Since the issuance of Statement No. 130, which established formal reporting of OCI, new OCI-expanding requirements were promulgated in Statement No. 133. Financial instruments, insurance, and leases are three examples of topics currently on the FASB's agenda where OCI has been discussed as an option to report various gains and losses. In all these discussions, a framework is lacking that can guide standard-setter decisions. The increased use of accumulated OCI to capture various changes in net assets and the likely expansion of OCI items reinforce the notion that standard-setters must eventually come to grips with the distinction between OCI and earnings, or even whether the practice of reporting OCI with recycling should be retained.7

    Presumably, elements with similar informational attributes should be classified together in financial statements. It is unclear what attributes the items listed in Table 2 possess that result in their being characterized differently from other components of income. Notably, the basis for conclusions of the FASB standards gives little to no economic reasoning for the decision to place these items in OCI. While not exhaustive, Table 2 presents four attributes that standard-setters could potentially use to distinguish between earnings and OCI: (1) the degree of persistence of the item, (2) whether the item results from a firm's core operations, (3) whether the item represents a change in net assets that is reasonably within management's control, and (4) whether the item results from remeasurement of an asset/liability. We discuss in turn the merits and potential problems of using these attributes to form a reporting framework for comprehensive income.

    Degree of Persistence.

    The degree of persistence of various comprehensive income components has significant implications for firm value (e.g., Friedman 1957; Kormendi and Lipe 1987; Collins and Kothari 1989). Ohlson's (1995, 1999) valuation model places a heavy emphasis on earnings persistence, which suggests that a reporting format that facilitates identifying the level of persistence across income components could be useful to investors. Examples abound as to how the concept of income persistence has been used in standard-setting, including separate presentation in the income statement for one-time items, extraordinary items, and discontinued operations. Standard-setters have justified several footnote disclosures (segmental disclosures) and disaggregation requirements (e.g., components of pension expense) on the basis of providing information to financial statement users about the persistence of various income statement components.

    Thus, the persistence of revenue and expense items potentially could serve as a distinguishing characteristic of earnings and OCI. Table 2 shows that we regard all the items currently recognized in OCI as having relatively low persistence. However, several other low-persistence items are not recognized in OCI; for example, gains/losses on sale of assets, impairments of assets, restructuring charges, and gains/losses from litigation. To be consistent with this definition of OCI, the current paradigm must change significantly, and the resulting total for OCI would look substantially different from what it is now.

    Using persistence of an item to distinguish earnings from OCI would create significant problems for standard-setters. Persistence can range from completely transitory (zero persistence) to permanent (100 percent persistence). At what point along this range is an item persistent enough to be recorded in earnings? While restructuring charges are typically considered as having low persistence, if they occur every two to three years, is this frequent enough to be classified with other earnings components or infrequent enough to be classified with OCI? Furthermore, the relative persistence of an item likely varies across industries, and even across firms.

    In spite of these inherent difficulties, standard-setters could establish criteria related to persistence that they might use to ultimately determine the classification of particular items. In addition, standard-setters would not be restricted to classifying income components in one of two categories. As an example, highly persistent components could be classified as part of “recurring earnings,” medium-persistence items could go to “other earnings,” and low-persistence items to OCI (or some other nomenclature). Standard-setters could create additional partitions as needed.

    Core Operations.

    Classifying income components as earnings or OCI based on whether they are part of a firm's core operations is intuitively appealing. This criterion is related to income persistence, as we would expect core earnings to be more persistent than noncore income items. Furthermore, classifying income based on whether it is part of core operations has a long history in accounting.

    In current practice, companies and investors place primary importance on some variant of earnings. However, it is not clear which variant of earnings is superior. Many companies report pro forma net income, which presumably provides investors with a more representative measure of the company's core income, but definitions of pro forma earnings vary across firms. Similarly, analysts tend to forecast a company's core earnings (Gu and Chen 2004). Evidence in prior research indicates that pro forma earnings and actual earnings forecasted by analysts are more closely associated with share prices than income from continuing operations based on current U.S. GAAP (e.g., Bradshaw and Sloan 2002; Bhattacharya et al. 2003).

    The problems inherent with this attribute are similar to those of the earnings-persistence criterion. No generally accepted definition of core operations exists. At what point along a continuum does an activity become part of the core operations of a business? As Table 2 indicates, classifying gains/losses from holding available-for-sale securities as part of core earnings depends on whether the firm operates in the financial sector. Different operating environments across firms and industries could make it difficult for standard-setters to determine whether an item belongs in core earnings or OCI.8 In addition, differences in application across firms may give rise to concerns about comparability and potential for abuse on the part of managers in exercising their discretion (e.g., Barth et al. 2011).

    The FASB's (2010) Staff Draft on Financial Statement Presentation tries to address the definitional issue by using interrelationships and synergies between assets and liabilities as a criterion to distinguish operating (or core) activities from investing (or noncore) activities. Specifically, the Staff Draft states:

    An entity shall classify in the operating category:

    Assets that are used as part of the entity's day-to-day business and all changes in those assets Liabilities that arise from the entity's day-to-day business and all changes in those liabilities.

    Operating activities generate revenue through a process that requires the interrelated use of the entity's resources. An asset or a liability that an entity uses to generate a return and any change in that asset or liability shall be classified in the investing category. No significant synergies are created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity. An asset or a liability classified in the investing category may yield a return for the entity in the form of, for example, interest, dividends, royalties, equity income, gains, or losses. (FASB 2010, paras. 72, 73, 81)

    The above distinction between operating activities and investing activities could similarly be used to distinguish between core activities and noncore activities. Alternatively, standard-setters might develop other definitions. Similar to the degree of persistence attribute, standard-setters would not be restricted to a simple core versus noncore dichotomy when using this definition.

    Another possible solution is to allow management to determine which items belong in core earnings. Companies exercise this discretion today when they choose to disclose pro forma earnings. Furthermore, the FASB established the precedent of the “management approach” when it allowed management to determine how to report segment disclosures. In several other areas of U.S. GAAP, management is responsible for establishing boundaries that define its operating environment. FASB Accounting Standards Codification Topic 320 (formerly Statement 115) permits different measurements for identical investments based on management's intent to sell or hold the instrument. Other examples where U.S. GAAP allows for management discretion include determining the rate to discount pension liabilities, defining reporting units, and determining whether an impairment is other than temporary. However, the management approach accentuates the concern about comparability and potential for abuse.

    Management Control.

    Given a premise that evaluating management's stewardship is a primary role of financial statements, a possible rationale for excluding certain items from earnings is that they do not provide a good measure to evaluate management.9 Management can largely control the firm's operating costs and can influence the level of revenues generated. However, some decisions that affect comprehensive income can be established by company policy or the company mission statement and, thus, be outside the control of management. For example, a company policy might be to invest excess cash in marketable securities with the objective of maximizing returns. Once the board of directors establishes this policy, management has little influence over how market-wide fluctuations in security prices affect earnings, and hedging the gains/losses would be inconsistent with the objective of maximizing returns. Similarly, a company's mission statement might include expansion overseas, or prior management might have already decided to establish a foreign subsidiary. The resulting gains/losses from foreign currency fluctuations would seemingly be out of management's control, and hedging these gains/losses would not make economic sense if the subsidiary's functional currency is its local currency and the parent has no intention of repatriating the subsidiary's cash flows.

    Of course, determining what is and is not ostensibly under management's control becomes highly subjective and would probably differ across industries, and perhaps even across firms within industries. For example, gains/losses from investment holdings might not be relevant in evaluating management of some companies, but might be very relevant for managers of holding companies. In addition, the time horizon affects what is under management's control. That is, as the time horizon lengthens, more things are under management's control.

    In Table 2, we classify items as not under management's control if they are based on fluctuations in stock prices or exchange rates, which academic research shows to be largely random within efficient markets. Using this classification model, most, but not all, of the OCI items listed in Table 2 are classified as not under the management's control. Some of the pension items currently recognized in OCI are within the control of management, because management controls the decision to revise a pension plan. While management has control over when to harvest gains/losses on available-for-sale (AFS) securities by deciding when to sell the securities, it cannot control market prices. Thus, under this criterion, unrealized gains/losses on AFS securities are appropriately recognized in OCI. However, gains/losses on trading securities and the effects of tax rate changes are beyond management's control, and yet, these items are currently included as part of earnings. Thus, “management control” does not distinguish what is and is not included in earnings under current U.S. GAAP.

    Remeasurements.

    Barker (2004) explains how the measurement and presentation of comprehensive income might rely on remeasurements. The FASB's (2010) Staff Draft on Financial Statement Presentation defines remeasurements as follows:

    A remeasurement is an amount recognized in comprehensive income that increases or decreases the net carrying amount of an asset or a liability and that is the result of:

    A change in (or realization of) a current price or value A change in an estimate of a current price or value or A change in any estimate or method used to measure the carrying amount of an asset or a liability. (FASB 2010, para. 234)

    Using this definition, examples of remeasurements are impairments of land, unrealized gains/losses due to fair value changes in securities, income tax expenses due to changes in statutory tax rates, and unexpected gains/losses from holding pension assets. All of these items represent a change in carrying value of an already existing asset or liability due to changes in prices or estimates (land, investments, deferred tax asset/liability, and pension asset/liability, respectively).

    Table 3 reproduces a table from Barker (2004) that illustrates how a firm's income statement might look using a “matrix format” if standard-setters adopt the remeasurement approach to reporting comprehensive income. Note that the presentation in Table 3 does not employ earnings as a subtotal of comprehensive income; however, the approach could be modified to define earnings as the sum of all items before remeasurements, if considered useful. Tarca et al. (2008) conduct an experiment with analysts, accountants, and M.B.A. students to assess whether the matrix income statement format in Table 3 facilitates or hinders users' ability to extract information. They find evidence suggesting that the matrix format facilitates more accurate information extraction for users across all sophistication levels relative to a typical format based on IAS 1.

     

    Table 3:  Illustration of Matrix Reporting Format

     

    Employing remeasurements to distinguish between earnings and other comprehensive income largely incorporates the criterion of earnings persistence. Most remeasurements result from price changes, where the current change has little or no association with future changes and, therefore, these components of income are transitory. In contrast, earnings components before remeasurements generally represent items that are likely more persistent.

    Perhaps the most significant advantage of the remeasurement criterion is that it is less subjective than the other criteria previously discussed. Most of the other criteria in Table 2 are continuous in nature. Drawing a bright line to differentiate what belongs in earnings from what belongs in OCI is challenging and will likely be susceptible to income manipulation. In contrast, determining whether a component of income arises from a remeasurement is more straightforward.

    Yet another advantage of this approach is it allows for a full fair value balance sheet that clearly discloses the effects of fair value measurement on periodic comprehensive income, while also showing earnings effects under a modified historical cost system (i.e., before remeasurements). This approach could potentially provide better information about probable future cash flows.

    Other.

    The attributes standard-setters could use to classify income components into earnings or OCI are not limited to the list in Table 2. Ketz (1999) suggests using the level of measurement uncertainty. As an example, gains/losses from Level 1 fair value measurements might be viewed as sufficiently certain to include in earnings, while Level 3 fair value measurements might generate gains/losses that belong in OCI. Song et al. (2010) provide some support for this partition in that they document the value relevance of Level 1 and Level 2 fair values exceeds the value relevance of Level 3 fair values.

    Another potential attribute might be the horizon over which unrealized gains/losses are ultimately realized. That is, unrealized gains/losses from foreign currency fluctuations, term life insurance contracts, or holding pension assets that will not be realized for many years in the future might be disclosed as part of OCI, whereas unrealized gains/losses from trading and available-for-sale securities could be part of earnings.

    As previously discussed, the attributes of measurement uncertainty and timeliness create similar problems in determining where to draw the line. Which items are sufficiently reliable (or timely) to include in earnings, and will differences in implementation across firms and industries impair comparability?

    The overriding purpose of the discussion in this subsection is to point out that several alternative attributes could potentially guide standard-setters in establishing criteria to differentiate earnings from OCI. Ultimately, the choice regarding whether/how to distinguish net income from OCI is a matter of policy. However, academic research can inform policy decisions, as described in the fourth and fifth sections.

    Summary

    Reporting OCI is a relatively recent phenomenon that presumes financial statement users are provided with better information when specific comprehensive income components are excluded from earnings-per-share (EPS), and recycled back into net income only after the occurrence of a specified transaction or event. The number of income components included in OCI has increased over time, and this expansion is likely to continue as standard-setters address new agenda items (e.g., financial instruments and insurance contracts). The lack of a clear definitional distinction between earnings and OCI in the FASB/IASB Conceptual Frameworks has led to: (1) ad hoc decisions on the income components classified in OCI, and (2) no conceptual basis for deciding whether OCI should be excluded from earnings-per-share (EPS) in the current period or recycled through EPS in subsequent periods. In this section, we discussed alternative criteria that standard-setters could use to distinguish earnings from OCI, along with the advantages and challenges of each criterion. Further, due to the inherent difficulties in drawing bright lines between earnings that are persistent versus transitory, core versus noncore, under management control or not, and amenable to remeasurement or not, standard-setters might consider eliminating OCI; that is, they might decide to adopt an all-inclusive income statement approach, where comprehensive income is reporte

    . . .

    Continued in article

    Jensen Comment
    I like this paper. Table 3 could be improved by adding bottom line net earnings before and after remeasurement.

    The paper does not provide all the answers, but it is well written in terms of history up to this point in time and alternative directions for consideration.


    No Bottom Line

    Question
    Is a major overhaul of accounting standards on the way?
    Hint
    There may no longer be the tried and untrusted earnings per share number to report!
    Comment
    It would be interesting to see a documentation of the academic research, if any, that the FASB relied upon to commence this blockbuster initiative. I recommend that some astute researcher commence to probe into the thinking behind this proposal.

    "Profit as We Know It Could Be Lost With New Accounting Statements," by David Reilly, The Wall Street Journal, May 12, 2007; Page A1 --- http://online.wsj.com/article/SB117893520139500814.html?mod=DAT

    Pretty soon the bottom line may not be, well, the bottom line.

    In coming months, accounting-rule makers are planning to unveil a draft plan to rework financial statements, the bedrock data that millions of investors use every day when deciding whether to buy or sell stocks, bonds and other financial instruments. One possible result: the elimination of what today is known as net income or net profit, the bottom-line figure showing what is left after expenses have been met and taxes paid.

    It is the item many investors look to as a key gauge of corporate performance and one measure used to determine executive compensation. In its place, investors might find a number of profit figures that correspond to different corporate activities such as business operations, financing and investing.

    Another possible radical change in the works: assets and liabilities may no longer be separate categories on the balance sheet, or fall to the left and right side in the classic format taught in introductory accounting classes.

    ACCOUNTING OVERHAUL

    Get a glimpse of what new financial statements could look like, according to an early draft recently provided by the Financial Accounting Standards Board to one of its advisory groups. The overhaul could mark one of the most drastic changes to accounting and financial reporting since the start of the Industrial Revolution in the 19th century, when companies began publishing financial information as they sought outside capital. The move is being undertaken by accounting-rule makers in the U.S. and internationally, and ultimately could affect companies and investors around the world.

    The project is aimed at providing investors with more telling information and has come about as rule makers work to one day come up with a common, global set of accounting standards. If adopted, the changes will likely force every accounting textbook to be rewritten and anyone who uses accounting -- from clerks to chief executives -- to relearn how to compile and analyze information that shows what is happening in a business.

    This is likely to come as a shock, even if many investors and executives acknowledge that net income has flaws. "If there was no bottom line, I'd want to have a sense of what other indicators I ought to be looking at to get a sense of the comprehensive health of the company," says Katrina Presti, a part-time independent health-care contractor and stay-at-home mom who is part of a 12-woman investment club in Pueblo, Colo. "Net income might be a false indicator, but what would I look at if it goes away?"

    The effort to redo financial statements reflects changes in who uses them and for what purposes. Financial statements were originally crafted with bankers and lenders in mind. Their biggest question: Is the business solvent and what's left if it fails? Stock investors care more about a business's current and future profits, so the net-income line takes on added significance for them.

    Indeed, that single profit number, particularly when it is divided by the number of shares outstanding, provides the most popular measure of a company's valuation: the price-to-earnings ratio. A company that trades at $10 a share, and which has net profit of $1 a share, has a P/E of 10.

    But giving that much power to one number has long been a recipe for fraud and stock-market excesses. Many major accounting scandals earlier this decade centered on manipulation of net income. The stock-market bubble of the 1990s was largely based on investors' assumption that net profit for stocks would grow rapidly for years to come. And the game of beating a quarterly earnings number became a distraction or worse for companies' managers and investors. Obviously it isn't known whether the new format would cut down on attempts to game the numbers, but companies would have to give a more detailed breakdown of what is going on.

    The goal of the accounting-rule makers is to better reflect how businesses are actually run and divert attention from the one number. "I know the world likes single bottom-line numbers and all of that, but complicated businesses are hard to translate into just one number," says Robert Herz, chairman of the Financial Accounting Standards Board, the U.S. rule-making body that is one of several groups working on the changes.

    At the same time, public companies today are more global than local, and as likely to be involved in services or lines of business that involve intellectual property such as software rather than the plants and equipment that defined the manufacturing age. "The income statement today looks a lot like it did when I started out in this profession," says William Parrett, the retiring CEO of accounting firm Deloitte Touche Tohmatsu, who started as a junior accountant in 1967. "But the kind of information that goes into it is completely different."

    Along the way, figures such as net income have become muddied. That is in part because more and more of the items used to calculate net profit are based on management estimates, such as the value of items that don't trade in active markets and the direction of interest rates. Also, over the years rule makers agreed to corporate demands to account for some things, such as day-to-day changes in the value of pension plans or financial instruments used to protect against changes in interest rates, in ways that keep them from causing swings in net income.

    Rule makers hope reformatting financial statements will address some of these issues, while giving investors more information about what is happening in different parts of a business to better assess its value. The project is being managed jointly by the FASB in the U.S. and the London-based International Accounting Standards Board, and involves accounting bodies in Japan, other parts of Asia and individual European nations.

    The entire process of adopting the revised approach could take a few years to play out, so much could yet change. Plus, once rule makers adopt the changes, they would have to be ratified by regulatory authorities, such as the Securities and Exchange Commission in the U.S. and the European Commission in Europe, before public companies would be required to follow them.

    As a first step, rule makers expect later this year to publish a document outlining their preliminary views on what new form financial statements might take. But already they have given hints of what's in store. In March, the FASB provided draft, new financial statements at the end of a 32-page handout for members of an advisory group. (See an example.)

    Although likely to change, this preview showed an income statement that has separate segments for the company's operating business, its financing activities, investing activities and tax payments. Each area has an income subtotal for that particular segment.

    There is also a "total comprehensive income" category that is wider ranging than net profit as it is known today, and so wouldn't be directly comparable. That is because this total would likely include gains and losses now kept in other parts of the financial statements. These include some currency fluctuations and changes in the value of financial instruments used to hedge against other items.

    Comprehensive income could also eventually include short-term changes in the value of corporate pension plans, which currently are smoothed out over a number of years. As a result, comprehensive income could be a lot more difficult to predict and could be volatile from quarter to quarter or year to year.

    As for the balance sheet, the new version would group assets and liabilities together according to similar categories of operating, investing and financing activities, although it does provide a section for shareholders equity. Currently, a balance sheet is broken down between assets and liabilities, rather than by operating categories.

    Such drastic change isn't likely to happen without a fight. Efforts to bring now-excluded figures into the income statement could prompt battles with companies that fear their profit will be subject to big swings. Companies may also balk at the expense involved.

    "The cost of this change could be monumental," says Gary John Previts, an accounting professor at Case Western Reserve University in Cleveland. "All the textbooks are going to have to change, every contract and every bank arrangement will have to change." Investors in Europe and Asia, meanwhile, have opposed the idea of dropping net profit as it appears today, David Tweedie, the IASB's chairman, said in an interview earlier this year.

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

    Such opposition doesn't surprise many accounting experts. Net income is "the basis for bonuses and judgments about what a company's stock is worth," says Stephen A. Zeff, an accounting professor at Rice University. "I just don't know what the markets would do if companies stopped reporting a bottom line somewhere." In the U.S., professional investors and analysts have taken a more nuanced view, perhaps because the manipulation of numbers was more pronounced in U.S. markets.

    That said, net profit has been around for some time. The income statement in use today, along with the balance sheet, generally dates to the 1940s when the SEC laid out regulations on financial disclosure. But many companies have included net profit in one form or another since the 1800s.

    In its fourth annual report, General Electric Co. provided investors with a consolidated balance sheet and consolidated profit-and-loss account for the year ended Jan. 31, 1896. The company, whose board at the time included Thomas Edison, generated "profit of the year" -- what today would be called net income or net profit -- of $1,388,967.46.

    For the moment, net profit will probably exist in some form, although its days are likely numbered. "We've decided in the interim to keep a net-income subtotal, but that's all up for discussion," the FASB's Mr. Herz says.

     


    Question
    What do CFO's think of Robert Herz's (Chairman of the FASB) radical proposed  format for financial statements that have more disaggregated financial information and no aggregated bottom line?

    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Before reading the article below you may want to first read about radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    "A New Vision for Accounting:  Robert Herz and FASB are preparing a radical new format for financial, CFO Magazine, by Alix Stuart, February 2008, pp. 49-53 --- http://www.cfo.com/article.cfm/10597001/c_10711055?f=home_todayinfinance

    Last summer, McCormick & Co. controller Ken Kelly sliced and diced his financial statements in ways he had never before imagined. For starters, he split the income statement for the $2.7 billion international spice-and-food company into the three categories of the cash-flow statement: operating, financing, and investing. He extracted discontinued operations and income taxes and placed them in separate categories, instead of peppering them throughout the other results. He created a new form to distinguish which changes in income were due to fair value and which to cash. One traditional ingredient, meanwhile, was conspicuous by its absence: net income.

    Kelly wasn't just indulging a whim. Ahead of a public release of a draft of the Financial Accounting Standards Board's new format for financial statements in the second quarter of 2008, the McCormick controller was trying out the financial statements of the future, a radical departure from current conventions. FASB's so-called financial statement presentation project is ostensibly concerned only with the form, or the "face," of financial statements, but it's quickly becoming clear that it will change and expand their content as well. "This is a complete redefinition of the financial statements as we know them," says John Hepp, a former FASB project manager and now senior manager at Grant Thornton.

    Some of the major changes under discussion: reconfiguring the balance sheet and the income statement to follow the three categories of the cash-flow statement, requiring companies to report cash flows with the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value changes. Companies will also likely have to report more about their segments, possibly down to the same level of detail as they currently report for the consolidated statements. Meanwhile, net income is slated to disappear completely from GAAP financial statements, with no obvious replacement for such commonly used metrics as earnings per share.

    FASB, working with the International Accounting Standards Board (IASB) and accounting standards boards in the United Kingdom and Japan, continues to work out the precise details of the new financial statements. "We are trying to set the stage for what financial statements will look like across the globe for decades to come," says FASB chairman Robert Herz. (Examples of the proposed new financial statements can be viewed at FASB's Website.) If the standard-setters stay their course, CFOs and controllers at every publicly traded company in the world could be following Kelly's lead as soon as 2010.

    It's too early to predict with confidence which changes will ultimately stick. But the mock-up exercise has made Kelly wary. He considers the direct cash-flow statement and reconciliation schedule among the "worst aspects" of the forthcoming proposal, and expects they would require "draconian exercises" from his finance staff, he says. And he questions what would result from the additional details: "If all of a sudden your income statement has 125 lines instead of 25, is that presentation more clarifying, or more confusing?"

    Other financial executives share Kelly's skepticism. In a December CFO survey of more than 200 finance executives, only 17 percent said the changes would offer any benefits to their companies or investors (see "Keep the Bottom Line" at the end of this article). Even some who endorsed the basic aim of the project and like the idea of standardizing categories across the three major financial statements were only cautiously optimistic. "It may be OK, or it may be excessive." says David Rickard, CFO of CVS/Caremark. "The devil will be in the details."

    Net Loss From the outset, corporate financial officers have been ambivalent about FASB's seven year-old project, which was originally launched to address concerns that net income was losing relevance amid a proliferation of pro forma numbers. Back in 2001, Financial Executives International "strongly opposed" it, while executives at Philip Morris, Exxon Mobil, Sears Roebuck, and Microsoft protested to FASB as well.

    (Critics then and now point out that FASB will have little control over pro forma reporting no matter what it does. Indeed, nearly 60 percent of respondents to CFO's survey said they would continue to report pro forma numbers after the new format is introduced.)

    Given the project's starting point, it's not surprising that current drafts of the future income statement omit net income. Right now that's by default, since income taxes are recorded in a separate section. But there is a big push among some board members to make a more fundamental change to eliminate net income by design, and promote business income (income from operations) as the preferred basis for investment metrics.

    "If net income stays, it would be a sign that we failed," says Don Young, a FASB board member. In his mind, the project is not merely about getting rid of net income, but rather about capturing all income-related information in a single line (including such volatile items as gains and losses on cash-flow hedges, available-for-sale securities, and foreign-exchange translations) rather than footnoting them in other comprehensive income (OCI) as they are now. "All changes in net assets and liabilities should be included," says Young. "Why should the income statement be incomplete?" He predicts that the new subtotals, namely business income, will present "a much clearer picture of what's going on."

    Board member Thomas Linsmeier agrees. "The rationale for segregating those items [in OCI] is not necessarily obvious, other than the fact that management doesn't want to be held accountable for them in the current period," he says.

    Whether for self-serving or practical reasons, finance chiefs are rallying behind net income. Nearly 70 percent of those polled by CFO in December said it should stay. "I understand their theories that it's not the be-all and end-all measure that it's put up to be, but it is a measure everyone is familiar with, and sophisticated users can adjust from there," says Kelly. Adds Rickard: "They're treating [net income] as if it's the scourge of the earth, which to me is silly. I think the logical conclusion is to make other things available, rather than hiding the one thing people find most useful."

    . . .

     

    Bob Jensen's threads on this proposed "radical change" in financial reporting are at http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay 

    Jensen Comment
    As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

    I have reservations about fair value reporting --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

    Bob Jensen's threads on the radical new changes on the way --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay


     

     


    Where Fair Value Market Accounting Fails:  Unique Items Not Traded (e.g., bank loans)
    Subjectivity Needed in Accounting for Bad Debts

    In the above module it was stressed how fair value adjustments are troubled for unique assets such as each of 300+ Days Inn hotels where no single hotel is alike due in large part by affects different locations can have on fair value. Fair value adjustments are possible for bonds traded in public markets, but hundreds of millions of bank loans are not traded in public markets. Each borrower is unique, and each purpose of a loan from a bank is unique. Unless the government will buy up selected types of bank loans (e.g., residential mortgages) there are no trading markets for these bank loans. Typically banks hold these investments to maturity (HTM Held-To-Maturity).  Such loans may be adjusted for inflation and interest rate changes, but there are no markets for mark-to-market adjustments.

    Much more subjectivity in valuation becomes necessary for "granular factors" that take uniqueness of each loan into consideration. The typical valuation model is discounted cash flow (DCF economic value) adjusted by granular factors. In 1932, Bill Paton (in his Accountants Handbook), Bill Paton outlines thos "appraisal factors" in the following categories:

    1.      Length of time the account has run.

    2.      Customer's pract6ice with respect to discounts.

    3.      General character of dealings with the customer.

    4.      Credit ratings and similar data.

    5.      Special investigations and reports.

    Fair value advocates sometimes mislead students into thinking that there are markets or surrogate markets for everything to be marked to market, but the fact of the matter is that more often than not it is impossible to find reliable market values.

     

    Banks must also submit much more granular information, including dozens of details about individual loans.
    See article below.

    "Stress for Banks, as Tests Loom," by Victoria McGrane and Dan Fitzpatrick, The Wall Street Journal, October 8, 2012 ---
    http://professional.wsj.com/article/SB10000872396390444024204578044591482524484.html?mod=WSJ_hp_LEFTWhatsNewsCollection.

    U.S. banks and the Federal Reserve are battling over a new round of "stress tests" even before the annual exams get going later this fall.

    The clash centers on the math regulators are using to produce the results. Bankers want more detail on how the calculations are made, and the Fed thus far has resisted disclosing more than it has already.

    A senior Fed supervision official, Timothy Clark, irked some bankers last month when he said at a private conference they wouldn't get additional information about the methodology, according to people who attended the event in Boston. Wells Fargo WFC -0.78% & Co. Treasurer Paul Ackerman said at the same conference that he still doesn't understand why the Fed's estimates are so different from Wells's. His remarks drew applause from bankers in the audience, said the people who attended.

    The annual examinations in their fourth year have become a cornerstone of the revamped regulatory rule book—and a continuing source of tension between the nation's biggest banks and their overseers.

    Smaller banks will soon have to grapple with similar requirements. On Tuesday, the three U.S. banking regulators—the Fed, the Comptroller of the Currency and the Federal Deposit Insurance Corp.—plan to complete rules requiring smaller banks with more than $10 billion in assets to also run an internal stress test each year. That would widen the pool of test participants beyond the Fed's current requirement of $50 billion in assets, a group comprised of 30 banks.

    The stress tests, which started in 2009 as a way to convince investors that the largest banks could survive the financial crisis, now are an annual rite of passage that determines banks' ability to return cash to shareholders.

    The financial crisis taught regulators that they need to be able "to look around the corner more often than in the past," said Sabeth Siddique, a director at consulting firm Deloitte & Touche, who was part of the Fed team that ran the inaugural stress test in 2009.

    The Fed asks the big banks to submit reams of data and then publishes each bank's potential loan losses and how much capital each institution would need to absorb them. Banks also submit plans of how they would deploy capital, including any plans to raise dividends or buy back stock.

    After several institutions failed last year's tests and had their capital plans denied, executives at many of the big banks began challenging the Fed to explain why there were such large gaps between their numbers and the Fed's, according to people close to the banks.

    Fed officials say they have worked hard to help bankers better understand the math, convening the Boston symposium and multiple conference calls. But they don't want to hand over their models to the banks, in part because they don't want the banks to game the numbers, officials say.

    It isn't clear if smaller banks will have to start running their tests immediately, as regulators have issued guidance indicating that midsize banks will have at least another year until they have to run the tests.

    One new frustration for big banks is that the information requested by the Fed is changing. This year the Fed began requiring banks to submit data on a monthly and quarterly basis, in addition to the annual submission. Banks must also submit much more granular information, including dozens of details about individual loans.

    Fed officials say the new data gives them the information they need to build their stress-test models and to see banks' risk-taking over time. Banks say the Fed has asked them for too much, too fast. Some bankers, for instance, have complained the Fed now is demanding they include the physical address of properties backing loans on their books, not just the billing address for the borrower. Not all banks, it turns out, have that information readily available.

    Daryl Bible, the chief risk officer at BB&T Corp., BBT -0.77% a Winston-Salem, N.C.-based bank with $179 billion in assets, challenged the Fed's need for all of the data it is collecting, saying in a Sept. 4 comment letter to the regulator that "the reporting requirements appear to have advanced beyond the linkage of risk to capital and an organization's viability," burdening banks without adding any value to the stress test exercise. BB&T declined further comment.

    The Fed has backed off some of its original requests after banks protested. For example, the Fed announced Sept. 28 that it wouldn't require chief financial officers to attest to the accuracy of the data submitted after banks and their trade groups argued that the still-evolving process was too fresh and confusing for any CFO to be able to be sure his bank had gotten it right.

    Banks needed more time to build up the systems and controls to report data reliably, the Fed said. But the regulator also warned that it may require CFO sign-off in the future.


    "Can corporate accounting ever be reformed?" by Eleanor Bloxham, Fortune, July 13, 2015 ---
    http://fortune.com/2015/07/13/accounting-reform/

    Getting accountants and auditors to follow the rules, as well as their spirit, isn’t easy—keeping them honest has been an uphill battle for going on 80 years.

    In a Fortune article three weeks ago, former SEC Chief Accountant Lynn Turner told me that the current accounting and auditing systems we all rely on need wholesale reform.

    Since then, there has been a flurry of activity from regulators, who have issued proposals to shore up weaknesses in U.S. corporate accounting and auditing. The Securities and Exchange Commission (SEC) issued a concept release on potential new audit committee disclosures, including possible new requirements for information about how the audit committee actually oversees the company’s auditor. And the Public Company Accounting Oversight Board (PCAOB) issued two new proposals. One could require disclosure of the partner and others involved in a company audit. The second relates to the potential creation and disclosure of what the PCAOB calls “measures that may provide new insights into audit quality.”

    Since audits have been required of public companies for 80 years, you’d think that measures of audit quality would already be clear, well established, and tracked. So why is this just now in the works? Given the choice between the stricter accountability of clear metrics and the greater freedom of none, companies, their auditors, and regulators have chosen flexibility.

    Coninued in article

    "Financial Engineering and the Arms Race Between Accounting Standard Setters and Preparers," by  Ronald A. Dye, Jonathan C. Glover, and Shyam Sunder, Accounting Horizons, Volume 29, Issue 2 (June 2015) --- 
    http://aaapubs.org/doi/full/10.2308/acch-50992
    This article is free only to AAA members.

    Abstract
    This essay analyzes some problems that accounting standard setters confront in erecting barriers to managers bent on boosting their firms' financial reports through financial engineering (FE) activities. It also poses some unsolved research questions regarding interactions between preparers and standard setters. It starts by discussing the history of lease accounting to illustrate the institutional disadvantage of standard setters relative to preparers in their speeds of response. Then, the essay presents a general theorem that shows that, independent of how accounting standards are written, it is impossible to eliminate all FE efforts of preparers. It also discusses the desirability of choosing accounting standards on the basis of the FE efforts the standards induce preparers to engage in. Then, the essay turns to accounting boards' concepts statements; it points out that no concept statement recognizes the general lack of goal congruence between preparers and standard setters in their desires to produce informative financial statements. We also point out the relative lack of concern in recent concept statements for the representational faithfulness of the financial reporting of transactions. The essay asserts that these oversights may be responsible, in part, for standard setters promulgating recent standards that result in difficult-to-audit financial reports. The essay also discusses factors other than accounting standards that contribute to FE, including the high-powered incentives of managers, the limited disclosures and/or information sources outside the face of firms' financial statements about a firm's FE efforts, firms' principal sources of financing, the increasing complexity of transactions, the difficulties in auditing certain transactions, and the roles of the courts and culture. The essay ends by proposing some other recommendations on how standards can be written to reduce FE.

    Jensen Comment
    The analytics of this Accounting Horizons article, rooted heavily in  Blackwell's Theorem, add academic elegance to the accountics science of the article but do not carry over well in the real world --- largely because of the limiting Plato's Cave assumptions of Blackwell's Theorem, However, the article lives up to the fine academic reputations of its authors in other respects that make it important to consider when pitting financial engineering against regulation.

    What needs to be extended is how financial engineering is not something that can be reduced per se. Changes in regulation are more apt to impact some firms positively (i.e., opportunity) and other  firms negatively (i.e., cost) simultaneously. And there are always considerations of direct impacts versus externalities. For example, eliminating coal as an energy source cleans the air and water but puts generations of miners and entire towns out of work as well as increasing the cost of electric power.

     The FASB requirement to book employee stock options when vested makes employee compensation more transparent to investors while making startups more costly to operate. And with each significant increase in financial reporting and compliance regulations businesses are increasingly mummified in red tape. As the saying goes:  "The road to Hell is paved with good intentions."

    The above article features lease accounting standards but ignores the positives and negatives of alternative details in setting such standards and the virtual impossibility of reliably measuring some liabilities such as estimating operating lease renewals ad infinitum.

    The above article ignores trade-offs in the standards. The prominent example is how balance sheet priorities of the FASB and IASB greatly harmed income statements.
     

    Net earnings and EBITDA cannot be defined since the FASB and IASB elected to give the balance sheet priority over the income statement in financial reporting ---
    "The Asset-Liability Approach: Primacy does not mean Priority," by Robert Bloomfield, FASRI Financial Accounting Standards Research Initiative, October 6, 2009 ---
    http://www.fasri.net/index.php/2009/10/the-asset-liability-approach-primacy-does-not-mean-priority/

    "Whither the Concept of Income?" by Shizuki Saito University of Tokyo and Yoshitaka Fukui Aoyama Gakuin University, SSRN, May 17, 2015 ---
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607234

    Abstract:
    Since the 1970s, the decision-usefulness has taken center stage and our attention has been concentrated on valuation of assets and liabilities instead of income measurement. The concept of income, once considered the gravitational center of accounting has lost its primacy and become a byproduct of the balance sheet derived from the measurement of assets and liabilities.

    However, we have not been equipped with robust conceptual foundation supporting theoretically reasoned accounting measurement. It is not only theoretically but also practically important to renew our seemingly waned interest in the concept of income because ongoing reforms of accounting standards cannot be successfully implemented without a sound understanding of the concept of income.

    From the CFO Journal's Morning Ledger on July 24, 2015

    Amazon posts surprising profit
    http://www.wsj.com/articles/amazon-posts-surprising-profit-1437682791?mod=djemCFO_h
    For just the second time, Amazon.com Inc. shared sales figures Thursday for its cloud-computing division Thursday. Amazon Web Services sales rose to $1.82 billion from $1 billion a year earlier, and operating profit increased to $391 million from $77 million. Some believe the unit could operate on a stand-alone basis and, because of its growth, is a primary reason to invest in Amazon. Amazon posted a profit of $92 million for the third quarter, helped by sales which rose a better-than-expected 20% to $23.18 billion.

    Jensen Comment
    The "surprising profit" of Amazon makes us wish that someday the accounting standard setters (think FASB and IASB) would someday be able to operationally define "profit" and make "profit" measures more comparable between business firms.

    Net earnings and EBITDA are all-important because investors change their portfolios based on net earnings and its derivatives more than anything in the balance sheet.
    "Accounting Alchemy," by Robert E. Verrecchia, Accounting Horizons, September 2013, pp. 603-618.
    Verrecchia alleges that it's not that managers have a functional fixation for earnings metrics as it is that they believe that other managers and investors are so fixated with earnings that it because of monumental importance not because it is inherently a great metric but because they believe deeply that the market itself makes this index of vital importance.

    . . .

    In summary, my thesis is that managers project that others are fixated on earnings—independent of any evidence in support of, or contrary to, this phenomenon. This leads to managers resisting the inclusion in earnings items that fail to enhance performance, such as the amortization of Goodwill, or measures that make future performance more volatile, such as those based on fair value. In the absence of acknowledging PEF and attempting to grapple with it, I continue to see confrontations over accounting regulation along the lines of recent debates about fair value accounting, in addition to further impediments along the path to greater transparency in financial statements.

    Investors change their portfolios based on earnings, eps, EBITDA, and P/E ratios when in fact those metrics are not defined and may have a lot of misleading noise and secret manipulation

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

    Bob Jensen's threads on accounting theory can be found at
    http://faculty.trinity.edu/rjensen/Theory01.htm


    The IASB and the U.S.’s FASB have previously diverged on standards, including the expected loss model for loan losses and accounting for exposure to derivatives.

    "IASB supports expected loss model for banks," by Ben Moshinsky, Bloomberg, March 7, 2013 ---
    http://www.businessweek.com/news/2013-03-07/banks-should-reveal-credit-losses-earlier-accounting-board-says

    Banks should be required to recognize losses on credit portfolios before the assets go into default, an international accounting standards body said today.

    The measures, known as the expected loss model, would mark a shift from the incurred loss model, which allows banks to wait until “financial assets are close to default,” the International Accounting Standards Board said in a report. Banks would have to recognize losses on portfolios as they deteriorate in quality, under the proposals.

    “We believe the model leads to a more timely recognition of credit losses,” Hans Hoogervorst, chairman of the London- based IASB, said in the statement. “At the same time, it avoids excessive front-loading of losses, which we think would not properly reflect economic reality.”

    The Group of 20 nations set up a group to examine alternatives to the incurred loss model following the 2008 financial crisis. The rules had been criticized for “delaying the recognition of losses” and for failing to accurately reflect losses on credit portfolios “that were expected to occur,” said the IASB, which is a global body in charge of harmonizing accounting standards.

    The proposals “provide enhanced transparency to an entity’s credit risk and are likely to increase the credit loss provision recorded by many financial institutions,” Tony Clifford, an accountant at Ernst & Young LLP, said in an e- mailed statement.

    No ‘Panacea’

    The proposals were developed in cooperation with the Financial Accounting Standards Board, the rule maker for U.S. banks, and “simplified to reflect feedback received from interested parties,” the IASB said.

    “It is important to be realistic; this is not going to be the panacea,” Nigel Sleigh-Johnson, head of the financial reporting group at the Institute of Chartered Accountants in England and Wales, said in an e-mailed statement. “There are potential pitfalls linked to any model.”

    The IASB and the U.S.’s FASB have previously diverged on standards, including accounting for exposure to derivatives.

    Continued in article

    Jensen Comment
    If the FASB and IASB had instead consulted Tom Selling, they would've gotten earfuls of protests about the expected loss model --- Click Here
    http://accountingonion.typepad.com/theaccountingonion/2012/10/marking-loans-to-model-is-far-easier-and-better-than-estimating-loan-loss-allowances-its-time-to-hear-from-the-fasb-members.html

    Also see
    http://accountingonion.typepad.com/theaccountingonion/2013/01/fasb-pretends-it-never-voted-to-mark-loans-to-market.html


    Teaching Case on Valuation
    From The Wall Street Journal Accounting Weekly Review on September 12, 2014

    The Heated Litigation Over Arizona Iced Tea
    by: Mike Esterl
    Sep 04, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Business Valuation

    SUMMARY: As a business partnership soured, hot heads got in the way of a cold calculation: What is the value of Arizona Beverage Co., maker of the popular Arizona iced tea? A New York State Supreme Court judge is set to hear closing arguments in a four-year-old fight over the valuation, in which Arizona's estranged co-founders have been as far apart as water in the desert. One co-founder, who wants to be bought out, contends that Arizona is worth between $3 billion and $4 billion. The other, who is willing to buy out his former partner, argues Arizona's value is closer to $500 million. Aside from wrapping up the messy business-divorce proceedings, a conclusion in the case could pave the way for Coca-Cola Co. or another drinks company to buy a stake.

    CLASSROOM APPLICATION: This article is appropriate for a class that covers the topic of business valuation.

    QUESTIONS: 
    1. (Introductory) What are the facts of this case? Who is the plaintiff and who is the defendant? What issue do the parties want the court to decide?

    2. (Advanced) What is a business valuation? Besides litigation, what are other uses of business valuations? Why might a business want to know its value?

    3. (Advanced) What are some methods used to value a business? Which of these might methods might be appropriate for use in this case?

    4. (Advanced) Why are the parties so far apart with these valuation amounts? Do each of the parties have a legitimate basis for the amount they are proposing? Which is more likely to be correct?

    5. (Advanced) What knowledge and skills are necessary to do business valuations? What education and business experience would be beneficial for someone interested in a career in business valuation? What are the career opportunities?
     

    Reviewed By: Linda Christiansen, Indiana University Southeast

    "The Heated Litigation Over Arizona Iced Tea," by Mike Esterl, The Wall Street Journal, September 4, 2014 ---
    http://online.wsj.com/articles/the-heated-litigation-over-arizona-iced-tea-1409787182?mod=djem_jiewr_AC_domainid

    As a business partnership soured, hot heads got in the way of a cold calculation: What is the value of Arizona Beverage Co., maker of the popular Arizona iced tea?

    On Thursday, a New York State Supreme Court judge is set to hear closing arguments in a four-year-old fight over the valuation, in which Arizona's estranged co-founders have been as far apart as water in the desert. One co-founder, who wants to be bought out, contends that Arizona is worth between $3 billion and $4 billion. The other, who is willing to buy out his former partner, argues Arizona's value is closer to $500 million.

    Aside from wrapping up the messy business-divorce proceedings, a conclusion in the case could pave the way for Coca-Cola Co. KO -0.19% or another drinks company to buy a stake.

    Nassau County, N.Y., Supreme Court Judge Timothy Driscoll will be the one to determine how much co-founder Domenick Vultaggio must pay co-founder John Ferolito to take full control. Depending on how much the court values Mr. Ferolito's stake, Mr. Vultaggio might have to seek outside investors for help. That could finally reopen talks between Arizona and several beverage companies like Coke that are eager to grab a huge part of the growing U.S. market for ready-to-drink tea.

    Judge Driscoll has told both parties he will try to issue a ruling by Columbus Day.

    As young men, Messrs. Ferolito and Vultaggio, two friends from Brooklyn, teamed up in 1971 to deliver beer around New York City from a Volkswagen VOW3.XE -0.66% bus. Decades later, after seeing Snapple teas fill up store shelves, they launched Arizona and its Southwestern-inspired label motif in 1992, eventually taking it national and unseating Snapple and several other brands owned by deeper-pocketed companies.

    Arizona had a 40% share of U.S. ready-to-drink tea in 2013 by volume, ahead of PepsiCo Inc., PEP +0.93% which sells Lipton through its joint venture with Unilever ULVR.LN -0.30% and had a 34% share, according to industry tracker Beverage Digest. Snapple, now owned by Dr Pepper Snapple Group Inc., DPS +0.56% had a 10% share.

    Beverage Digest estimates annual U.S. ready-to-drink tea sales to be around $6 billion.

    The two founders have been feuding for years and Mr. Ferolito has long stopped being involved in day-to-day operations, moving to Florida.

    Mr. Ferolito began looking at selling his stake in Arizona roughly a decade ago, but was blocked by Mr. Vultaggio. An agreement prevented either side from selling its stake without the other's consent.

    The legal battle has featured plenty of fireworks. Mr. Vultaggio's lawyers have accused Mr. Ferolito of trying to intimidate Mr. Vultaggio at one point in the yearslong dispute by appearing at the company with an armed former New York City detective. Nicholas Gravante, an attorney for Mr. Ferolito, called the allegation "a complete fabrication.''

    "Both sides have thrown a lot of grenades back and forth. The court has shown absolutely no interest in that nonsense. This is a valuation case,'' added Mr. Gravante, an attorney at Boies, Schiller & Flexner LLP.

    The case, which went to trial earlier this summer, has produced about 5,000 pages of transcripts and thousands of pages in exhibits, according to Louis Solomon, an attorney for Mr. Vultaggio.

    Mr. Solomon, an attorney at Cadwalader, Wickersham & Taft LLP, said Mr. Vultaggio has no intention of selling the company. "He's not a seller. He's never been a seller,'' Mr. Solomon said, adding that Mr. Vultaggio's children also are involved in the business.

    But attorneys for both men acknowledge that companies including Coke, Nestlé SA NESN.VX +0.28% and Tata Global Beverages 500800.BY -4.67% have approached Mr. Ferolito and Arizona in the past about acquiring part or all of the company. The valuation court case, which began in 2010, effectively killed such talks.

    Coke and Nestlé declined Wednesday to comment on any previous talks, or any potential interest in acquiring part or all of Arizona if it becomes available. Tata, which is based in India, didn't immediately return calls on Wednesday. The Wall Street Journal reported in 2007 that Coke and Arizona executives had held talks.

    "If it is for sale, it would be a terrific deal for Coke because it needs a much bigger North American tea business,'' said John Sicher, publisher of Beverage Digest, adding tea should continue to grow thanks to its "health and wellness aura.''

    Coke's Fuze, Gold Peak and Honest Tea brands had a 5.5% share of the U.S. ready-to-drink tea market by volume last year, according to Beverage Digest. Coke ended its Nestea partnership in the U.S. with Nestlé in 2012.

    Coke already has made two moves into caffeinated drinks this year, buying minority stakes in countertop coffee maker Keurig Green Mountain Inc. GMCR +1.16% and energy drink maker Monster Beverage Corp. MNST -0.51%

    Bob Jensen's threads on valuation are at
    http://faculty.trinity.edu/rjensen/roi.htm

     


    "Banks Need Long-Term Rainy Day Funds: Accounting rules prevent banks from building loss reserves until shortly before a bad loan is actually written off. That's just too late," by Eugene A. Ludwig and Paul A. Volcker, The Wall Street Journal, November 16, 2012 ---
    http://professional.wsj.com/article/SB10001424127887324556304578120721147710286.html?mg=reno64-wsj#mod=djemEditorialPage_t

    Governments around the world are taking bold steps to minimize the likelihood of another catastrophic financial crisis. Regulators and financial institutions already have their hands full, so the bar for adding anything to the agenda should be high.

    However, one relatively simple but critically important item should move to the top of the list: reforming the accounting rules that inexplicably prevent banks from establishing reasonable loan-loss reserves. If reserve rules had been written correctly before 2008, banks could have absorbed bad loans more easily, and the financial crisis probably would have been less severe. It is now time, before the next crisis, to recognize that reality.

    Loan-loss reserves get far less attention than capital or liquidity requirements, which are subject to specific government regulations. Nevertheless, the "Allowance for Loan and Lease Losses" should be an essential part of assessing the safety and soundness of any bank. The ALLL—not Tier 1 capital or even cash-on-hand—is the most direct way a bank recognizes that lending, including necessary and constructive lending, entails risk. Those risks should be recognized in both accounting and tax practices as a reasonable cost of the banking business.

    However, banks are now only allowed to build their loan-loss reserves according to strict accounting conventions, enforced by the Securities and Exchange Commission. Reserves have to be based on losses that are strictly "incurred," in effect shortly before a bad loan is written off. Bankers have been prohibited from establishing reserves based on their own expectations of future losses.

    The practical result is that in good times real earnings are overrated. Conversely, the full impact of loan losses on earnings and capital is concentrated in times of cyclical strain.

    Why have accounting conventions created this perverse result? Some accountants claim that giving banks flexibility with their reserves is bad because it lets bankers "manage earnings"—that is, to raise or lower results from quarter to quarter to look better in investors' eyes. This is a weak argument, because the ALLL reflects a banking reality, and the allowance itself is completely transparent.

    No one is misled when sufficient disclosures exist. The size of the bank's reserve cushion will be on the balance sheet, and it would need to be recognized as reasonable by auditors, supervisors and tax authorities. Importantly, from a financial policy point of view, reserves will tend to be countercyclical, likely to discourage aggressive lending into "bubbles" but helping to absorb losses in times of trouble.

    Capital is vital to the safety and soundness of banks. It is the ultimate and necessary protection against insolvency and failure. However, permitting a more flexible allowance for loan-loss reserve, an approach that gives banks and prudential regulators the right to exercise reasonable discretion to build a more flexible cushion in case of loss, is a must. Accounting rules need to change to permit this to happen.

    Mr. Ludwig, the CEO of Promontory Financial Group, was Comptroller of the Currency from 1993 to 1998. Mr. Volcker, former chairman of the Federal Reserve System, is professor emeritus of international economic policy at Princeton University.

     

    Bob Jensen's threads on where fair value accounting fails ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#FairValueFails

    Bob Jensen's threads on Cookie Jar Accounting ---
    http://faculty.trinity.edu/rjensen/theory01.htm#CookieJar

     

     


    "FASB Will Propose New Credit Impairment Model," by Anne Rosivach, AccountingWeb, October 16, 2012 ---
    http://www.accountingweb.com/article/fasb-will-propose-new-credit-impairment-model/220047?source=aa

    How to measure and disclose evidence that a loan or bond is not performing continues to be an issue in the ongoing deliberations of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The two boards have been working on a single, converged Accounting for Financial Instruments standard for years.
     
    FASB announced recently that it will separately issue an exposure draft, possibly by the end of 2012, of a new model for disclosing credit impairment. The draft of the new approach, which FASB calls the "Current Expected Credit Loss Model" (CECL Model), may be viewed in FASB Technical Plan and Project Updates. The CECL Model applies a single measurement approach for credit impairment. 
     
    FASB developed the CECL Model in response to feedback from US stakeholders on the "three-bucket" credit impairment approach, previously agreed upon by the FASB and the IASB. US constituents found the three-bucket approach hard to understand and suggested it might be difficult to audit. 
     
    The IASB continues to propose the three-bucket approach. 
     
    FASB board members agreed that the CECL Model would apply in all cases where expected credit losses are based on an expected shortfall in the cash flows that are specified in a contract, and where the expected credit loss is discounted using the interest rate in effect after the modification. This would include troubled debt restructurings. The board has provided additional guidance.
     
    The Technical Plan explains the CECL Model as follows:
     
    "At each reporting date, an entity reflects a credit impairment allowance for its current estimate of the expected credit losses on financial assets held. The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect. . . . 
     
    "Under the CECL Model, the credit deterioration (or improvement) reflected in the income statement will include changes in the estimate of expected credit losses resulting from, but not limited to, changes in the credit risk of assets held by the entity, changes in historical loss experience for assets like those held at the reporting date, changes in conditions since the previous reporting date, and changes in reasonable and supportable forecasts about the future. As a result, the balance sheet reflects the current estimate of expected credit losses at the reporting date and the income statement reflects the effects of credit deterioration (or improvement) that has taken place during the period."
     
    The FASB has tentatively decided to require disclosure of the inputs and specific assumptions an entity factors into its calculations of expected credit loss and a description of the reasonable and supportable forecasts about the future that affected their estimate. The entity may be asked to disclose how the information is developed and utilized in measuring expected credit losses.
     
    In July, when the FASB decided to pursue a separate course from the IASB and develop a simpler Model, the FASB explained the three-bucket approach as follows: 
     
    "Previously, the Boards had agreed on a so-called 'expected loss' approach that would track the deterioration of the credit risk of loans and other financial assets in three 'buckets' of severity. Under this Model, organizations would assign to 'Bucket 1' financial assets that have not yet demonstrated deterioration in credit quality. 'Bucket 2' and 'Bucket 3' would be assigned financial assets that have demonstrated significant deterioration since their acquisition."
     
    FASB states in its Technical Plan that the key difference between the CECL Model and the previous three-bucket model is that "under the CECL Model, the basic estimation objective is consistent from period to period, so there is no need to describe a 'transfer notion' that determines the measurement objective in each period."

     


     

    Historical Cost Accounting: Unadjusted for General Price-Level Changes

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Bob Jensen's threads on fair value accounting --- http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue

    Bad News for Fair Value Accounting Theorists
    Noise: A Flaw in Human Judgment ---
    https://marginalrevolution.com/marginalrevolution/2021/05/noise-a-flaw-in-human-judgment.html

    "Mark-to-market Madness," by David M. Katz, CFO.com, April 24, 2009 --- http://www.cfo.com/blogs/?f=header

    As if they needed any, the critics of fair value got a fresh new example of the craziness of an oft-decried provision in FAS 157, paragraph 15 of Fair Value Measurements. The provision rewards companies whose credit spreads on their debt liabilities have widened and punishes those who have become more creditworthy.

    On Wednesday, Morgan Stanley reported that it had to cut its first-quarter net revenues $1.5 billion because the credit spreads on some of its long-term debt had narrowed. What happened was that as the investment bank grew more reliable to its creditors over the first part of the year, its debt became more valuable. And under the dictates of mark-to-mark accounting, the firm had to take a writeoff because of this very positive occurrence.

    Sound nuts? It has sounded so to many observers. In the 15th paragraph of 157 FASB says, nevertheless, that "the fair value of [a company's] liability shall reflect the nonperformance risk relating to that liability." Thus, as the nonperformance risk--as reflected by slimmer credit spreads—narrowed, Morgan Stanley had to reflect the decreased value of its debt as a decrease in sales on its income statement.

    Like the alleged evils of mark-to-market accounting in illiquid markets—although to a lesser extent—the irrational practice of forcing improved creditworthiness to be reflected in revenue decreases has become fodder for fair value’s enemies. When FASB made its recent amendments to 157, it neglected to attack the provision. If only to preserve fair-value accounting from more political attacks, it should do so now.

    "The Fair-Value Deadbeat Debate Returns: On hiatus while other fair-value questions were debated, the hotly-contested issue of why companies can book a gain when their credit rating sinks has returned to center stage," by  Marie Leone, CFO.com, June 29, 2009 --- http://www.cfo.com/article.cfm/13932186/c_2984368/?f=archives

    "Is Fair Value Foul? A Stanford professor argues that the less that investors use fair value accounting to value companies, the better.," by David M. Katz, CFO Magazine, September 22, 2014 ---
    http://ww2.cfo.com/management-accounting/2014/09/is-fair-value-accounting-foul/

     


    Accounting rule Warren Buffett loathes boosts Berkshire's bottom line to $81B ---
    https://www.foxbusiness.com/money/accounting-rule-warren-buffett-loathes-boosts-berkshires-bottom-line-to-81b

    Jensen Comment
    The accounting rule is controversial in that net earnings and portfolio values are subject to short-term transitory variations in security prices that may have little to do with long-term earnings and value. For example, Tesla share prices are subject to huge day-by-day volatility caused news events that usually do not reflect changes future cash flows of the company.

    Reporting of a portfolio's value becomes highly dependent upon what day the reporting takes place.

    Also there's a difference in value based upon such factors as control. For example, if Buffett's firm only owns a few shares of Company X the price of $100 per share means something different than if his firm owns 51% of the voting shares. That $100 per share represents the liquidity value of one share of stock. It does not reflect the possibly enormous value of having control of the management of the company.

    The same rule could be a stock market and real estate disaster for any tax (think a wealth or income tax)  that forces investors to liquidate portfolios to pay the tax. At the moment tax accounting rules do not generally require liquidation for value appreciation alone.

    It's a little like reporting the number of birds to be served for dinner while they are still in the bush and can fly away before dinner time.

    Bob Jensen's threads on value accounting theory ---
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValueFails

    Also see
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting

     


    Reply to Mohammad Raza from Bob Jensen on September 23, 2014

    Hi Mohammad,
     

    We had some discussion on the AECM when this paper by Professor Katz was originally published in Stanford Magazine.
     
    My own threads on the various alternatives for valuing assets and liabilities are given at
    http://faculty.trinity.edu/rjensen/Theory02.htm#BasesAccounting 
     
    My main objection for entry or exit revaluation of fixed assets in going concerns is that these revaluations create earnings fictions if the unrealized gains and losses are posted to earnings. For example, ups and downs in the value of the land under a giant Boeing assembly plant are earnings fictions if there's zero chance that the land will be sold apart from the factory and zero chance that Boeing will sell the factory.

    Revaluation makes more sense when when the probability of a factory sale in the near future becomes much greater --- hence the reason accounting rules call for exit valuation of non-going concerns.
     
    Stock prices are of little use in revaluing booked assets and liabilities because stock prices reflect market values of the unbooked as well as the booked assets and liabilities such as the values of the human resources, reputation, contingencies, and off-balance sheet financing.

    It's interesting to compare the history of theory debates over valuation of booked assets and liabilities in going concerns. Theorists that promoted historical costs like AC Littleton and Yuji Ijiri contended that historical costs is not valuation at all --- they are simply stewardship scorekeeping rules that have survived for over 500 years --- survival of the fittest so to speak.

    "The Asset and Liability View: What It Is and What It Is Not—Implications for International Accounting Standard Setting from a Theoretical Point of View"
    Jens Wüstemann, University of Mannheim; Sonja Wüstemann, Goethe University Frankfurt am Main
    American Accounting Association Annual Meetings, August 4, 2010
    http://aaahq.org/AM2010/display.cfm?Filename=SubID_2022.pdf&MIMEType=application%2Fpdf


     
    A very concise summary of the positions of various accounting theory experts in history since 1909 and authoritative bodies over the years since 1936:
    "Asset valuation: An historical perspective"
    Authors: Racliffe, Thomas A. (Thomas Arthur) and Munter, Paul
    Accounting Historians Journal
    1980
    http://umiss.lib.olemiss.edu:82/record=b1000230
    Jensen Comment:  I really liked this summary of the valuation literature prior to 1980.
    For example, what was the main difference between exit value advocates Chambers versus Sterling?
     

     

    Two of the most vocal advocates of replacing historical costs with exit values were the following members of the Accounting Hall of Fame:

    Ray Chambers ---
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/raymond-john-chambers/

    Bob Sterling ---
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/robert-raymond-sterling

    Ray Chambers defined fair value accounting as the sum of the exit values of all of its parts as if they would be sold in a yard sale. He thus ignored any synergy value (value in use) of assets and liabilities in combination under existing management. Bob Sterling defined fair value as the exit value of groupings of assets and liabilities that captured synergy value (value in use) of assets and liabilities in combination under existing management.

    Personally I think the Chambers valuation makes sense only when booked items are to be sold for a non-going concern in a yard sale. Sterling's arguments make more sense for going concerns, but estimates of such values of booked items is usually quite impractical. Stock prices and valuations of segments of the company are eof little help for booked item valuations if those valuations include unbooked as well as booked items such as the values of the human resources, reputation, contingencies, and off-balance sheet financing.

    Both the Chambers and Sterling exit value arguments add fictions to earnings if the unrealized gains and losses of remeasurement are posted to earnings.

    Famous Historical Cost Theorists
    Probably the best known historical cost advocate of all time is AC Littleton followed by mathematician Yuji Ijiri. Both argued that historical cost balance sheets do not pretend to be valuations beyond the original dates on which the transactions were booked into the ledgers. Balance sheet numbers are simply residuals in from the calculation of income statement numbers under the Realization Principle for revenues and the Matching Principle for costs and expenses. Although Littleton and Ijiri also advocate price level adjustments, they are not advocates of current value adjustments beyond supplementary disclosures of exit values or entry values.

    The most famous publication of the American Accounting Association is the 1941 monograph on historical cost theory by Paton and Littleton ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Paton
    The biggest selling monographs in the AAA's Studies in Accounting Research series are the double/triple bookkeeping monographs by Yuji Ijiri that were rooted in historical cost accounting ---
    http://aaahq.org/market/display.cfm?catID=5

    Famous Exit Value (Disposal Value) Theorists
    In history, the strongest advocates of exit value replacement of historical costs in financial statements included Kenneth MacNeal, Bob Sterling, and Australia's famous Ray Chambers. Their main arguments boiled down to very simple wash sale illustrations. Suppose Company H and Company S begin with identical balance sheets of A=$1000 Corn Inventory and E=$1.000 Equity where each company paid $1 for 1,000 bushels of corn. In order to dress up the financial statements before closing its books, Company S sells its corn for $2 per bushel in an intended wash sale. Then immediately after closing its books Company S buys back corn for $2 per bushel. Company S now has a balance sheet of A=$2,000 Corn Inventory and E=$1000 Invested Capital + $1,000 retained earnings.

    In the above example Company S looks like it performed twice as well as Company H even though in the final outcome both remain identical in terms of all economic criteria. Company H has simply undervalued its historical cost inventories and did not realize any revenue from sales. In real life, however, the situation is not so simple. In 1981 when Days Inns of America wanted to dress up its historical cost balance sheet (for an IPO) the transactions cost of selling each of its 300+ hotels would've been immense for selling and then buying back each hotel. Accounting rules did not permit departing from historical cost valuations for each of these hotels in its main Price Waterhouse-audited financial statements.. However, nothing prevented Days in from hiring a large real estate appraisal firm from deriving 1981 unaudited exit value estimates of each of the 300+ hotels.

    To make matters worse, the "value in use" of these 300+ plus hotels most likely plunged dramatically the day its dynamic President had a sudden heart attack and died at a very young age. A "value in use" estimate is much more volatile than historical cost or replacement cost valuations.

    The 1981 Days Inns Annual Report (for which I have three copies in my barn remaining from my days of teaching in which I loaned a copy of this 1981 Annual Report to each of my students) would've made MacNeal, Chambers, and Sterling ecstatic. The historical cost book values of these 300+ hotels aggregated to $87,356,000 whereas the exit values aggregated to an unaudited amount of $194,812,000. Wow!

    This is probably value added when it comes to financial analysts and investors willing to trust these unaudited estimates from a real estate appraisal firm. The numbers of course are much more subjective and easy to manipulate for devious purposes than the cost numbers. Ande even if totally accurate, there's a huge problem of having measured current hotel values of a company's assets in there worst possible economic uses --- disposing each asset separately in assumed liquidation of the company. The $194,812,000. sum of disposal values of Days Inns hotels  totally ignores the synergy value of these when grouped together under the management of Days Inns. Exit value theorists have never provided us with a way of measuring the value of the whole other than by summing the exit disposal values of the parts. In reality the "value in use" of these 300+ hotels might've been $294,812,000, $394,812,000, or $494,812,000. We will never know because exit theorists cannot measure "value in use" of grouped assets of one company let alone the "value in use" if these hotels are sold to other companies like Holiday Inns of America where "value in use" is probably very different than "value in use" for Days Inns.

    Famous Replacement Cost (Entry Value) Theorists
    I think the best known theorists advocating entry values (replacement costs) are John Canning (in a published doctoral thesis) and William A Paton (in a lifetime of writing and speaking). Although Paton's most famous book is probably the 1941 Paton and Littleton monograph on historical cost theory this was more of an academic exercise for Bill Paton since his heart was truly in replacement cost fixed asset valuations ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Paton

    Whereas the exit value of a 20 year old hotel might be $1 million in a liquidation sale, the replacement cost (entry value) of a new hotel might be $5 million. In entry value theory this $5 million would have to be adjusted for 20 years of hypothetical depreciation to arrive at its $2 million replacement cost estimate. Exit value theorists are proud of their not having to resort to arbitrary depreciation calculations. Entry value theorists are proud of being able to estimate current values when exit values are meaningless.

     Many older assets may have $0 exit value even though their value in use is still considerable. This is especially the case when costs of dismantling an old and large piece of equipment and re-installing it in another factory is so prohibitive that nobody will pay to re-install the item. There's also the problem of the way exit value markets work even for new assets. If a farmer pays $500,000 for a new diesel tractor the exit value may decline by 100,000 before the tractor is moved from tractor dealer's show room. Such is the nature of "new" versus "used" equipment exit values even when used is still or almost new.. Entry values are not quite so flaky since the replacement cost of that tractor might remain constant between the date of purchase and a month later after the tractor was used vigorously.

    Also in the case of exit values of 300+ hotels, exit values of a New Orleans Days Inn versus a Fargo Days Inn (of identical age, style, and sizes) may differ greatly due to variations resale markets  in local economies. This is not generally true of replacement costs since the cost of constructing new hotels is not so variable in terms of local economies.

    Thus replacement costs overcome the flaky nature of many exit value estimates. But replacement costs suffer from the same maladies of historical cost valuations in that arbitrary formulas for such things as depreciation and amortization.

    To put my Bill Paton quotations into perspective it should be noted that most accounting historians describe him as a "replacement cost" man ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Paton

    Also Paton's writings are best known from the days before we had accounting standard setting bodies like the APB, FASB, and IASB. The AICPA and its ARB committees seldom set accounting rules on really controversial issues. Instead GAAP, like common law, was drawn from "generally accepted" practices of accounting in industry and practices acceptable to accounting system auditors. The SEC was formed in 1933 with powers to dictate accounting standards for corporations listed on major stock exchanges in the U.S. However, the SEC was then and still is reluctant to take standard setting away from professional accountants.

    In 1932 corporations and their auditors had much more flexibility than today in how to value current and fixed assets than the have today. For example in 2010 both the FASB and IASB rules virtually require historical cost inventory valuation for the majority of inventories reported globally in balance sheets. But in 1932 it was much easier for a company to report inventories at current values if its shareholders did not make a big fuss over exit value or entry value reporting of inventories.

    But in since the crash of 1929, most companies stuck with historical cost valuation. Beside my desk I always keep the Second Edition of Accountants' Handbook edited by and heavily written by William A. Paton. The First Edition is dated 1923, and my copy is the Second Edition dated 1932.

     

    Jensen Comment to a posting by Tom Selling
    I don't think Tom wants me to rehash our old debates where we can't agree on some of these matters ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#BasesAccounting

    Suffice it to say that the Number 1 topic on which we do not agree is his claim that
    "The only relevant basis of measurement for the assets and liabilities that are recognized can be current value.  Comparative amounts must presented in constant units of purchasing power."

    He has never convinced me of this claim, and I do not think Tom provides evidence that replacement costs (entry values, current costs) are the "only relevant" choices among the alternatives. Firstly, replacement costs suffer from the necessity of arbitrary  accruals (like depreciation and depletion) that he criticizes in historical costs. Secondly, replacement cost accounting can easily mislead when replacement options are quite unlike operating assets in use. Thirdly, replacement cost accounting entails recognition  of transitory market changes in inventory replacement costs that will never be realized as long as the inventory remains on hand.

    Entry value accounting has never gained much traction in the academic community, certainly not like exit value accounting expounded by various leading professors in the 20th Century. Historical cost accounting is not really "value accounting," which is a  point made over and over again by AC Littleton in his time. An exception is Bill Paton who broke away from Littleton later in life, but Paton's advocacy of replacement costing  never caught on in the financial analyst community.

    The great FAS 33 experiment in practice certainly never excited financial analysts.  Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under  three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies complained heavily that users did not obtain value that justified the cost  of implementing FAS 33. Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates. The FASB rescinded FAS 33 when it issued FAS 89 in 1986. FAS 33 failed largely because  financial analysts had little interest in the supplementary FAS 33 tables

    Tom Selling can't explain why in the many years of replacement cost (entry value, current value) measurement advocacy (going back at least as far as John Canning's thesis) replacement cost accounting never really found traction in academe or the world in  investment analysts who never put up pleas to for companies to incur the huge costs of meaningful current cost financial statements.

    If Tom is going to "sell" his replacement cost (entry-value) basis of accounting he's not going to do so by continued whipping the FASB in what is now his accustomed negativism style where the FASB is concerned. Negativism seldom sells in practice or academe.

    If Tom is going to "sell" his replacement cost basis of accounting he's going to have to convince the user community, especially financial analysts that the benefits of replacement cost accounting to them greatly exceeds the considerable cost of generating  "objective" replacement cost measurements of assets, liabilities, revenues, expenses, and net income.

    I appeal to Tom to begin by writing cases, preferably focused on real world companies, that make a sales pitch to the financial analyst constituency of the FASB/IASB. Then let the analysts carry the ball demanding change by the FASB/IASB. I'm skeptical that  Tom's excellent blog for accounting thought is a must-read site for financial analysts. He's going to have to make his case in their literature.

    It will take a whole lot of positive demonstration instead of negativism.

    Tom could begin by identifying the best of the best in the literature of replacement cost accounting. John Canning's thesis is a good place to start.
    Jim Martin's MAAW site has a pretty good archive on replacement cost accounting
    http://maaw.info/ReplacementCostArticles.htm
    Entry-value accounting never got the support of leading academics to the extent that exit-value accounting got some traction.

    Jim Martin's references in the past did not alter academic or practitioner opinion markedly.

    The next step for Tom is to make financial analysts blink and take note. He should make his case with financial analysts who in turn have influence on the SEC and FASB and IASB.

    Later on:

    After FAS 33, when the FASB required large companies to provide current cost comparisons with historical cost numbers, financial analysts yawned. In fact their lack of support coupled with preparer laments about the costs of providing those current cost numbers led to the rescinding of the FAS 33 requirement for such comparisons.
     
    And you don't provide any evidence of  interest in current cost financial statements among financial analysts before or after the dead FAS 33.
     
    Nor do you provide any evidence that entry value accounting gained any traction in academic accounting history. Hall of Famers AC Littleton and Yuji Ijiri were champions of historical cost accounting when leading academics who never carried the ball for  either entry value or exit value accounting.
     
    There were also some academics who carried the ball for exit value accounting --- notably Hall of Famers Ray Chambers and Bob Sterling. But they never got a following for exit value accounting of going concerns.
     
    Who were the leading academic researchers and scholars in the past who carried the ball for entry value accounting?
     
    If you're carrying the ball for entry value accounting Tom it's necessary that you gain a constituency of academics and users (especially financial analysts) to be on your team. Simply calling existing financial statements s**t is not going to do the job  until you demonstrate that your alternatives have many more benefits to financial statement users than costs to preparers and auditors.
     
    PS

    Companies that tried exit value accounting (Day's Inn in 1987) and entry value accounting (US Steel during the FAS 33 years) found that costs of departing from GAAP greatly exceeded the benefits in terms of lowering cost of capital. You can see summaries of their departures from GAAP by scrolling down at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValueFails

    The Double-Entry Bookkeeping Model is Crucial for Being Able to Calculate Some Items That Can Only Be Defined as Plug Amounts That Make Balance Sheets Balance

    1.
    Net income is defined by both the FASB and IASB as a plug figure that makes balance sheets balance under double-entry bookkeeping. In some ways computing the net income plug amount is like the Hicksian economic concept of income, although it really is not Hicksian income due to the many ways of measuring various balance-sheet components of assets and liabilities in modern-day mixed-model measuring systems. Also there are "assets" and "liabilities" in the Hicksian model that accountants cannot measure for balance sheet accounts such as some intangibles (think the value of human resources and business reputations), contingent liabilities, etc.


    2.
    Purchasing power gains or losses on monetary items are computed as a double-entry-based plug amounts.
    https://en.wikipedia.org/wiki/Constant_purchasing_power_accounting
    Suppose all balance sheet items are partitioned into monetary versus non-monetary items. Non-monetary items are those items having value changes that move with general price levels (think inflation). Examples include real estate, equipment, variable rate investments, and variable rate debt.

    Monetary items include cash on hand, fixed rate receivables/investments, and fixed rate debt. Some derivative financial items on the balance sheet are monetary items and some are non-monetary. Interest rate swaps are commonly used to hedge monetary gains and losses. Monetary items are subject to purchasing power gains and losses. Firms minimize holdings of monetary assets in highly inflationary economies like Venezuela where monetary holdings are a disaster. Firms often experience some monetary asset losses in mildly inflationary economies. They also experience purchasing power gains on monetary liabilities such as long-term fixed-rate mortgages.

    In my theory courses I used a tabbed Excel workbook to illustrate the calculation of monetary-item gains and losses as plug figures ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls
    Especially note the Answers tab.

    3.

    Exit value accounting replaces accrual accounting GAAP when accounting for personal estates and non-going concerns. ---
    Scroll Down to Exit Value at
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting

     In some ways computing exit value net income plug amount is like the Hicksian economic concept of income (a plug calculation), although it really is not Hicksian income due to the many ways of measuring various balance-sheet components of assets and liabilities in modern-day mixed-model measuring systems. Also there are "assets" and "liabilities" in the Hicksian model that accountants cannot measure for balance sheet accounts such as some intangibles (think the value of human resources and business reputations), contingent liabilities, etc.

    In my theory courses I used a tabbed Excel workbook to illustrate the calculation of exit value net earnings as a plug vfubure. ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls
    Especially note the Answers tab.

    4.
    Entry value (replacement cost) accounting replaces accrual accounting GAAP when accounting for personal estates and non-going concerns. ---
    Scroll Down to Entry Value at
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting

     In some ways computing exit value net income plug amount is like the Hicksian economic concept of income (a plug calculation) , although it really is not Hicksian income due to the many ways of measuring various balance-sheet components of assets and liabilities in modern-day mixed-model measuring systems. Also there are "assets" and "liabilities" in the Hicksian model that accountants cannot measure for balance sheet accounts such as some intangibles (think the value of human resources and business reputations), contingent liabilities, etc.

    Unlike exit values, entry (replacement costs) are not really "values" since entry value accounting is subject to arbitrary accrual adjustments (think depreciation) just like historical costs.

    In my theory courses I used a tabbed Excel workbook to illustrate the calculation of exit value net earnings as a plug vfubure. ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls
    Especially note the Answers tab.

     


    Jensen Comment About Tom Selling's Forthcoming Book on Valuation of a Corporation
    If and when I review your forthcoming book, here are some things I will probably address.

    1. The operational definition of Hicksian income and value. Replacement cost adjustments have roots in historical costs (such as the need for depreciation calculations at are arbitrary and the difficulty of dealing with technological change when measuring replacement costs). Exit value accounting usually values assets in their worst possible usage (liquidation in yard sales). Exit values are generally far different from "value in use" and nobody, to my knowledge, has a reliable way to measure value in use.

    2. Hicks never dealt with the spikes and valleys of transient market value changes seemingly independent of the items being valued --- when the entire market moves up and down to short-term  transient happenings. This is related to the problem of having periodic (annual) income measures that are almost certain not to be realized in short runs --- such as the value of the land under the new $1 billion Apple Corporation complex in Austin, TX. Annual changes in the value of the land are not likely to be realized since the land will not likely be bought and sold apart from the entire plant that is built on the land, and that plant is itself not likely to be liquidated for many years by Apple since it's intended for operations and not financial investment.

    Hicks never contemplated the complicated items that in the 21st Century greatly complicate the practical measurement of the value of a firm. The first thing that comes to mind are all the contingency items that generally are either not disclosed or disclosed only in footnotes to financial statements because of the tremendous uncertainties in those contingencies. The second thing that comes to mind is the related issue of all the complicated items in contracts of a firm, especially debt conversion items. The third thing that comes to mind are the intangibles that accountants have never really figured out how to value such as the values of Apple Corporation's work force, reputation, etc.

    4. Hicksian valuation probably does will not pass a cost benefit text in practice since reliable valuations for some items are extremely expensive to obtain and usually end up being highly subjective in terms of differences of opinions of alternate appraisers. Historical cost avoids this dilemma by not pretending to be a total "valuation" of the firm, a point repeatedly hammered by AC Littleton. Economists are often valued by the predictive value of historical cost accounting that financial analysts seem to like and defend (Exhibit A is the short life of FAS 33). Time and time again empirical studies by accountic scientists find predictive value in traditional accounting statements of the FASB and IASB. Your book should provide some empirical evidence of the predictive value of Hicksian financial statements.

     

    Hicks on Accounting ---
    http://www.accountingin.com/accounting-historians-journal/volume-9-number-1/hicks-on-accounting/

    Hicks himself warned that income and related concepts are “bad tools, which break in your hands.”4 However, with few exceptions, most theorists have not only ignored this admonition, but they also have overlooked other work by Hicks which is more directly related to accounting practice.

    Sprouse's what-you-may-call-its: fundamental insight or monumental mistake?
    https://www.thefreelibrary.com/Sprouse%27s+what-you-may-call-its%3A+fundamental+insight+or+monumental...-a0230061133

    Hicksian income is defined only for a world of complete and perfect markets and is less useful for a firm operating in costly incomplete markets. Hicks [1939, pp. 193-196] describes a firm's decision as ...

    Earnings Quality---
    https://www.questia.com/library/journal/1G1-105368177/earnings-quality

    Have Academic Accountants and Financial Accounting Standard SettersTraded Place ---
    https://www.scribd.com/document/290584113/Accounting-Economics-and-Law-A-Convivium

    Book Review
    IAN DENNIS, The Nature of Accounting Regulation (New York, NY: Routledge, 2014, ISBN 978-0-415-89195-0, pp. 135) ---
    https://aaapubs.org/doi/full/10.2308/accr-10404
    Especially note the references cited in this book review:

    REFERENCES
      Bromwich, M., R. Macve, and S. Sunder. 2010Hicksian income in the conceptual frameworkAbacus 46 (3): 348376.10.1111/j.1467-6281.2010.00322.x [Crossref] [Google Scholar]
      Georgiou, O., and L. Jack. 2011In pursuit of legitimacy: A history behind fair value accountingThe British Accounting Review 43 (4): 311323.10.1016/j.bar.2011.08.001 [Crossref] [Google Scholar]
      Gill, M. 2009Accountants' Truth: Knowledge and Ethics in the Financial WorldNew York, NYOxford University Press[Google Scholar]
      Latour, B. 2005Reassembling the Social: An Introduction to Actor-Network TheoryNew York, NYOxford University Press[Google Scholar]
      Macintosh, N. B. 2005Accounting, Accountants and Accountability: Poststructuralist PositionsLondon, U.K.: Routledge[Google Scholar]
      Macve, R. 1997A Conceptual Framework for Financial Accounting and Reporting: Vision, Tool Or Threat? New York, NYGarland[Google Scholar]
      Mouck, T. 2004Institutional reality, financial reporting and the rules of the gameAccounting, Organizations and Society 29 (5-6): 525541.10.1016/S0361-3682(03)00035-7 [Crossref] [Google Scholar]
      Power, M. 1997The Audit Society: Rituals of VerificationOxford, U.K.: Oxford University Press[Google Scholar]
      Power, M. 2010Fair value accounting, financial economics and the transformation of reliabilityAccounting and Business Research 40 (3): 197210.10.1080/00014788.2010.9663394 [Crossref] [Google Scholar]
      Young, J. J. 2014Separating the political and technical: Accounting standard setting and purificationContemporary Accounting Research (forthcoming). [Google Scholar]
      Zeff, S. A. 2013The objectives of financial reporting: A historical survey and analysisAccounting and Business Research 43 (4): 262327.10.1080/00014788.2013.782237 [Crossref] [Google Scholar]
     
    YVES LEVANT and OLIVIER DE LA VILLARMOIS (editors), French Accounting History: New Contributions (Abingdon, Oxon, U.K.: Routledge, 2012, ISBN 13:978-0-415-84783-4, pp. viii, 178).

     

    Accounting Theory Bibliography ---
    https://maaw.info/AccountingTheoryArticles.htm

    The Hicksian Method and The Slutskian Method ---
    https://owlcation.com/social-sciences/The-Hicksian-Method-and-The-Slutskian-Method

     


     

     

    Market Value Accounting: Entry Value (Current Cost, Replacement Cost) Accounting

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33. Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates. The FASB rescinded FAS 33 when it issued FAS 89 in 1986.

    Current cost accounting by whatever name (e.g., current or replacement cost) entails the historical cost of balance sheet items with current (replacement) costs. Depreciation rates can be re-set based upon current costs rather than historical costs. 

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies are no longer required to generate FAS 33-type comparisons. The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. Exit value accounting is required for firms deemed highly likely to become non-going concerns. Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people). Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities. Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting. Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

    The Decline of Interest in Current (Replacement) Cost Accounting in the 1980s

    In the 1980s the FASB introduced FAS 33 as an experiment in the value added to investors of supplemental current (replacement) cost accounting. The FASB concluded that financial analysts and investors found little value in the supplemental disclosures, and the FASB a few years later rescinded FAS 33.

    The Accounting Standards Committee in England also ran a similar  experiment that was rescinded ---
    http://onlinelibrary.wiley.com/doi/10.1111/j.1467-6281.1996.tb00449.x/full

    The Withdrawal of Current Cost Accounting in the United Kingdom: A Study of the Accounting Standards Committee

    . . .

    Evidence from the archives of the U.K. Accounting Standards Committee (ASC) is used to trace the events leading to the withdrawal of the current cost accounting standard, SSAP 16, from 1980 to 1988. Three central issues are addressed. First, the ASC's role as a regulatory body is considered in the light of the failure to obtain compliance with SSAP 16 and to find an acceptable replacement. Second, the decline in support for SSAP 16 is explained in terms of changes in the economic environment. Third, the roles of different interest groups in the process are analysed.

    Market Value Accounting: Entry Value (Current Cost, Replacement Cost) Accounting

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies are no longer required to generate FAS 33-type comparisons. The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. Exit value accounting is required for firms deemed highly likely to become non-going concerns. Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people). Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities. Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting. Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.


    Tom Selling:  Double-Entry Accounting in Modern Times (May 17, 2017) ---
    http://accountingonion.com/2017/05/double-entry-accounting-in-modern-times.html

    Truth in labeling —Starting with a clean sheet should also mean jettisoning such time-worn terminology as “earnings” and “financial position” that have come to promise more than they can deliver.  There might have been a time long ago when accounting came reasonably close to measuring economic earnings and financial position, but not anymore, and likely never again.

    Jensen Comment
    What Tom needs to avoid is what I call the Baruch Lev mistake of promising more than can be delivered realities of "truth" and measurement of "economic earnings." Truth to me entails facts that are so obvious they cannot be disputed by rational beings. Economists have never found truth except in artificial worlds built on hypothetical assumptions detached from the real world. This is probably why the SEC approached the accounting profession rather than the economics profession when it passed the baton on standard setting for financial reporting in capital markets.

    Economic earnings cannot be measured in the real world because there are so many intangibles that cannot be reliably measured.  Baruch Lev preaches these intangibles can be measured, but he's not convinced business decision makers that he has reliable measurement systems.

    Tom wants to "jettisoning such time-worn terminology as 'earnings' and 'financial position' that have come to promise more than they can deliver. Note how Tom fails to mention the vast body of literature demonstrating (by empirical studies and by interviews and by case studies) where "earnings" and "financial position" have considerable impact on financial and business operating decisions. Tom avoids this literature by sticking his head in the sand. Starting with a blank sheet is doomed to failure if it ignores the scholarly literature of the past and present. For example, has he looked at the vast amount of evidence that suggests "earnings" however badly designed as a plug figure that makes the balance sheet balance is predictive of future earnings.

    I keep looking for citations and references in Tom's posts. His "blank sheet" will never impress academics or practitioners until he cites prior research and builds upon such research.

    He will one day have to demonstrate to decision makers that his own definitions are more predictive and reliable. I doubt that he will succeed here, but I greatly look forward to when he has a measurable "earnings" and "financial position" surrogates that are more predictive and reliable.  

    Indeed I fear that his concepts will depend upon value appraisals in thin and unstable markets that are far less reliable than present measures assets and liabilities.

     

    Reconcile, reconcile —  The property of double-entry accounting that comprehensively links stocks to flows (i.e., “articulation”) will be exploited to the maximum extent practicable through detailed quantitative disclosures that are linked directly and explicitly to the financial statements, and among themselves.

    My mentor, Yuji Ijiri, modeled the perfect accounting system for reconciliation. But it was totally impractical for the real world. As you build soft numbers into the system it becomes even less and less reliable.

     

    Corresponding recognition criteria — Although I can’t say this for sure, I wouldn’t be surprised if Pacioli had realized that a claims on one entity must also be an asset of some other entity (more on that in a follow-up post).  Therefore, a non-corresponding definition for liabilities, and other non-residual claims, is not necessary.  All that is needed is a definition of “asset” for accounting purposes.

     

    I always remember a statement made by a University of Chicago professor years ago. He said Boeing wants to book a sale of an airplane purchased by Eastern Airlines. Eastern Airlines denies it purchased an airplane (back in the days when even capital leases were not booked by lessees).

    Do current accounting standards require correspondence in initial booking by independent buyers and sellers? They do when payment is made in cash. But in barter transactions (say real estate exchanges) between X and W does the booked value of the property received by X have to equal the booked value of the property received in exchange by Y?

     

    Claims presentation — Instead of liabilities versus owners’ equity, S-OFA will refer to ‘non-residual interests’ versus ‘the residual interest’ (the latter being measured as the difference between total assets and total non-residual interests).  Thus, the question that has bedeviled the FASB of what is a liability, or what is not, will come down to a question of presentation.  For example, pure liabilities may be presented as a group, apart from the hybrid claims I mentioned earlier

    The huge complicating factor here will be "residual interests" that involve contingency claims based upon outcomes of the unknown future.

    Presumably Tom intends to define a bright line for the real world that partitions residual and non-residual claims. We don't do that now very well at the moment, and it's not at all clear that Tom can pull this bright line out of the hat for the millions of kinds of variations in contingency claims in the real world.

     

    Closing Comment
    Financial accounting academic research in my opinion is pretty much a big yawn these days. Both Tom Selling and Baruch Lev add some excitement to the accountics studies that for four decades have dominated the field. Some of those studies are useful and interesting, but there's little excitement and commentary about the findings. Tom and Baruch add some excitement, But I'm not optimistic about their pending contributions to the real world.

    In any case I'm watching and will keep the AECM posted when I find something that I think is worth noting. Hopefully others will also watch and point out things that I miss.

    I might make the following proposition:
    I think Tom Selling needs to retain double entry to avoid having to define earnings as something other than a plug to make balance sheets balance.

    May 24, 2017 reply from Tom Selling

    Bob,

    Thanks for posting a link to my blog and for taking the time to respond in a systematic fashion.  But I need to point out some fundamental misunderstandings on your part:

     

    I have tried to make it crystal clear that I do not intend to claim that S-OFA will be capable of reporting economic earnings.    I didn’t mention this in my post, but the term I am thinking about using to replace “net income” is “recognized earnings.”  It implies that S-OFA will estimate a subset of economic earnings.  It is similar in concept to Tobin’s Q where economic value is seen as the replacement cost of recognized net assets plus the value of unrecognized intangibles.

     None of the empirical literature I am aware of that documents the relevance of reported earnings to investors deals with the question of whether we could do better.  I intend to show that U.S. GAAP lacks face validity – ie, it clearly does not reflect the concept it purports to measure.  S-OFA will have higher face validity by, among other things, not using misleading terminology, not committing numerous egregious violations of mathematical principles, and enhancing representational faithfulness.

     Yuji Ijiri was a great theoretician. I will be proposing implementable improvements to actual deficiencies in U.S. GAAP.  I believe that my proposals will be compelling because they will result in better information, be more understandable, less costly to implement, and reduce opportunities to manipulate the financial statements.

    The FASB already solved the claims presentation problem in a proposal with a bright line.  It was called basic ownership interests.   It was shot down by the EU and the IASB, so the FASB backed away from implementation.  I’m going to implement it. 

     

    As to your proposition, the point of my post is that double-entry accounting is still useful, even if no longer for the reasons contemplated in the 15th century.

     

    As to applicability to the “real world,” I admit that you could well be correct.  S-OFA will be apolitical, which is not the way the real world works.  My clean sheet of paper metaphor is an allusion to Rawls theory of social justice.  Very loosely speaking, if the writers of accounting rules could not know how it would affect them, what would the rules provide for?

     

    Best,
    Tom

    May 14, 2017 reply from Bob Jensen

    Hi Tom,

    One thing you will have to address is the economics studies pointing to failures of Tobin's Q. The number one problem is that Tobin's Q was found to not predict as well as traditional fundamentals --- check out the literature, including the findings of Larry Summers and Wesley Mitchell.

    Similar findings were found with the FASB's FAS 33 effort to provide replacement cost numbers:

    Watts, R. L. and J. L. Zimmerman. 1980. On the irrelevance of replacement cost disclosures for security prices. Journal of Accounting and Economics (August): 95-106.

    Beaver, W. H., P. A. Griffin and W. R. Landsman. 1982.The incremental information content of replacement cost earnings. Journal of Accounting and Economics (July): 15-39.

    Schaefer, T. F. 1984. The information content of current cost income relative to dividends and historical cost income. Journal of Accounting Research (Autumn): 647-656

    Sutton, T. G. 1988. The proposed introduction of current cost accounting in the U.K.: Determinants of corporate preference. Journal of Accounting and Economics (April): 127-149.

    Swanson, E. P. 1990. Relative measurement errors in valuing plant and equipment under current cost and replacement cost. The Accounting Review (October): 911-924.

     

    The real problem with exit value or entry value (replacement cost) appraisals of disaggregated assets is that the market (e.g., yard sale transactions prices or current construction costs) ignore the synergies of "value in use" --- that illusive measurement that economists and accountants have never been able to measure reliably because it varies so much between "uses" of an asset among the other assets for which that asset is only a small part. For example, does the replacement cost estimate of a giant warehouse really mean much apart from the how the owner uses it such as when the owner of Amazon versus Sears.

    The best estimate of value in use is share prices, but share prices have too much noise in that that they reflect things other than value in use such as daily political happenings, terror incidents somewhere in the world, and fake news in the media. Quant models that trade on current events affecting transitory share prices may capture gains and losses totally apart from the fundamental value in use of aggregated net assets of a business firm.

     

    It's easy to criticize enduring historical cost accounting in terms of neither measuring either disaggregated or aggregated value of an asset. However, as AC Littleton and Yuji Ijiri point out the purpose of historical cost accounting is not to measure economic value. Investors don't divide the reported retained earnings by the number of outstanding shares to look for pricing opportunities on the stock market when historical cost accounting is the main basis for measuring retained earnings. Nor could they do so if all assets and liabilities were measured reliably at entry values (replacement costs) or exit values. It's that aggregative value in use thing that none of the bases of accounting (entry value, exit value, historical cost, PLA historical cost) provide.

    Bob Jensen

     

     


    Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Conforms to capital maintenance theory that argues in favor of matching current revenues with what the current costs are of generating those revenues. For example, if historical cost depreciation is $100 and current cost depreciation is $120, current cost theory argues that an excess of $20 may be wrongly classified as profit and distributed as a dividend. When it comes time to replace the asset, the firm may have mistakenly eaten its seed corn.

     

    ·     If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price level adjustments are avoided.

     

    ·     Avoids to some extent booking the spread between selling price and the wholesale "cost" of an item. Recording a securities “inventory” or any other inventory at exit values rather than entry values tends to book unrealized sales profits before they’re actually earned. There may also be considerably variability in exit values vis-à-vis replacement costs.
     

    Disadvantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Discovery of accurate replacement costs is virtually impossible in times of changing technologies and newer production alternatives.  For example, some companies are using data processing hardware and software that no longer can be purchased or would never be purchased even if it was available due to changes in technology. Some companies are using buildings that may not be necessary as production becomes more outsourced and sales move to the Internet. It is possible to replace used assets with used assets rather than new assets. Must current costs rely only upon prices of new assets?

    ·     Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.

    ·     Accurate derivation of replacement cost is very difficult for items having high variations in quality. For example, some ten-year old trucks have much higher used prices than other used trucks of the same type and vintage. Comparisons with new trucks is very difficult since new trucks have new features, different expected economic lives, warranties, financing options, and other differences that make comparisons extremely complex and tedious. In many cases, items are bought in basket purchases that cover warranties, insurance, buy-back options, maintenance agreements, etc. Allocating the "cost" to particular components may be quite arbitrary.

    ·     Use of "sector" price indices as surrogates compounds the price-index problem of general price-level adjustments. For example, if a "transportation" price index is used to estimate replacement cost, what constitutes a "transportation" price index? Are such indices available and are they meaningful for the purpose at hand? When FAS 33 was rescinded in 1986, one of the major reasons was the error and confusion of using sector indices as surrogates for actual replacement costs.

    ·     Current costs tend to give rise to recognition of holding gains and losses not yet realized.

    Jensen Comment

    MAAW's Replacement Cost Bibliography --- http://maaw.info/ReplacementCostAccountingMain.htm

    In the 1980s academic accounting research did more to undermine FAS 33 than to save it. Examples of research that found no significant value added (relative to cost added) to current (replacement) cost supplements included the following:

    Watts, R. L. and J. L. Zimmerman. 1980. On the irrelevance of replacement cost disclosures for security prices. Journal of Accounting and Economics (August): 95-106.

    Beaver, W. H., P. A. Griffin and W. R. Landsman. 1982.The incremental information content of replacement cost earnings. Journal of Accounting and Economics (July): 15-39.

    Schaefer, T. F. 1984. The information content of current cost income relative to dividends and historical cost income. Journal of Accounting Research (Autumn): 647-656

    Sutton, T. G. 1988. The proposed introduction of current cost accounting in the U.K.: Determinants of corporate preference. Journal of Accounting and Economics (April): 127-149.

    Swanson, E. P. 1990. Relative measurement errors in valuing plant and equipment under current cost and replacement cost. The Accounting Review (October): 911-924.

     

    Tom Selling wrote the following at
    http://accountingonion.typepad.com/theaccountingonion/2009/04/replacement-cost-rebound.html

     

    ***********Begin Quote
    The most straightforward way to determine replacement cost to meet the wealth measurement objective is to ask oneself what would be the least amount one would have to pay for an asset (or a similar asset that provided the same utility), if one did not actually already own it. It seems to me that real estate appraisers make estimates for specific properties on that basis as a matter of course. Often, their best estimate is the result of making somewhat objective adjustments to 'comparables' for age, floor space and even location.

    Having said that, I would allow for any number of approaches to approximating replacement cost, so long as they adequately answered the question I posed in the previous paragraph.  Like FAS 157, the greater the subjectivity in the estimates, the more detailed would be the disclosures.  However, in all cases, I would require reconciliations of the changes in balance sheet accounts in sufficient detail to make all assumptions, and changes in assumptions, transparent.
    ***********End Quote

     

    True Story
    Bob Jensen has a Sears Craftsman snow thrower purchased in 2006 for $1,800 with a five-year onsite warranty for all parts and labor. If he decides to replace the machine every five years, he’s really not concerned with physical deterioration if he assumes that the salvage value is after five years is $300 for a perfectly working machine maintained by Sears mechanics at his beckoning call. There is historical cost depreciation of $300 per year assuming the decline in value on the used snow machine market is strictly linear. Assume that replacement cost depreciation is $$350 per season.

    Bob’s good friend Helmut Gottwick survived four years as an engineer and machinist on a German U-Boat in World War II. After arriving in New Hampshire in 1950 he bought a used snow thrower for $24. It was made by Studebaker in 1937. Unlike Bob Jensen who has no mechanical skills whatsoever, Helmut can make most old machines work perfectly as long as he is still of sound mind and body to work in the machine shop in his garage. He’s totally rebuilt the Studebaker snow thrower engine two times, including the making of virtually all new parts in his shop. Assuming that his remaining life expectancy was 60 years in 1950, the depreciation on his snow thrower is $0.40 per year for the rest of his life. Assume replacement cost depreciation is $350 per season.

    Fiction Added
    Suppose Bob and Helmut clear driveways for neighbors for an average of $1,000 per season net of gasoline expense (there’s a lot of snow in these mountains). Replacement cost write ups of Bob Jensen’s snow machine and depreciations of $350 per year make some sense on Capital Maintenance Theory. If Bob Jensen used historical cost accounting and declared a $700 dividend to himself each season, he would not have sufficient retained earnings to cover the cost of a new snow thrower every five years. It makes some sense, therefore, for Bob to only declare a $650 dividend for wild women and booze. If he saves an amount of cash equal to retained earnings each season, he will have sufficient savings to buy that new snow thrower after every five year period.

    But suppose we impose a replacement cost accounting rule on Helmut Gottwick’s snow throwing business. If he can only declare a $650 dividend every year the fact of the matter is that for 60 years he’s have been deprived of a lot of wild women and booze (in reality he’s a very devoted husband and grandfather). His reported earnings also distort the fact that, because of his machinist skills, he's a heck of a lot better business man than Bob Jensen who must settle for older women and younger whiskey.

    The Point of the Story
    Replacement cost accounting can distort reported assets and earnings under totally different maintenance and replacement policies. Over 60 years, the CPA auditing firm might uselessly force Helmut Gottwick to retain $350 per year for a machine that cost him $24 in 1950 and has a useful life of 60 years in his situation, Capital maintenance theory makes no sense in Helmut’s case since during his lifetime the old Studebaker snow thrower will work as well or better than a new snowthrower. In Bob Jensen’s situation, capital maintenance theory makes much more sense.

    In truth Helmut would not be required to take $350 replacement cost depreciation for 60 years, because he would only be required to bring book value up to depreciated replacement value each year. But I thought my exaggeration above made a better story.

     

    A very concise summary of the positions of various accounting theory experts in history since 1909 and authoritative bodies over the years since 1936:
    "Asset valuation: An historical perspective"
    Authors: Racliffe, Thomas A. (Thomas Arthur) and Munter, Paul
    Accounting Historians Journal
    1980
    http://umiss.lib.olemiss.edu:82/record=b1000230
    Jensen Comment:  I really liked this summary of the valuation literature prior to 1980.
    For example, what was the main difference between exit value advocates Chambers versus Sterling?
     


    Humanity is forgetting its history more rapidly. And celebrities are losing their fame faster than ever.
    Marc Parry, "Scholars Elicit a 'Cultural Genome' From 5.2 Million Google-Digitized Books," Chronicle of Higher Education, December 16, 2010 ---
    http://chronicle.com/article/Scholars-Elicit-a-Cultural/125731/?sid=wc&utm_source=wc&utm_medium=en

    Jensen Comment
    It's ironic that the irrelevance of history in our academic disciplines is transpiring at at time when historical works are increasingly available and searchable at virtually zero cost. Perhaps one problem is that we're increasingly discovering how vast the histories of our discipline have become. Do intermediate accounting instructors even mention the works of O'Neal, Canning, Paton, and Littleton in this century?

    December 17, 2010 message from Bob Jensen to Tom Selling,

  • Hi Tom,

  • Historical costing versus valuation is primarily a debate over primacy of balance sheets versus income statements. In valuation models like exit and entry value models, primacy is given to balance sheet accounts. Income accounts are residuals that typically blend realized and unrealized changes in values in a confusing way that often obscures the importance of a bird in hand versus 100 in the bush. Most temporal ups and downs in unrealized values are never realized. They're like vapors that never condense if you'll pardon my mixed metaphors.

  • In historical costing the primacy is on the matching concept with net income being the major focus on how well management performed as stewards with the resources entrusted to those managers. Balance sheet accounts emerge as leftovers from the measurement of income. The Paton and Littleton (1940) monograph is mostly a statement on how to compute net income based upon realized revenues.

  • There is also the issue that historical cost ledger balances are attested to history of auditing standards. We've not yet reached a point where most entry and exit values are allowed to be attested to in the auditing standards.

  • Historical cost has the advantage in the presumption that historical cost is equal to value when resources are first acquired. This greatly facilitates auditing of historical costs in the ledger accounts, and I know of no system where historical costs are erased from the ledgers.

  • I don't think AC Littleton argued that there was not value added in also learning how management is performing in terms of unrealized value changes. He just did not think they should be booked into the ledgers until realization took place. He also thought that there were many types of exit values that auditors had no business including in the attestation process, including the appraisal values of over 300 hotels provided in the 1981 Days Inn financial statements as a separate column beside the historical cost column.

  • To this day in 2010 auditing standards do not allow auditors to attest to appraisal values of hotels and to do so would be an enormous leap in the scope of attestation services. In comparison the attestation to exit values of financial and derivative financial instruments is a mini-step in that direction. To attest to real estate exit or entry values would be a giant step.

  • By being forced to have only one horrid column in mixed model financial statements, this has forced scholars like Mary Barth to compare the matching concept as dead meat. If she were allowed the to add valuation columns alongside the historical costing column the matching concept could be revived and put to good use in my judgment.

    The reference is
    "Global Financial Reporting: Implications for U.S.," by Mary Barth, The Accounting Review, Vol. 83, No. 5, September 2008 ---
    Not free at http://www.atypon-link.com/AAA/doi/pdfplus/10.2308/accr.2008.83.5.1159

    In the area of fair value accounting I agree with Mary Barth on fair value accounting for financial assets. I strongly disagree on fair value accounting for most non-financial assets. My disagreements are stated at http://faculty.trinity.edu/rjensen/theory01.htm#FairValue

    On Page 1166 she flatly asserts:

    First, there is no “matching principle.” That is, matching is not an end in itself and matching is not an acceptable justification for asset or liability recognition or measurement. The conceptual framework explains that matching involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events (FASB 1985, para. 146; IASB 2001, para. 95). Matching will be an outcome of applying standards if the standards require accounting information that meets the qualitative characteristics and other criteria in the conceptual framework. Matched economic positions will naturally result in matched accounting outcomes. However, the application of a matching concept in the conceptual framework does not allow the recognition of items in the statement of financial position that do not meet the definition of assets or liabilities (IASB 2001, para. 95). Thus, there would be no justification for deferring expense recognition for an expenditure that provides no future economic benefit or for deferring income recognition for a cash inflow that will not result in a future economic sacrifice.

    I strongly disagree. The standards just do not allow automobile inventories to be written up to expected sales prices until those sales are finalized. Carrying the inventories at historical cost or LCM (if permanently impaired)  is part and parcel to the "matching principle" eloquently laid out years ago by Paton and Littleton. Both international and domestic standards still require cost amortization, depreciation, and creation of warranty reserves. These are all rooted in the "matching principle" which has not yet died when defining assets and liabilities in the conceptual framework. In most instances the historical cost is still being booked and spread over the expected life of future economic benefits. Even if a company adopted a replacement cost (current cost) adjustment of historical cost of a depreciable asset, those replacement costs still have to be depreciated since old equipment cannot simply be adjusted upward to new, un-depreciated replacement cost.

    Automobile manufacturers should not be allowed to report earnings when they produce more vehicles to add to vast parking lots of unsold vehicles.

    Paton and Littleton never argued that the "matching principle" for expense deferral applies to assets that have "no future economic benefits." In that case there would be no benefits against which to match the deferred expense.  Hence there's no deferral in such instances. I do not buy Barth's contention that there is no longer any "matching principle." If there are potential future benefits, the matching principle still is king except in certain instances where assets are carried at exit values such is the case for precious metals actively traded in commodity markets that are extremely liquid.

    Bob Jensen

    December 18, 2010 message from Bob Jensen
  •  

    Issues in Replacing Historical Cost of Inventories with Replacement Costs (Entry Values)

    Aside of John Canning's famous dissertation, perhaps the best known advocate, across several decades of writing and speaking, of replacement cost accounting for fixed assets is the University of Michigan's famous Bill Paton. When Patricia Walters declared on the AECM that she, like Tom Selling, was an advocate of replacing historical costs of inventories with replacement costs, I became inspired to quote what Bill Paton had to say about replacing historical costs of inventories with replacement costs. That quotation appears near the end of this tidbit.

    Before quoting Professor Paton, however, I thought I might mention some of the most famous advocates of current value theory theorists and advocates in history. You can read about most of the theorists mentioned in this tidbit in their Accounting Hall of Fame citations at
    http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/
    Of course other Hall of Famers like Edgar O. Edwards and Philip Bell also advocated some forms of current value accounting, but their writings were somewhat more complex than the Hall of Famers mentioned below.

    Famous Historical Cost Theorists
    Probably the best known historical cost advocate of all time is AC Littleton followed by mathematician Yuji Ijiri. Both argued that historical cost balance sheets do not pretend to be valuations beyond the original dates on which the transactions were booked into the ledgers. Balance sheet numbers are simply residuals in from the calculation of income statement numbers under the Realization Principle for revenues and the Matching Principle for costs and expenses. Although Littleton and Ijiri also advocate price level adjustments, they are not advocates of current value adjustments beyond supplementary disclosures of exit values or entry values.

    The most famous publication of the American Accounting Association is the 1941 monograph on historical cost theory by Paton and Littleton ---
    http://faculty.trinity.edu/rjensen/theory02.htm#Paton
    The biggest selling monographs in the AAA's Studies in Accounting Research series are the double/triple bookkeeping monographs by Yuji Ijiri that were rooted in historical cost accounting ---
    http://aaahq.org/market/display.cfm?catID=5

    Famous Exit Value (Disposal Value) Theorists
    In history, the strongest advocates of exit value replacement of historical costs in financial statements included Kenneth MacNeal, Bob Sterling, and Australia's famous Ray Chambers. Their main arguments boiled down to very simple wash sale illustrations. Suppose Company H and Company S begin with identical balance sheets of A=$1000 Corn Inventory and E=$1.000 Equity where each company paid $1 for 1,000 bushels of corn. In order to dress up the financial statements before closing its books, Company S sells its corn for $2 per bushel in an intended wash sale. Then immediately after closing its books Company S buys back corn for $2 per bushel. Company S now has a balance sheet of A=$2,000 Corn Inventory and E=$1000 Invested Capital + $1,000 retained earnings.

    In the above example Company S looks like it performed twice as well as Company H even though in the final outcome both remain identical in terms of all economic criteria. Company H has simply undervalued its historical cost inventories and did not realize any revenue from sales. In real life, however, the situation is not so simple. In 1981 when Days Inns of America wanted to dress up its historical cost balance sheet (for an IPO) the transactions cost of selling each of its 300+ hotels would've been immense for selling and then buying back each hotel. Accounting rules did not permit departing from historical cost valuations for each of these hotels in its main Price Waterhouse-audited financial statements.. However, nothing prevented Days in from hiring a large real estate appraisal firm from deriving 1981 unaudited exit value estimates of each of the 300+ hotels.

    To make matters worse, the "value in use" of these 300+ plus hotels most likely plunged dramatically the day its dynamic President had a sudden heart attack and died at a very young age. A "value in use" estimate is much more volatile than historical cost or replacement cost valuations.

    The 1981 Days Inns Annual Report (for which I have three copies in my barn remaining from my days of teaching in which I loaned a copy of this 1981 Annual Report to each of my students) would've made MacNeal, Chambers, and Sterling ecstatic. The historical cost book values of these 300+ hotels aggregated to $87,356,000 whereas the exit values aggregated to an unaudited amount of $194,812,000. Wow!

    This is probably value added when it comes to financial analysts and investors willing to trust these unaudited estimates from a real estate appraisal firm. The numbers of course are much more subjective and easy to manipulate for devious purposes than the cost numbers. Ande even if totally accurate, there's a huge problem of having measured current hotel values of a company's assets in there worst possible economic uses --- disposing each asset separately in assumed liquidation of the company. The $194,812,000. sum of disposal values of Days Inns hotels  totally ignores the synergy value of these when grouped together under the management of Days Inns. Exit value theorists have never provided us with a way of measuring the value of the whole other than by summing the exit disposal values of the parts. In reality the "value in use" of these 300+ hotels might've been $294,812,000, $394,812,000, or $494,812,000. We will never know because exit theorists cannot measure "value in use" of grouped assets of one company let alone the "value in use" if these hotels are sold to other companies like Holiday Inns of America where "value in use" is probably very different than "value in use" for Days Inns.

    Famous Replacement Cost (Entry Value) Theorists
    I think the best known theorists advocating entry values (replacement costs) are John Canning (in a published doctoral thesis) and William A Paton (in a lifetime of writing and speaking). Although Paton's most famous book is probably the 1941 Paton and Littleton monograph on historical cost theory this was more of an academic exercise for Bill Paton since his heart was truly in replacement cost fixed asset valuations ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Paton

    Whereas the exit value of a 20 year old hotel might be $1 million in a liquidation sale, the replacement cost (entry value) of a new hotel might be $5 million. In entry value theory this $5 million would have to be adjusted for 20 years of hypothetical depreciation to arrive at its $2 million replacement cost estimate. Exit value theorists are proud of their not having to resort to arbitrary depreciation calculations. Entry value theorists are proud of being able to estimate current values when exit values are meaningless.

     Many older assets may have $0 exit value even though their value in use is still considerable. This is especially the case when costs of dismantling an old and large piece of equipment and re-installing it in another factory is so prohibitive that nobody will pay to re-install the item. There's also the problem of the way exit value markets work even for new assets. If a farmer pays $500,000 for a new diesel tractor the exit value may decline by 100,000 before the tractor is moved from tractor dealer's show room. Such is the nature of "new" versus "used" equipment exit values even when used is still or almost new.. Entry values are not quite so flaky since the replacement cost of that tractor might remain constant between the date of purchase and a month later after the tractor was used vigorously.

    Also in the case of exit values of 300+ hotels, exit values of a New Orleans Days Inn versus a Fargo Days Inn (of identical age, style, and sizes) may differ greatly due to variations resale markets  in local economies. This is not generally true of replacement costs since the cost of constructing new hotels is not so variable in terms of local economies.

    Thus replacement costs overcome the flaky nature of many exit value estimates. But replacement costs suffer from the same maladies of historical cost valuations in that arbitrary formulas for such things as depreciation and amortization.

    To put my Bill Paton quotations into perspective it should be noted that most accounting historians describe him as a "replacement cost" man ---
    http://faculty.trinity.edu/rjensen/theory01.htm#Paton

    Also Paton's writings are best known from the days before we had accounting standard setting bodies like the APB, FASB, and IASB. The AICPA and its ARB committees seldom set accounting rules on really controversial issues. Instead GAAP, like common law, was drawn from "generally accepted" practices of accounting in industry and practices acceptable to accounting system auditors. The SEC was formed in 1933 with powers to dictate accounting standards for corporations listed on major stock exchanges in the U.S. However, the SEC was then and still is reluctant to take standard setting away from professional accountants.

    In 1932 corporations and their auditors had much more flexibility than today in how to value current and fixed assets than the have today. For example in 2010 both the FASB and IASB rules virtually require historical cost inventory valuation for the majority of inventories reported globally in balance sheets. But in 1932 it was much easier for a company to report inventories at current values if its shareholders did not make a big fuss over exit value or entry value reporting of inventories.

    But in since the crash of 1929, most companies stuck with historical cost valuation. Beside my desk I always keep the Second Edition of Accountants' Handbook edited by and heavily written by William A. Paton. The First Edition is dated 1923, and my copy is the Second Edition dated 1932.

    I think the following quotation from Paton's 1932 handbook pretty well describes the debate among theorists that carries on to the 21st Century: Perhaps the doctoral thesis of John Canning eventually strengthened Paton's advocacy of replacement cost accounting. He generally did not advocate exit values for going concerns.

     

    Accountants' Handbook. Edited by William A. Paton,  Second Edition (Ronald Press, 1932, pp. 741-742).
    (emphasis added with red underlining)
    The Balance Sheet of Going Concern --- Conventional View
    In connection with special statements for enterprises undergoing reorganization or liquidation it is generally conceded that appraisal values---"fair market values"---are of decided importance; in the case of regular balance sheets for the going concern, however, most accountants question the general and continuous use of other bases of valuation than cost. In "Limitations of the Present Balance Sheet," Journal of Accountancy, 1928, Couchman states:

    The theory underlying the balance sheet of a going concern is that every classification displayed therein shall have resulted from accomplished financial transactions and/or unfilled obligations to which the organization is a party, modified by the attempt allocate to proper fiscal periods all earnings and all expenses.

     Kester writes in "Accounting Theory and Practice," Vol. II

    The controlling purpose in the valuation of assets subject to depreciation is not so much the statement of accurate values for use of the balance sheet but rather a distribution of the depreciation charge as will spread the cost of the depreciating asset most equitably over the product turned out by the asset. It is the operating (income statement) rather than the balance sheet view of what should govern.

    Canning, emphasizing the distinction between cost of replacing the existing agent and cost of replacement of service, in Economics of Accountancy, writes

    The consequential difficulties and losses from substituting one instrument for another, whether they are like or unlike in physical character, are in services is nearly always a more appropriate value than any other, even in the case in which the capital item in use can be replaced by another at a price less than was paid for the one in use, it does not follow that this price reduction should necessarily affect the proper valuation of the present instrument. It may not pay actually to replace now.

    And at another point in the same treatise, he writes substantially as follows:

    Accountants are properly skeptical of valuation bases other than original cost. But when the weight of evidence tends to show that some higher or lower basis is really more significant they are not unwilling to revise valuations. Outlay cost is a real thing. So too will replacement cost become a real thing when it is incurred. But because prices of equipment fluctuate because of the amount and kind of service needed in an enterprise change with its selling opportunities---because of all these extremely elusive matters requires a good deal of positive evidence to show on which side of experienced cost per unit of service a future unit cost is likely to lie. It must be cost, as such, to serve as a datum point for revaluations. On the other hand it must be emphatically asserted that adequately to consider possible future substitutions it is a difficult and expensive a task as redesigning all plants and fixed equipment. Cost of reproduction new (of existing agencies) les an allowance for depreciation may be a good working rule in damage suits; it is absurd as a sole rule of going-concern value.

    Littleton in "Value and Price in Accounting," Accounting Review, September 1929, holds: "Cost is not value and is not entered in the accounts as such/" And again, "Accounting is a record function, not a valuation function."

     

    Limited Recognition of Changing Values
    On the other hand, there are numerous accountants who are inclined to disagree with the conventional position. H.C. Daines in "The Changing Objectives of Accounting," Accounting Review, 1929 writes:

    The adoption of the completed-transaction theory of income has forced the accountant into a rather embarrassing position with reference to the valuation of his balance-sheet items. In keeping with the double-entry process the accountant has thought it necessary to tie his income statements to the balance sheet. This has resulted in a rather artificial showing of values in the balance sheet and an attempt on the part of the accountant to justify this method of showing values as proper for a going concern.

    Quotations that follow suggest limited recognition of changing values

     


    What the FASB and IASB has given us in ensuing years are rules for "limited recognition" of changing values in a single-column horrid mixed model for financial statements that pleases nobody and renders aggregations such as the number for "Total Assets" or "Net Income" meaningless summations of apples plus oranges plus partridges in a pear tree. Bob Jensen's contention is that the "limited recognition" show be required in the form of historical cost columns alongside current value columns.

     

    Famous Replacement Cost (Entry Value) of Inventories
    Replacement cost advocates are generally pretty consistent when it comes to fixed assets although they vary as to whether replacement costs should replace historical costs or whether they should just be supplements to historical cost statements as they were during the short life of FAS 33. Replacement cost advocates are less consistent when it comes to inventories where even some replacement cost theorists contend that profits should only be booked when goods are sold rather than for value changes while the goods sit finished goods inventory. A huge problem here is the moral hazard that management may overproduce inventory or capitulate in labor negotiations just to dress up inventory profits when replacement costs are increasing, especially when managers have generous profit sharing compensation plans.

     

    Accountant's Handbook. Edited by William A. Paton,  Second Edition (Ronald Press, 1932, Page 419).
    Replacement Cost Inventories
    . . . Further in the retail market selling prices do not always fluctuate closely in terms of replacement costs and accordingly the point that the merchandise reports to management should in all cases show current costs rather than actual book costs has less force in this field. This is particularly true of style goods and highly specialized goods in general; it is less true in staples such as flour, sugar, coal, etc. In the wholesale market, on the other hand, selling prices tend to move more closely with changing costs and hence there is more force to the argument in favor of valuation on a replacement cost basis in this field.

    Specific Objections

    1. It is not approved for income tax purposes by the Bureau of Internal Revenue. (in 1932 there were no computers such that having more than one basis of inventory valuation was a computational nightmare)
       
    2. Where it means the inclusion of appreciation in income it has no general legal standing. (meaning that co-mingling unrealized price appreciations with realized revenues renders mixed-model income statements confusing)
       
    3. It is viewed as non-conservative by accountants, bankers, and business men generally. (in 1932 there was a significantly lower proportion of business women)
       
    4. It requires the determination of replacement costs for entire stock at the inventory date, a considerable task, especially for certain classes of goods. (this is a problem that still exists in the 21st Century after having witnessed the extreme inaccuracies of firms that tried to comply with FAS 33 while it was in effect)
       
    5. It leaves the more or less dependable field of book records for a territory where estimate plays a considerable part. (which is why auditors to this day are not allowed by auditing standards to generally attest to current values of non-financial assets except in the cases of extreme impairment where inaccuracies are more acceptable in the accounting standards)

    Paton continues the discussion here with the "Meaning of Replacement Cost"

     

     

    And thus I've added a bit of history to my ongoing debate with my friends Tom Selling and Patricia Walters. . I don't think it will change their minds, but it does add historical perspective to the debate.

    Bob Jensen's threads on bases of valuation in accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#BasesAccounting


    I've really enjoy these intense friendly debates about single-column versus multiple column financial statements with Tom Selling and Patricia Walters on the AECM. But I do not want to leave anybody with the impression that I'm an advocate of historical costing balance sheets. I'm opposed to such balance sheets for reasons never envisioned by current value reporting scholars like Kenneth MacNeal, John Canning, Ray Chambers, Bob Sterling, Edgar Edwards, Phillip Bell, and others. I merely advocate a historical cost column in the balance sheet because I believe there is value added in reporting net earnings based upon only legally realized revenues and profits under the matching principle. I do think the historical cost balance accounts are residuals of the realized revenue matching concept that have enormous limitations in terms of evaluating financial opportunities and risks.

    For one thing, historical cost balance sheets are too easy to abuse in terms of off-balance sheet financing. Secondly, historical cost balance sheets are bad alternatives for both speculation and hedging derivative financial instruments.

    In 1941 Paton and Littleton could deal with some derivative financial instruments. Futures contracts presented no problems since they're cleared in cash each day. Purchased options were not viewed as being especially problematic for historical costing because financial risk was limited to cash lost in the rather nominal premiums paid. Covered written options were not problematic since they have an inherent hedge that limits financial risk. Naked written options were huge problems that I don't know that Paton and Littleton ever wrote about. But there is an escape clause in the Paton and Littleton monograph --- the escape clause that allows departures from historical cost based upon conservatism. Presumably, a company facing huge losses in naked written options must bring those estimated losses into the ledgers based upon conservatism. I don't think this escape clause is nearly as good as adding a current value column alongside a historical cost column in financial statements.

    In their 1941 monograph Paton and Littleton did not envision interest rate swaps invented in 1984. Interest rate swaps are really portfolios of forward contracts and, as a matter of tradition, forward contracts usually have zero historical costs as counterparties take differing long and short positions without paying a premium like they would when buying or writing options. Until FAS 119 was passed in 1994, clients worldwide entered into over $100 trillion in interest rate swap notionals without even disclosing those swaps. One of the incentives to enter into such swaps was the ease of off-balance-sheet financing. These swaps also replaced U.S. Treasury note inventories as a means of managing cash.

    In the early 1990's the Director of the SEC ordered the Chairman of the FASB to issue standards for disclosure and eventually booking of interest rate swaps on some basis other than historical costs since historical cost of a swap contract was $0. In doing so the Director of the SEC declared that the three main problems with financial reporting were "derivatives, derivatives, and derivatives." :

    Video and audio clips of FASB updates on FAS 133 

    I support at least one required current value column alongside a historical cost column in every set of financial statements. I do not support the current mixed model, single-column financial statements under IFRS and FASB rules today because they're such a conglomeration of historical cost and fair value components that aggregations are meaningless and the mix of audited and unaudited numbers mangles the credibility of the presentation. I favor a historical cost column to that does not co-mingle realized revenues with unrealized price changes. I support a current value column that provides more insights into financial risks and risk management.

    Maintaining any derivatives, including credit derivatives, in the historical cost column at zero historical cost or a nominal premium cost is totally non-informative of financial risks of the derivative contracts in their present state. I support maintaining the FAS 133 rules and their amendments in the current value column of a set of financial statements. In order to distinguish speculation derivatives from hedging derivatives I advocate allowing hedge accounting relief for qualified hedges even though the relief varies of cash flow and FX hedges using OCI for relief and fair value hedging that uses the "firm commitment" account for fair value hedges of unbooked purchase contracts at fixed future rates/prices.

    I don't think historical cost accounting is suited for other types contracts in the 21st century, including securitization contracts, mezzanine debt, and variable interest entities (SPEs). It's impossible to conclude that that any single-column set of financial statements can be an optimal choice. What I believe is that the time has come to disaggregate the current mixed-model, single column GAAP reporting under current IFRS or FASB standards. My first suggestion would be to disaggregate the historical cost alternatives from the current value alternatives for two main reasons. The first would be to disaggregate realized income statement items from unrealized income statement items arising from changes in fair values. The second would be to disaggregate numbers that are audited from numbers that are either not audited at all or have audit-lite attestations to the actual numbers themselves such as auditor reviews of the fair value estimation process without attesting to the actual fair value numbers themselves. Flags should be put on numbers to indicate the degree of verification with the audit process. For example, cash balances are audited better than most anything else in traditional CPA audits. Current appraisal values of real estate cannot be attested to at all by CPA auditors under present auditing standards. I recommend putting these appraisals into the current value column with strong warnings that these numbers have not be verified by auditors.

    I think Tom Selling and Patricia Walters and Bob Jensen are in full agreement on most things. The difference is that Tom and Pat seem to be advocating a single-column set of financial statements that inevitably becomes a mixed model that co-mingles too many bases of measurement. Bob Jensen advocates a multiple-column set of financial statements that segregates realized transaction outcomes from unrealized changes in current values. GAAP rules should cover all multiple columns.

    I'm not a fan of having a pro-forma column because I think this makes it too easy for clients to manipulate the numbers outside of GAAP rules. Until GAAP contains strict rules about pro-forma reporting, auditors should not associate their names with any financial statements having a pro-forma column ---
    http://faculty.trinity.edu/rjensen/theory02.htm#ProForma

    Yes, multiple-column statements might create some short-term confusion among analysts and investors. But I think the current single-column financial statements create more confusion, especially with the co-mingling of realized revenues with unrealized current value changes.

    Bob Jensen's threads on fair value accounting are at
    http://faculty.trinity.edu/rjensen/theory02.htm#FairValue


    Tom Selling has what I consider to be a much more reasonable posting on replacement costing:
    "What I Mean by "Replacement Cost" is not Literally Replacement Cost," by Tom Selling, The Accounting Onion, January 17, 2012 --- Click Here
    http://accountingonion.typepad.com/theaccountingonion/2012/01/what-i-mean-by-replacement-cost-is-not-literally-replacement-cost.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

    Jensen Comment
    His latest posting remains, however, disappointing to me in that he does not delve into how traditional replacement (current) cost accounting of operating assets like factories, stores, hotels, airliners, can be more misleading than helpful if it is not accompanied by traditional historical cost financial statements and possibly exit value statements (although exit value is not very relevant for going concerns with lots of synergy covariances of asset values "in use."

    Some of his statements do not adequately stress that replacement cost accounting is not value accounting since it has identical accrual issues of depreciation, depletion, amortization, bad debt estimation, etc. that plagues historical cost accounting. For example, he states:

    "First, replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth."
    Tom Selling as cited above

    Firstly, I almost always advise against sweeping generalization such as the "only possible way to reflect wealth invested by shareholders ..."
    Such sweeping generalizations should be avoided in the Academy, especially when when our accounting history research literature is brimming articles from scholars who do not share Tom's view about replacement cost accounting (even in theory). Kenneth MacNeal would not call replacement cost accounting "Truth in Accounting" or even being the best of asset measurement alternatives ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#BasesAccounting

    Secondly, he still is speaking of "flowers in spring" to Julie Andrews without giving her the "show me" she's demanding. He still has not made a convincing case on how even his hybrid version of replacement cost accounting would be relevant to my two Holiday Inn case seeds at
    http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm

    To his credit, in his latest posting Tom does not mention Tobin's Q. Perhaps I convinced him that Tobin's Q is just not relevant to this analysis since the value of a firm is affected by so many factors other than items accountants book into the ledgers. I discuss this problem with Tobin's Q at
    http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm

    In any case I hope Tom will continue our debate on replacement costs. My challenge to him remains to take my two Holiday Inn case seeds and show how replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth" in these two hotels.
    http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm


    Hi Tom,

     Thank you for this working draft:
    "Does FASB Statement No. 157 Provide “The Most Relevant Information for Financial DecisionMaking”?" --- Click Here
    http://grovesite.com/GSLibrary/Downloads/download.ashx?file=sites/4/7280/212568/IsFAS157MostRelevant_singlespaced_withtitlepage.pdf

    And congratulations on choosing Walter Teets as a co-author. I used to correspond with Walter Teets quite a lot in the early days of FAS 133. He has a PhD in finance from the University of Chicago and is a genuine expert on derivative financial instruments.

    I think that the Hicksian concept of income and the Hicksian demand functions, like Pareto optimality in general, are weak concepts defined mostly for mathematical convenience that are not really very good guidelines for real-world standard setters ---
    http://en.wikipedia.org/wiki/Hicksian_demand_function
    Also see http://en.wikipedia.org/wiki/Hicks_optimality

    Also see
    "Hicksian Income in the Conceptual Framework" --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1576611
    Michael Bromwich London School of Economics
    Richard H. Macve London School of Economics & Political Science (LSE) - Department of Accounting and Finance
    Shyam Sunder Yale School of Management
    March 22, 2010

    Abstract:
    In seeking to replace accounting ‘conventions’ by ‘concepts’ in the pursuit of principles-based standards, the FASB/IASB joint project on the conceptual framework has grounded its approach on a well-known definition of ‘income’ by Hicks. We welcome the use of theories by accounting standard setters and practitioners, if theories are considered in their entirety. ‘Cherry-picking’ parts of a theory to serve the immediate aims of standard setters risks distortion. Misunderstanding and misinterpretation of the selected elements of a theory increase the distortion even more. We argue that the Boards have selectively picked from, misquoted, misunderstood, and misapplied Hicksian concepts of income. We explore some alternative approaches to income suggested by Hicks and by other writers, and their relevance to current debates over the Boards’ conceptual framework and standards. Our conclusions about how accounting concepts and conventions should be related differ from those of the Boards. Executive stock options (ESOs) provide an illustrative case study.

    Be that as it may, let me look a little closer at the illustrations provided by you and Walter.

    I'm a little confused by your example Tom. Since you report a cash holding loss of ($17.33) it would appear that there really has not been an increase in replacement costs other than due to general price level changes (16/12) and no increase in replacement costs apart from the change in general purchasing power of a dollar. Thus this is not really a very good example of replacement cost accounting where specific price index changes should differ from general price index changes as is clearly what FAS 33, before it was rescinded, was all about. FAS 133 used a single general price level index to price level adjust historical cost financial statements and multiple specific prices indices to adjust constant-dollar (PLA) financial statements to current cost (replacement cost) financial statements. My favorite example is the 1981 U.S. Steel annual report:

    FAS 33 had a significant impact on some companies. The adjustments were not trivial! For example the earnings reported by United States Steel in the 1981 Annual Report as required under FAS 33 were as follows:

    1981 United States Steel Income Before Extraordinary items and Changes in Acctg. Principles

    Historical Cost (Non-PLA Adjusted)

    Historical Cost (PLA Adjusted)

    Replacement Cost (Current Cost)

    $1,077,000,000 Income

    $475,300,000 Income 
    Plus $164,500,000 PLA gain due to decline in purchasing power of debt

    $446,400,000 Income
    Plus $164,500,000 PLA Gain

    Less $168,000,000 Current cost increase less effect of increase in the general price level

     

    Having only general price level changes and not specific price level changes confuses your example, because I can generate the same net income by simply doing a general price level adjustment of the historical cost income statement making the same assumptions that you make in your example ---  --- Click Here
    http://grovesite.com/GSLibrary/Downloads/download.ashx?file=sites/4/7280/212568/IsFAS157MostRelevant_singlespaced_withtitlepage.pdf

    One assumptions that I read into your example is that sales were made at the beginning of the second day when the price was $20 per keg. In terms of period-end dollars the sales are then $53.33. Similarly the FIFO cost of goods sold of $24 becomes $32 in end of period dollars. Normally these would be averaged for the day but since sales only took place at the beginning of the day there's no need to average this out. .

    The general price level adjusted historical cost income statement using end-of-period dollar purchasing power becomes:

    $53.33  Sales
      32.00  CGS
    $21.33  Operating income
     (17.33) Purchasing power loss on monetary items
    $  4.00  Net income which is identical to your net income under replacement cost accounting

    This is the same net income that you derived, because you really not have had any increase in keg production costs aside from general price level increases. . Hence I don't think your example is a very good illustration of replacement cost accounting since the constant-dollar replacement cost of kegs really did not change throughout the example.

    Hence I think you should improve your illustration with both general price level increases and specific keg production price increases apart from price changes in the units of purchasing power. I might quibble with the $17.33 number, but production timing assumptions can be made to make this number acceptable in terms of cash outlays for new kegs and consumption.

    A simplifying example would be to have no change in general purchasing power of the dollar and make all the price changes apply only to kegs of beer production costs during the second day after sales of the two kegs early in the morning.

    $ 40.00  Sales
       24.00  CGS (Fifo)
    $ 16.00  Operating income
      (  0.00) Purchasing power loss on monetary items
    $  16.00  Net income (realized)
        12.00  Unrealized replacement cost gain assuming inventory produced at sunrise  
        84.00  BOP equity
    $ 112.00  EOP before dividends (beer consumption)

    Maximum Hicksian consumption = $28.
    If he consumed no beer until sunset that he produced at sunrise we would allow the guy to consume $28 worth of beer at the end of the period to have the the BOP and EOP equity be identical at $84.00 since the value of the dollar remains constant.

    Of course this will get complicated if the guy is consuming the beer while he's producing the beer throughout the period since we have to know the cost of each swallow as factor prices increase during a production run. .

    The Hicksian Concept of Income
    In any case the Hicksian criterion is a very weak economic criterion since in a real company there are many alternative portfolios of assets that have very different discounted cash flow net income based upon discounted future cash flows even though they have the same Hicksian income. Also the Hicksian concept of income is simplistic because it provides no information about portfolio risk differences such as when speculations versus hedges give the same Hicksian outcomes in different portfolios.

    As a final note I don't think FAS 157 was written for inventory valuations. To my knowledge this standard applies only to financial assets and liabilities. Presumably it could be extended to inventories, but this was not its original intent. I think many amendments would be required for valuing most non-financial assets such portfolios of real estate.

    But I have to admit this illustration has some great potential if it is extended to different assumptions about timings of revenues and expenses along with combinations of general and specific price index movements.

    Balance Sheet Versus the Income Statement Focus of Standard Setters
    Early theorists like Professors Littleton and Ijiri focused heavily on the income statement as do financial analysts and investors who track net income as a primary indicator of economic performance. This focus built upon the Revenue Realization Principle and the Matching Principle leads to weak conceptualizations of assets and liabilities.

    Largely because they cannot define net income on anything other than cherry-picked Hicksian theory, the FASB and IASB standard setters instead focus on the balance sheet where think they are on more solid footing conceptualizing  assets and liabilities. This, however, is not without its troubles.
    See
    "The Asset and Liability View: What It Is and What It Is Not—Implications for International Accounting Standard Setting from a Theoretical Point of View"
    Jens Wüstemann, University of Mannheim; Sonja Wüstemann, Goethe University Frankfurt am Main
    American Accounting Association Annual Meetings, August 4, 2010
    http://aaahq.org/AM2010/display.cfm?Filename=SubID_2022.pdf&MIMEType=application%2Fpdf

    I would like you, Tom, and Patricia to especially note the reference to the "stewardship function" below in the context of historical cost accounting.

    ABSTRACT
    In their current standard setting projects the FASB and the IASB seek to enhance consistency in the application of accounting standards and comparability of financial statements by fully implementing the asset and liability view. However, neither in standard setting nor in the accounting literature is there agreement on what the asset and liability view constitutes. In this paper, we show that the asset and liability view is compatible with different, sometimes even opposing concepts, such as historical cost accounting and fair value accounting, and thus cannot ensure internal consistency on its own. By means of the example of revenue recognition we point out the difficulty to determine the changes in assets and liabilities that shall give rise to revenue. We argue that the increase in assets that leads to revenue is the obtainment of the right to consideration and thus should be focused on by the

    Boards.

    1. Introduction

    A major aim of the FASB and the IASB in their current standard setting projects is to achieve internal consistency of the accounting regimes U.S. GAAP and IFRS (IASB 2008c, BC2.46; IASB 2008a, S3; IASB 2008d, par. 5; IASB 2009, p. 5). One of the reasons for inconsistencies in present U.S. GAAP and IFRS is that recognition and measurement principles and rules are developed on the basis of two competing concepts − the asset and liability view and the revenue and expense view (Wüstemann and Wüstemann 2010).

    Until the 1970s the so called revenue and expense view had been prevailing in international accounting standard setting. In the U.S. this view was introduced by Paton and Littleton in the American Accounting Association Monograph No. 3 in 1940 (Paton and Littleton 1940: 1956) and soon became the state of the art in U.S. accounting theory and practice. Similar developments took place in other countries, e.g. Germany, where Schmalenbach (1919) was the main driver for the establishment of the comparable ’dynamic accounting theory’

    (Dynamische Bilanztheorie)
    According to the revenue and expense view the principal purpose of accounting is to determine periodic net income as a measure of an entity’s effectiveness in using inputs to obtain and sell output (
    stewardship function) by recognising revenue when it is earned or realised and by matching the related costs with those revenues (FASB 1976, par. 38−42; Paton and Littleton 1940: 1956, p. 10 et sqq.; see for the tradition of the stewardship function Edwards, Dean and Clarke 2009). Some proponents of the revenue and expense view see net income as an indicator of an entity’s ‘usual, normal, or extended performance’ (‘earning power’) (FASB 1976, par. 62) that may help users not only to assess management’s performance but also to estimate the value of the firm (Black 1980, p. 20; Breidleman 1973, p. 654). This requires irregular and random events that distort net periodic profit, such as the receipt of grants and losses from bad debt, to be smoothed out (Beidleman 1973, p. 653 et sqq.; Bevis 1965: 1986, p. 104−107; FASB 1976, par. 59; Schmalenbach 1919, p. 32−36). Under the revenue and expense view the function of the balance sheet is to ‘store’ residuals resulting from the matching and allocation process; the deferred debits and credits depicted in the balance sheet do not necessarily represent resources and obligations (Paton and Littleton 1940: 1956, p. 72−74; Schmalenbach 1919, p. 26; Sprouse 1978, p. 68).

    In the 1970s the FASB realised that the key concepts under the revenue and expense view − revenues and expenses − are not precisely definable making earnings ‘unduly subject to the effects of personal opinion about what earnings of an enterprise for a period should be’ (FASB 1976, par. 60). In order to limit arbitrary judgements and to achieve a more consistent income determination the FASB decided to shift the focus to the more robust concepts of assets and liabilities and thus to the asset and liability view as evidenced by the issuance of SFAC 3 Elements of Financial Statements (now SFAC 6) in 1980 (Storey 2003, p. 35 et sqq.; Miller 1990, p. 26 et seq.; see for a similar development in Germany around the same time Moxter 1993). The so called asset and liability view in the U.S. has its origins in the Sprouse and Moonitz monograph that was published in 1962 as part of the AICPA’s Accounting Research Studies.

    Under this view all financial statement elements are derived from the definitions of assets and liabilities. Income resulting from changes in assets and liabilities measures an entity’s increase in net assets (FASB 1976, par. 34; Johnson 2004, p. 1; Ronen 2008, p. 184; Sprouse and Moonitz 1962, par. 11, 46, 49). The asset and liability view can serve the purpose to objectify income measurement by restricting recognition in the balance sheet to those items that embody resources and obligations (Sprouse 1978, p. 70). Alternatively, the asset and liability view can be adopted in order to inform users about future cash flows that are expected to flow from an entity’s assets and liabilities, which are supposed to help them in estimating firm value (Scott 1997, p. 159−162; Hitz 2007, p. 333 and 336−338).

    Despite the declared shift from the revenue and expense view to the asset and liability view in the 1970s, certain U.S. standards and also the ‘older’ IFRS, for example those on revenue recognition, still follow the revenue and expense view (Ernst & Young 2009, p. 1558; Wüstemann and Kierzek 2005, p. 82 et seq.). In the beginning of the 21st century the FASB and the IASB have begun several projects, above all the Conceptual Framework Project, that shall lead to an all-embracing implementation of the asset and liability view (Wüstemann and Wüstemann 2010).

    We observe that both in the accounting literature and the standard setting processes, there is confusion about the meaning and implications of the asset and liability view, especially as regards the role of the realisation principle and the matching principle as well as fair value measurement (see literature review below). A second problem is that the asset and liability view does not provide clear guidance on how assets and liabilities shall be defined and which changes in assets and liabilities shall give rise to income. The FASB and the IASB have − up to now − been struggling with the problem of bringing current revenue recognition guidance in conformity with the asset and liability view for seven years. In December 2008, they finally published a Discussion Paper ‘Preliminary Views on Revenue Recognition in Contracts with Customers’, but the issuance of the new standard is not yet foreseeable.

    The aim of this paper is to shed light on the conceptual underpinnings of the asset and liability view, to clarify misunderstandings in the accounting literature and standard setting about its meaning and to discuss implications for international accounting standard setting. The remainder is organised as follows: In the first part of the paper we depict the different opinions that exist with regard to the asset and liability view and then clarify the concept by defining recognition and measurement principles as well as purposes of financial statements that are compatible with this view. Subsequently, we analyse in how far the asset and liability view is implemented in present U.S. GAAP and IFRS and in which areas accounting principles still exist that oppose the asset and liability view. In the final part we point out the difficulty to define assets and liabilities taking the current FASB’s and IASB’s joint project on revenue recognition as an example and make suggestions for improvement.

    Continued in article
     http://aaahq.org/AM2010/display.cfm?Filename=SubID_2022.pdf&MIMEType=application%2Fpdf

    Conclusion
    And after all these years of trying the standard setters have not yet come up with standards that are very good for evaluating financial performance of business firms, something that they are well aware of in Australia ---
    "GAAP Based Financial Reporting:  Measurement and Business Performance" --- Click Here
    http://www.charteredaccountants.com.au/Industry-Topics/Reporting/Resources-and-toolkits/~/media/Files/Industry topics/Reporting/Resources and toolkits/Reports/GAAPbased_financial_reporting.ashx

     I think the major problem, aside from the cost of generating more relevant and reliable information, is that standards setters never look beyond single-column financial statements that inevitably lead them to horrid mixed model measurements that destroy aggregations into summary measures like "Total Assets" and "Net Income." Bob Herz recommends doing away with aggregating net income metrics. I recommend having multiple columns and multiple net income aggregations.
    See http://faculty.trinity.edu/rjensen/theory02.htm#ChangesOnTheWay

    Respectfully,
    Bob Jensen

     


    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Advantages of Historical Cost

    ·     Survival Concept --- Historical cost accounting has met the Darwin survival test for thousands of years. One of the most noted books advocating historical cost is called Introduction to Corporate Accounting Standards by William Paton and A.C. Littleton (Sarasota: American Accounting Association, 1940). Probably no single book has ever had so much influence or is more widely cited in accounting literature than this thin book by Paton and Littleton.

    Except in hyperinflation nations, unadjusted historical cost is still the primary basis of accounting, although there are numerous exceptions for certain types of assets and liabilities. Most notable among these exceptions are financial instruments assets and liabilities where FAS 115 and FAS 133 spell out highly controversial exceptions.

    ·     The Matching Concept --- costs of resources consumed in production should be matched against the revenues of the products and services of the production function. (Assumes costs attach throughout the production process in spite of complicating factors such as joint costs, indirect costs, fungible resources acquired at different costs, changing price-levels, basket purchases such as products and their warranties, changing technologies, and other complications). Profit is the "residuum (as efforts) and revenues (as accomplishments) for individual enterprises." This difference (profit) reflects the effectiveness of management. One overriding concept, however, is conservatism that Paton and Littleton concede must be resorted to as a basis for writing inventories down to market when historical cost exceeds market. This leads to a violation of the matching concept, but it is necessary if investors will be misled into thinking that inventories historical costs are surrogates for value.

    ·     The Audit Trail --- historical costs can be traced to real rather than hypothetical market transactions. They leave an audit trail that can be followed by auditors.

    ·     Predictive Value --- empirical studies post to reasonably good predictive value of past historical cost earnings on future historical cost earnings. In some cases, historical cost statements are better predictors of bankruptcy than current cost statements.

    ·     Accuracy --- Historical cost measurement is more accurate and, relative to its alternatives, is more uniform, consistent, and less prone to measurement error.

    Nobody I know holds the mathematical wonderment of double entry and historical cost accounting more in awe than Yuji Ijiri. For example, see Theory of Accounting Measurement, by Yuji Ijiri (Sarasota: American Accounting Association Studies in Accounting Research No. 10, 1975) --- http://accounting.rutgers.edu/raw/aaa/market/studar.htm 

    Disadvantages of Historical Cost

    ·     Does not eliminate or solve such controversial issues as what to include/exclude from balance sheets and does not overcome complex schemes for off-balance-sheet financing (OBSF). It is too simplistic for complex contracting. For example, many derivative financial instruments having current values of millions of dollars (e.g., forward contracts and swaps) have zero or negligible historical costs. For example, a firm may have an interest rate swap obligating it to pay millions of dollars even though the historical cost of that swap is zero. Investors might be easily misled by having such huge liabilities remain unbooked. Historical cost accounting has induced game playing when writing contracts (leases, employee compensation, etc.) in order to avoid having to book what are otherwise assets and liabilities under fair value reporting.

    ·     Historical cost mixes apples and oranges such as LIFO inventory dipping that may match costs measured in 1950s purchasing power with inflated dollars in the 21st Century that have much less purchasing power. Historical cost income in periods of rising prices overstates earnings and understates how a firm is maintaining its capital assets. Even historical cost advocates admit that historical cost accounting is useless in economies subject to hyperinflation.

    ·     Historical cost accrual accounting assumes a going concern. Under current U.S. GAAP, historical cost is the basis of accounting for going concerns. If the firm is not deemed a going concern, the basis of accounting shifts to exit (liquidation) values. For many firms, however, it is difficult and/or misleading to make a binary designation of going versus non-going. Many firms fall into the gray area on a continuum. Personal financial statements seldom meet the going concern test since they are generally used in estate and divorce settlements. Hence, exit (liquidation) value is required instead of historical cost for personal financial statements.

    ·     Historical cost is perpetuated by a myth of objectivity when there are countless underlying subjective estimates of asset economic life, allocation of joint costs, allocation of indirect costs, bad debt reserves, warranty liabilities, pension liabilities, etc.


    Going Concern Accounting and Bear Stearns

    From The Wall Street Journal Accounting Weekly Review on April 11, 2008

    Officials Say They Sought To Avoid Bear Bailout
    by Kara Scannell and Sudeep Reddy
    The Wall Street Journal

    Apr 04, 2008
    Page: A1
    Click here to view the full article on WSJ.com
    http://online.wsj.com/article/SB120722972567886357.html?mod=djem_jiewr_AC
     

    TOPICS: Accounting, Banking

    SUMMARY: This article covers the testimony in Congressional hearings for the weekend events of March 15-16 leading to the Bear Stearns bailout and acquisition by J.P. Morgan.

    CLASSROOM APPLICATION: Understanding the relationship between the balance sheet equation and the notions of a run on the bank, going concern and fire sale is made evident in this review. The economic concept of moral hazard also is covered.

    QUESTIONS: 
    1. (
    Introductory) Summarize the events leading to Bear Stearns demise and acquisition by J.P. Morgan.

    2. (
    Introductory) What is the assumption of going concern in accounting? Give an example of how that assumption influences the accounting for one balance sheet item, then explain the assumption's overall influence on the balance sheet equation.

    3. (
    Introductory) What prices for Bear Stearns' stock were considered in negotiations leading to J.P. Morgan's acquisition? What evidence is given in the article that these prices were based on assumptions other than the going concern assumption?

    4. (
    Advanced) Define the notions of "capital adequacy" and "liquidity" in banks. For what type of entity are these levels now regulated? How might that regulation now expand as a result of the Bear Stearns debacle?

    5. (
    Advanced) Explain the U.S. government's role in the transaction between J.P. Morgan and Bear Stearns. How does that role differ from the usual government regulation in financial markets?

    6. (
    Advanced) Why did Bear Stearns have to negotiate a finished deal by the end of the weekend of March 15-16? In your answer, explain the concept of a "run on the bank" and its relationship to the going concern assumption.

    7. (
    Introductory) What is the economic notion of "moral hazard?" How did that issue also influence the price that Bear Stearns was able to negotiate from J.P. Morgan?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "Officials Say They Sought To Avoid Bear Bailout," by Kara Scannell and Sudeer Reddy, The Wall Street Journal, April 4, 2008; Page A1 -- Click Here

    The government sought a low sale price for Bear Stearns Cos. to send a message that taxpayers wouldn't bail out firms making risky bets, a top Treasury Department official testified, as regulators offered Congress the first detailed explanation of the unprecedented rescue.

    Representatives of Washington and Wall Street painted a dire picture of the chaos they believe would have ensued if the government hadn't orchestrated a rescue of Bear Stearns by J.P. Morgan Chase & Co. over the hectic weekend of March 15-16.

    "This would have been far more, in my opinion, expensive to taxpayers had Bear Stearns gone bankrupt and added to the financial crisis we have today," said J.P. Morgan chief executive James Dimon. "It wouldn't have even been close."

    Officials said they were acutely aware of the moral-hazard problem, and that is why the government insisted that Bear Stearns shareholders get a low price for their shares. In the original deal, announced the night of March 16, J.P. Morgan agreed to pay $2 a share. After Bear Stearns shareholders protested, J.P. Morgan raised its price a week later to $10 a share -- still a fraction of the level Bear Stearns shares had traded at before it faced a funding crisis.

    "There was a view that the price should not be very high or should be towards the low end...given the government's involvement," Treasury Undersecretary Robert Steel told a congressional committee during a five-hour hearing Thursday.

    "These were exceptionally consequential acts, taken with extreme reluctance and care because of the substantial consequences it would have for moral hazard in the financial system," added Timothy Geithner, president of the Federal Reserve Bank of New York.

    Mr. Steel and other officials told the Senate Banking Committee that they didn't dictate the precise sale price, but wanted to see a deal done quickly to avoid a sudden market-shaking crash of the company.

    At the hearing, the first one focusing on the Bear Stearns rescue, lawmakers questioned top Fed officials, including Chairman Ben Bernanke, as well as the chief executives of Bear Stearns and J.P. Morgan. Held in a cavernous room reserved for big gatherings, rather than the more-intimate regular room, the hearing sometimes had the feel of a Hollywood red-carpet event as photographers descended on the panelists.

    Officials rejected lawmakers' suggestions that they bailed out Bear Stearns, noting that shareholders took steep losses and many employees may lose their jobs. But under questioning, Mr. Bernanke agreed with a lawmaker who suggested the Fed rescued Wall Street more broadly.

    "If you want to say we bailed out the market in general, I guess that's true," he said. "But we felt that was necessary in the interest of the American economy." He reiterated comments from a day earlier that the Fed doesn't expect to lose money on its $30 billion loan. J.P. Morgan has agreed to cover the first $1 billion in losses, if there are any.

    Mr. Dimon said his bank "could not and would not have assumed the substantial risk" of buying Bear without the Fed's involvement.

    At the hearing, the government and company officials gave an exhaustive account of the frenetic scramble in the days preceding the Bear Stearns sale. "We had literally 48 hours to do what normally takes a month," said Mr. Dimon.

    During the week of March 10, market rumors swirled that Bear Stearns might not be able to stay in business. At the hearing Alan Schwartz, Bear Stearns's chief executive, said that the firm's balance sheet was strong -- as good as that of any other financial institution -- but that Bear Stearns couldn't keep up with the rumors.

    By Thursday, March 13, the rumors had become a "self-fulfilling prophecy" and resulted in a "run on the bank," Mr. Schwartz said. Bear Stearns reached out to the regulators, who worked throughout the night. By Friday morning, March 14, the Fed agreed to extend financing to Bear Stearns through J.P. Morgan. Then the firms and government officials worked through the weekend to spur Bear Stearns's sale and prevent a bankruptcy filing.

    Along with the sale announcement on March 16, the Fed announced that it would lend directly to investment banks from its discount window, a historic reversal of its longtime policy of lending only to banks. While some have said that Bear Stearns could have avoided a sale if it had had access to the new lending program, Mr. Geithner said that wasn't feasible.

    "We only allow sound institutions to borrow against collateral," he said. "I would have been very uncomfortable lending to Bear given what we knew at that time."

    When it became clear that a deal had to happen before Asian markets opened late Sunday night, Bear Stearns's negotiating leverage "went out the window," said Mr. Schwartz. Among the parties examining Bear Stearns's books was a sophisticated buyer who was "prepared to write a multibillion check to invest in equity," but that would have required another financial institution to help finance the deal, Mr. Schwartz said. He didn't identify the potential buyer.

    Mr. Dimon testified that he couldn't recall whose idea it was to bring in the Fed. Treasury's Mr. Steel said it was J.P. Morgan that suggested the Fed's involvement.

    Continued in article


    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Replacement (Current) Cost Accounting Versus Historical Cost Accounting

    "Windfall Profits for Dummies," The Wall Street Journal, May 3, 2008; Page A10 ---
    http://online.wsj.com/article/SB120977019142563957.html?mod=djemEditorialPage

    This is one strange debate the candidates are having on energy policy. With gas prices close to $4 a gallon, Hillary Clinton and John McCain say they'll bring relief with a moratorium on the 18.4-cent federal gas tax. Barack Obama opposes that but prefers a 1970s-style windfall profits tax (as does Mrs. Clinton).

    Mr. Obama is right to oppose the gas-tax gimmick, but his idea is even worse. Neither proposal addresses the problem of energy supply, especially the lack of domestic oil and gas thanks to decades of Congressional restrictions on U.S. production. Mr. Obama supports most of those "no drilling" rules, but that hasn't stopped him from denouncing high gas prices on the campaign trail. He is running TV ads in North Carolina that show him walking through a gas station and declaring that he'll slap a tax on the $40 billion in "excess profits" of Exxon Mobil.

    The idea is catching on. Last week Pennsylvania Congressman Paul Kanjorski introduced a windfall profits tax as part of what he called the "Consumer Reasonable Energy Price Protection Act of 2008." So now we have Congress threatening to help itself to business profits even though Washington already takes 35% right off the top with the corporate income tax.

    You may also be wondering how a higher tax on energy will lower gas prices. Normally, when you tax something, you get less of it, but Mr. Obama seems to think he can repeal the laws of economics. We tried this windfall profits scheme in 1980. It backfired. The Congressional Research Service found in a 1990 analysis that the tax reduced domestic oil production by 3% to 6% and increased oil imports from OPEC by 8% to 16%. Mr. Obama nonetheless pledges to lessen our dependence on foreign oil, which he says "costs America $800 million a day." Someone should tell him that oil imports would soar if his tax plan becomes law. The biggest beneficiaries would be OPEC oil ministers.

    There's another policy contradiction here. Exxon is now under attack for buying back $2 billion of its own stock rather than adding to the more than $21 billion it is likely to invest in energy research and exploration this year. But hold on. If oil companies believe their earnings from exploring for new oil will be expropriated by government – and an excise tax on profits is pure expropriation – they will surely invest less, not more. A profits tax is a sure formula to keep the future price of gas higher.

    Exxon's profits are soaring with the recent oil price spike, but the energy industry's earnings aren't as outsized as the politicians seem to think. Thomson Financial calculates that profits from the oil and natural gas industry over the past year were 8.3% of investment, while the all-industry average is 7.8%. And this was a boom year for oil. An analysis by the Cato Institute's Jerry Taylor finds that between 1970 and 2003 (which includes peak and valley years for earnings) the oil and gas business was "less profitable than the rest of the U.S. economy." These are hardly robber barons.

    This tiff over gas and oil taxes only highlights the intellectual policy confusion – or perhaps we should say cynicism – of our politicians. They want lower prices but don't want more production to increase supply. They want oil "independence" but they've declared off limits most of the big sources of domestic oil that could replace foreign imports. They want Americans to use less oil to reduce greenhouse gases but they protest higher oil prices that reduce demand. They want more oil company investment but they want to confiscate the profits from that investment. And these folks want to be President?

    Late this week, a group of Senate Republicans led by Pete Domenici of New Mexico introduced the "American Energy Production Act of 2008" to expand oil production off the U.S. coasts and in Alaska. It has the potential to increase domestic production enough to keep America running for five years with no foreign imports. With the world price of oil at $116 a barrel, if not now, when? No word yet if Senators Clinton and Obama will take time off from denouncing oil profits to vote for that.

    How Will a Windfall Profits Tax Increase Supply?
    by Frank J. Stalzer and David P. McElvain
    The Wall Street Journal

    May 08, 2008
    Page: A14
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB120977019142563957.html?mod=djemEditorialPage
     

    TOPICS: Advanced Financial Accounting, Financial Accounting, Oil and Gas Accounting, Tax Laws, Taxation

    SUMMARY: The second of these two letters to the editor is written by a 70 year old reader who has worked in the oil and gas industry for all of his life. Both letters discuss the Obama-proposed windfall profits tax, but the latter also refers to the fact that historical cost-based financial statements show higher income statement profits than would statements prepared under replacement cost accounting.

    CLASSROOM APPLICATION: The article may be used to addressed the current political debates of the presidential candidates' proposed policies in either a taxation or an advanced financial accounting class.

    QUESTIONS: 
    1. (
    Introductory) What are "windfall profits?" What is a "windfall profits tax?"

    2. (
    Introductory) Why might a windfall profits tax appeal to voters who are unsophisticated in their understanding of its potential economic impact?

    3. (
    Advanced) What is "replacement cost accounting?" In your answer, compare this measurement method to our current historical cost method.

    4. (
    Advanced) Why might historical cost accounting be particularly problematic in the oil and gas industry as opposed to, say, a traditional manufacturing industry?

    5. (
    Advanced) What is the argument put forth by Mr. McElvain that historical-cost basis financial statements are contributing to the potential implementation of a windfall profits tax?

    6. (
    Advanced) "Major oil companies need to administer their businesses on the basis of true replacement costs, not historical accounting costs." Is that possible even if the business must use historical cost accounting in published financial statements?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Windfall Profits for Dummies
    by N/A
    May 03, 2008
    Page: A10
     


    A Daunting Problem With Replacement Cost Accounting

    Although Tom Selling hates to admit it, I think that the difficulty or impossibility of replacing operating assets with anything like those existing assets that are not being replaced makes entry value (replacement cost, current cost) accounting a daunting task that ends up with numbers of dubious value to investors because of their arbitrary and subjective nature. The following case illustrates the problem for deriving replacement cost of a ten-year old airliner still in use with slower travel time, inefficient fuel usage, lower cargo capacity, and higher maintenance costs. What should be its depreciation-adjusted replacement cost while still in use?

    From The Wall Street Journal's Accounting Weekly Review on July 16, 2010

    FedEx Looks to 777s to Deliver an Edge
    by: Jennifer Levitz
    Jul 14, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Capital Budgeting, Capital Spending, Supply Chains

    SUMMARY: This article discusses FedEx's investment in new Boeing aircraft that allow overseas shipments to be 1 to 3 hours faster by eliminating a fuel stop in FedEx's Alaskan hub. Combining this point with latest economic growth trends based on information about the U.S. and worldwide, Frederick W. Smith, FedEx's founder, chairman, and chief executive, argues that this equipment is a "game changer." Helping to reduce risk of large investment in a new fleet of planes

    CLASSROOM APPLICATION: This article can be used in managerial accounting and supply chain management courses to understand the influence of various factors on capital expenditure decisions. This understanding is then tied to an ultimate impact on choice of carrier in the supply chain process.

    QUESTIONS: 
    1. (
    Introductory) In general, how does a company decide on its capital spending strategy for a year or longer period of time?

    2. (
    Introductory) What factors led FedEx to invest in Boeing's new 777 aircraft? Describe all that are listed in the article. Explain how each factor you list would impact an assessment of capital spending under the structure you describe in answer to question 1 above.

    3. (
    Advanced) Why do both FedEx and UPS see different opportunities in the economic outlook than might a domestic-only U.S. carrier?

    4. (
    Advanced) Refer again to your answers to questions 1 and 2. How does the outlook you describe impact those methods of assessing capital expenditure decisions?

    5. (
    Introductory) How does FedEx's capital expenditures in 2010 compare to that of its rival, UPS?

    6. (
    Advanced) Suppose you are a supply chain professional charge with selecting an overnight shipper for product. Would FedEx's claims about its fleet influence your choice of carrier? What other factors would you consider in your decision-making?

    7. (
    Introductory) What personal force might also influence FedEx's decision to invest in Boeing 777s?

    Reviewed By: Judy Beckman, University of Rhode Island

    RELATED ARTICLES: 
    FedEx CEO Takes Stock of Alternative Energy, Obama and China
    by Jennifer Levits
    Jul 13, 2010
    Online Exclusive

    Bill Paton admitted being hung up on this weakness of replacement cost alternatives to historical cost accounting as noted by Larry Revsine in 1979:
    "Technological Changes and Replacement Costs: A Beginning," by Larry Revsine, The Accounting Review, April 1979 ---
    http://www.jstor.org/pss/245517

    Steve Zeff also writes extensively about this issue --- http://www.routledge.com/books/details/9780415554299/

    Paton was not an advocate of exit value accounting for operating assets
    It should be noted that Bill Paton was in an advocate of "value accounting"  clear back in his 1922 Accounting Theory, but I take this to be replacement cost rather than exit value later advocated by MacNeal in 1939 and Chambers and Sterling in the 1960s.  In his famous (prior to the 1940 Paton and Littleton monograph) Accountants Handbook (Ronald Press, 1932, Second Edition, Page 525) it is stated:

    In particular the case of specialized equipment market value is usually little more than scrap value. That is, a specialized machine, bolted to the factory floor, has little value apart from the particular situation, and hence its market value, unless it is being considered as an element of the market value of the entire business as a going concern, is limited to net salvage ... buildings and equipment have a "going concern value" or "value in use" in excess of liquidation or market value

    For current thinking of the FASB on “value in use” see Accounting Standards Update (ASU) 2010-6
    "Fair Value Measurements and Dicsclosures Topic 820" Click Here
    http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820873224&blobheader=application%2Fpdf

    Also see KPMG's commentary on ASU 2010-6
    http://www.kpmginstitutes.com/financial-reporting-network/insights/2010/pdf/di-10-26-fasb-proposes-changes-fair-value-measurements.pdf

    Valuation Premises
    Fair value measurements of assets must consider the highest and best use of the asset, which is determined from the perspective of market participants rather than the reporting entity’s intended use. Under current U.S. GAAP, the asset’s highest and best use determines the valuation premise. The valuation premise determines the nature of the fair value measurement; that is, whether the fair value of the asset will be measured on a stand-alone basis ("in-exchange") or measured based on an assumption that the asset will be used in combination with other assets ("in-use"). The proposed ASU would remove the terms in-use and in-exchange because of constituents’ concerns that the terminology is confusing and does not reflect the objective of a fair value measurement. The proposed ASU would also prohibit financial assets from being measured as part of a group. The FASB decided that the concept of highest and best use does not apply to financial assets, and therefore their fair value should be measured on a stand-alone basis. Entities would still have the ability to measure fair value for a nonfinancial asset either on a stand-alone basis or as part of a group, consistent with the nonfinancial asset’s highest and best use.


    Example:  Accounting for a Website

    August 7, 2006 message from Ganesh M. Pandit, DBA, CPA, CMA [profgmp@hotmail.com]

    Hi Bob,

    How would you answer this question from a student: "I wonder if a company's Web site is considered a long-lived asset!"

    Ganesh M. Pandit
    Adelphi University

    August 9, 2006 reply from Bob Jensen

    Hi Ganesh,

    Accounting for Website investment is a classic example of the issue of "matching" versus "value" accounting. From an income statement perspective, matching requires the matching of current revenues with the expenses of generating that revenue, including the "using up" of fixed asset investments. But we don't depreciate investment in the site value of land because land site value, unlike a building, is not used up due to usage in generating revenue. Like land site value, a Website's "value" probably increases in value over time. One might argue that a Website should not be expensed since a successful Website, like land, is not used up when generating revenue. However, Websites do require maintenance fees and improvement outlays over time which makes it somewhat different than the site investment in land that requires no such added outlays other than property taxes that are expensed each year.

    I don't think current accounting rules for Websites are appropriate in theory --- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Issue08

    It seems to me that you can partition your Website development and improvement outlays into various types of assets and expenses. For example, computers used in development and maintenance of the Website are accounted for like other computers. Software is accounted for under software amortization accounting rules. Purchased goodwill is accounted for like purchased goodwill under new impairment test rules. Labor costs for Website maintenance versus improvements are more problematic.

    Leased Website items are treated like leases, although there are some complications if a Website is leased entirely. For example, such a leased Website is not "used up" like airplanes that are typically contracted as operating leases. Leased Website space may be appropriately accounted for as an operating lease. But leasing an entire Website is more like the capital lease of a land in that the asset does not get "used up." My hunch is that most firms ignore this controversy and treat Website leases as operating leases. It is pretty easy to bury custom development costs into the "rental fee" for leased Website server space, thereby burying the development costs and deferring them over the contracted server space rental period. It would seem to me that rental fees for Websites that are strictly used for advertising are written off as advertising expenses. Of course many Websites are used for much more than advertising.

    Firms are taking rather rapid write-offs of purchased Websites such as write-offs over three years. I'm not certain I agree with this, but firms are "depreciating" these for tax purposes and you can see them in filed SEC financial statements such as the one at Briton International (under the Depreciation heading) ---
    http://sec.edgar-online.com/2006/01/27/0001127855-06-000047/Section27.asp

    It is more common in annual reports to see the term Website Amortization instead of Website Depreciation. A few sites amortize on the basis of Website traffic --- http://www.nexusenergy.com/presentation6.aspx
    This makes no sense to me since traffic does not use up a Website over time.

    Bob Jensen

    October 5, 2006 reply from Scott Bonacker [cpas-l@BONACKER.US]

    I can't think of anyone that would be more knowledgeable than David Hardesty, at http://davidhardesty.com/ 

    His book, published by CCH, is excellent.

    Hope this helps ....

    Scott Bonacker, CPA
    Springfield, Missouri

    Bob Jensen's threads on e-Commerce and e-Business revenue accounting controversies are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

    Example 2 --- Proposition 87 VAT Tax

    An interesting accounting problem (or employment opportunity?) posed by Proposition 87 on the State of California November 7 ballot in 2006

    Proposition 87 would tax every barrel of oil pumped from an in-state well . . .But just to make sure, the proposition would fund investigations of oil companies that try to "pass on" the tax increase in the price. Severin Borenstein, director of University of California Energy Institute at UC Berkeley, points out that this would lead to "constant investigation that will yield no more than what past investigations (on why gasoline prices spike) have yielded, or even less." The oil tax revenues would Go to fund "alternative energy." That approach didn't work for former President Carter, is not working for President Bush, and won't work in California. Government funding, by definition, is not subject to a market test. "Alternate energy" will make sense only when its cost is less than the cost of using oil. The market will handle this problem as it did over a century ago by replacing the depleting whale-oil supply with petroleum. Amazingly, over $40 million of the $45.6 million contributed to the campaign for the tax comes from one man, Hollywood big shot Stephen Bing.
    David Henderson, "'Sinful and Tyrannical'," The Wall Street Journal, October 14, 2006; Page A7 --- http://online.wsj.com/article/SB116078251442292601.html?mod=todays_us_opinion

    Jensen Comment
    Proposition 87 is like (well not entirely) a VAT tax. Although I'm not against value added taxes (VAT), VAT taxes have been fought tooth and nail in U.S. politics (unlike in Europe). Apart from the VAT economic debates that are well known, Proposition 87 raises interesting accounting issues because it in effect introduces cost-plus pricing controls where fuel prices in California would now be in a sense regulated by California officials. Fuel companies in essence must justify prices with a full analysis of costs to verify that the $50 per barrel tax is not being passed on at the pump. In contrast, most VAT taxes are typically passed on to consumers in other nations (I think)

    Proposition 87 runs four square into the enormous and famous joint costing problem that has generally never been solved by accountants. Joint costs are always allocated arbitrarily unless laws govern (arbitrarily) such allocations. Given the complexity of oil refining joint costs, it would seem that unscrupulous oil refiners could devise ways of burying this new tax (in fuel prices) in such a manner that it is impossible for state auditors to detect. In practice, I think it is absurd to think that any type of corporate taxes cannot be factored into product and service prices unless prices themselves are to be regulated by the state. Price regulations themselves generally become either a joke (if industry controls the regulators) or a disaster (if regulators as central planners ignore the laws of supply and demand).

    Presumably California will not object to this Proposition 87 VAT tax being passed along to out-of-state customers of oil refiners. It would be difficult to pass along the tax if out-of-state customers had open access to world markets. However, some Nevada and Oregon fueling stations may not have any efficient source, at least in the short-run, of 92-octane gasoline other than from California refiners.

    Proposition 87 might then be viewed as a tax on surrounding states if 100% of the Proposition 87 VAT tax can be passed on to states surrounding California. Sounds like a good deal for California if those other states are willing to be taxed for California schools. Nevada may in fact punch a whole in the new immigration wall large enough for a gasoline pipe into Mexico.

    In any case, Proposition 87 might be better termed California's Cost Accountant Employment Relief Act.
    It would seem to be a whole lot easier to simply raise the corporate income tax, which of course is what California voters are being asked to do in another proposition, Proposition 89. It is totally naive to think that business taxes of any kind will not be passed along to customers in one way or another. You can fool some of the people some of the time, but not all the people all of the time (didn't someone else think of that line first?).

    As an aside, there is also Proposition 88 that will impose a $50 flat tax on every parcel of land, which of course is a tax that will be easily raised in future years. This in reality is a state-wide property tax that will grow and grow in spite of an older Proposition 13 assurance that property taxes cannot grow and grow for long-time home owners. What happens in California when new ballot propositions clash with older ballot propositions already voted in by the public?

     


    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. The international IASB standards require PLA accounting in hyperinflation nations.

    The SEC issued ASR 190 requiring PLA supplemental reports. This was followed by the FASB's 1979 FAS 33 short-lived standard. Follow-up studies did not point to investor enthusiasm over such supplemental reports. Eventually, both ASR 190 and FAS 33 were rescinded, largely from lack of interest on the part of financial analysts and investors due to relatively low inflation rates in the United States. However, PLA adjustments are still required for operations in nations subject to high rates of inflation.

    Advantages of PLA Accounting

    ·     Attempts to perfect historical cost accounting by converting costs to a common purchasing power unit of measurement.

    ·     Has a dramatic impact upon ROI calculations in many industries even in times of very low inflation.

    ·     Is essential in periods of hyperinflation.

    ·     Uses a readily available and reasonably accurate government-generated consumer price index (usually the CPI for urban households).

    Disadvantages of PLA Accounting

    ·     There is not general agreement regarding what is the best inflation index to use in the PLA adjustment process. Computing a price index for such purposes is greatly complicated by constantly changing technologies, consumer preferences, etc.

    ·     There is no common index across nations, and nations differ greatly with respect to the effort made to derive price indices.

    ·     Empirical studies in the U.S. have not shown PLA accounting data to have better predictive powers than historical cost data not adjusted for inflation.

     

     


    From Ernst & Young on January 20, 2012

    Financial reporting alert: Highly inflationary economies

    The Center for Audit Quality (CAQ) SEC Regulations Committee’s International Practices Task Force (the Task Force) today posted highlights from its recently finalized 22 November 2011 discussions, which indicate that based on available economic data, the Belarus three-year cumulative inflation rate exceeded 100 percent as of 30 September 2011.

    An economy whose cumulative inflation rate is 100 percent or more over a three-year period is highly inflationary for US GAAP reporting purposes. Generally, highly inflationary accounting is applied as of the first day of the reporting period immediately following the reporting period (including interim reporting periods) in which an economy is assessed to be highly inflationary. However, for reasons noted in the Task Force’s highlights, the SEC staff would not object to registrants treating the economy of Belarus as highly inflationary no later than the first reporting period beginning after 15 December 2011.

    Separately, the SEC staff expects registrants to continue to treat the economies of the Democratic Republic of Congo and Venezuela as highly inflationary.

    There may be other countries with cumulative inflation rates of 100 percent or more or that should be monitored that are not mentioned above because the sources used by the Task Force do not include inflation data for all countries. Accordingly, companies should closely monitor the inflation rates in economies in which they operate.

    For further information, including SEC disclosure considerations related to the events in Belarus, see the
    Task Force Highlights Excerpt.
    http://thecaq.org/iptf/pdfs/highlights/2011_November22_IPTF_JointMeetingHLs.pdf

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Bob Jensen's threads on price-level adjustments ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#BasesAccounting

     

     


    From The Accounting Onion

    "Lease Accounting: Replacement Cost is the Only Hope for a Principles-Based Solution," Accounting Onion, April 8, 2009 --- Click Here

    "Replacement Cost Rebound," Accounting Onion, April 2, 2009 --- Click Here

     


    Question
    What is the difference between "replacement cost" and "factor replacement cost?"
    Scroll down quite a ways and I will eventually point out the difference.

    Hi Tom, 

    Your latest Onion piece is a good starting point for a “blank paper” beginning for the debate on fair value accounting --- http://accountingonion.typepad.com/theaccountingonion/2009/04/a-new-title.html  

    But it overlooks some of the major problems, particularly problems in current (replacement) cost accounting that are summarized at http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Replacement costs also have huge problems as summarized below.

    Market "Value" Accounting: Entry Value (Current Cost, Replacement Cost) Accounting
    Which is often incorrectly called a form of "value accounting"

     

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies are no longer required to generate FAS 33-type comparisons. The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. Exit value accounting is required for firms deemed highly likely to become non-going concerns. Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people). Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities. Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting. Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

    Replacement Cost Accounting Experiments in Practice in the United States

    Replacement cost (entry-value, current cost) accounting is more than price-level adjusted (PLA) historical cost accounting. Whereas PLA only tries to adjust historical cost book values over time for the changed purchasing power of unit of measurement (e.g., the U.S. dollar), replacement cost accounting attempts to adjust for relative differences in changed prices of balance sheet items. For example, PLA would make the same adjustment to 1981 purchases of tractors and buildings whereas replacement cost accounting would re-price tractors at tractor new prices and buildings at building new prices.

    It should be noted that replacement cost (entry value, current cost ) accounting is not considered fair value accounting. It is in fact a modified form of historical cost accounting where original costs are adjusted to what it would cost to replace the items at their current prices. But those "replacement costs" are adjusted for depreciation and amortization such that replacement cost accounting does not take much of the period-to-period cost allocation arbitrariness out of the financial statements.

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization).  Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33.  Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates.  The FASB rescinded FAS 33 when it issued FAS 89 in 1986.  

    FAS 33 had a significant impact on some companies. The adjustments were not trivial! For example the earnings reported by United States Steel in the 1981 Annual Report as required under FAS 33 were as follows:

    1981 United States Steel Income Before Extraordinary items and Changes in Acctg. Principles

    Historical Cost (Non-PLA Adjusted)

    Historical Cost (PLA Adjusted)

    Replacement Cost (Current Cost)

    $1,077,000,000 Income

    $475,300,000 Income 
    Plus $164,500,000 PLA gain due to decline in purchasing power of debt

    $446,400,000 Income
    Plus $164,500,000 PLA Gain

    Less $168,000,000 Current cost increase less effect of increase in the general price level

    Companies are no longer required to generate FAS 33-type comparisons.  The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for operations in hyperinflation nations.  Exit value accounting is required for firms deemed highly likely to become non-going concerns.  Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people).  Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities.  Exit value accounting is required for impaired items such as damaged inventories and inoperable machinery.

    One of the criticisms of FAS 33 is that, in order to make adherence less costly for financial reporting, the FASB allowed rather crude indices of sector price changes to be used that were often highly inaccurate in terms of specific items at specific locales. Hence FAS 33 replacement costs were subject to enormous margins of error. This is one of the reasons financial analysts tended to ignore the supplemental balance sheet reports required under FAS 33.

    Long before the FAS 33 (1979-1986), there were some questionable attempts by selected companies to voluntarily provide replacement cost information. Professor Zeff reported several case studies in replacement cost accounting in 1962:
    "Replacement Cost:  Member of the Family, Welcome Guest, or Intruder," by Stephen A. Zeff, The Accounting Review, October 1962, pp. 611-723.

    These early attempts at replacement cost adjustment frustrated analysts because the companies were generally vague about details regarding how they made the adjustments. Analysts could not be certain how they went about estimating replacement costs and even what they meant by imprecise mention of "fair value" adjustments.

    Firstly Zeff contrasted Type A price adjustments that were PLA adjustments and not replacement cost adjustments. Hence TypeA=PLA. Type B adjustments are specific-item replacement cost adjustments that are, in turn, adjusted again for depreciation and amortization and changing prices levels. Hence Type B=RC in its purist form. Steve also defines Type C to be replacement cost accounting that does not factor out general price level changes in the purchasing power of the dollar. Hence Type C does not take into account the fact that if there is price inflation/deflation, some of the Type C adjustment may not reflect the fact that part of the changed price of the item is due only to the changing purchasing power of the currency.

    Zeff then writes as follows between pages 615-616 about long-term fixed assets cost adjustments;
    "Replacement Cost:  Member of the Family, Welcome Guest, or Intruder," by Stephen A. Zeff, The Accounting Review, October 1962:

    Indiana Telephone Corporation has, since 1955, used Type C and Type A indices concurrently. With the assistance of a consulting engineer, the company classifies "gross plant additions" on a FIFO basis by years of acquisition, selects an appropriate Type C index for each plant category, and then applies the derived multiplier to each year's cost of acquisition. Since this plant-account analysis is undertaken only once every three or four years, as needed, financial-statement amounts for interim years are found by applying a final multiplier to the Type C-adjusted figures. This final multiplier is based on the "all commodities other than farm and foods" component of the Wholesale Price Index.

    Beginning in 1957, the Sacramento Municipal Unility District and Ayrshire Collieries Corporation recorded "supplementary" depreciation charges. Sacramento uses the term "fair value depreciation," while Ayrshire calls it "price level depreciation." Iowa-Illinois Gas and Electric Company, in response to a 1957 Iowa Supreme Court decision that allowed the company's rate base to reflect "fair value depreciation," began to record in 1958 a supplementary "fair value depreciation" charge on property located in Iowa districtrs in which the court decision had been implemented.

    None of these latter three companies discloses the manner by which the supplementary depreciation charged is computed. Although they occasionally refer in their annual reports to "current purchasing power of the dollar" and "inflation," they uniformly contend that the new basis of accounting replaces "historical cost." Further, the key adjectives "general" and "specific" as well as equivalents thereto are not used. "Fair value" is hardly a definitive term.

    Zeff goes on to write the following on Page 617:

    Indeed, prominent foreign companies utilize replacement cost in the determination of their net income. N.V. Phillips' Gloeilamphenfabrieken, of The Netherlands, employs replacement cost for valuing long-lived assets adn inventories. Imperial Tobacco Co. of Canada, Ltd., converted in its 1961 annual report to full-fledged replacement cost accounting for long-lived assets. Previously, it had not revalued long-lived assets, but since 1955 had shown supplementary replacement-cost depreciation charge. The one-shot revaluation of its long-lived assets did not, however, affect the carrying value of the company's total assets. Conveniently, the $25 million write-up in long-lived assets was more than offset by a concurrent write-down in goodwill. Imperial had charged operations with an inventory-replacement increment, but this practice was apparently abandoned in 1961.

    A replacement-cost adjustment should hardly be viewed as an alternative to Type A restatement. Both the Philips and Imperial adjustments, for example, are recognition of Type C price movement, implying that these companies fail to disclose the important distinction between the fictitious  (i.e., general) and real (i.e., specific) price changes.

    Question
    What is the difference between "replacement cost" and "factor replacement cost?"

    Answer
    It is much like a make versus buy decision. As an illustration, the "replacement cost" of a computer is the price one would pay for a computer in the market to replace an existing computer. That presumably includes the mark up profits of vendors in the supply chain. The "factor replacement cost" excludes such mark up profits to the extent possible by estimating what it would cost in the "transformation process" to purchase the components for transformation of those components into a computer. The "factor replacement cost" adds in labor and manufacturing overhead. It excludes vendor profits in the computer supply chain but not necessarily vendor profits in the purchase price of components. It becomes very complicated in practice, however, because computer vendors do such things as include warranty costs in the pricing of computers. Assembled computers in house probably have no such warranties. A more detailed account of factor replacement costing is provided in Chapters 3 and 4 of Edwards and Bell.
    Edgar O. Edwards and Philip W. Bell, The Theory and Measurement of Business Income (Berkeley:  University of California Press, 1961).

    Of course this does not solve the fundamental problem of replacement cost accounting that arises when there are no current assets or component parts of assets that map directly into older assets still being used by the company. For example, old computers and parts for those computers are probably no longer available. Newer computers have many more enhancements that make them virtually impossible to compare with older computers such using prices of current computers is a huge stretch when estimating replacement costs of older computers that, for example, may not even have had the ability to connect to local networks and the Internet.

    Zeff writes as follows on Page 623:

    Edwards and Bell, in their provocative volume, propound a measure called "business profit," which is predicated on what might be termed "factor replacement cost." "Business profit" is the sum of (1) the excess of current revenues over the factor replacement cost of that portion of assets that can be said to have expired currently, and (2) the enhancement during the current period of the factor replacement cost.

    Advantages and disadvantages of replacement cost (entry value, current cost) accounting are discussed in greater detail are listed below.

    Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Conforms to capital maintenance theory that argues in favor of matching current revenues with what the current costs are of generating those revenues. For example, if historical cost depreciation is $100 and current cost depreciation is $120, current cost theory argues that an excess of $20 may be wrongly classified as profit and distributed as a dividend. When it comes time to replace the asset, the firm may have mistakenly eaten its seed corn.

     

    ·     If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price level adjustments are avoided.

     

    ·     Avoids to some extent booking the spread between selling price and the wholesale "cost" of an item. Recording a securities “inventory” or any other inventory at exit values rather than entry values tends to book unrealized sales profits before they’re actually earned. There may also be considerably variability in exit values vis-à-vis replacement costs.
     

    Although I am not in general a current cost (replacement cost, entry-value) advocate, I think you and Tom are missing the main theory behind the passage of the now defunct FAS 33 that leaned toward replacement cost valuation as opposed to exit valuation.

    The best illustration in favor of replacement cost accounting is the infamous Blue Book used by automobile and truck dealers that lists composite wholesale trading for each make and model of vehicle in recent years. The Blue Book illustration is relevant with respect to business equipment currently in use in a company since virtually all that equipment is now in the “used” category, although most of it will not have a complete Blue Book per se.

    The theory of Blue Book pricing in accounting is that each used vehicle is unique to a point that exit valuation in particular instances is very difficult since no two used vehicles have the same exit value in a particular instances. But the Blue Book is a market-composite hundreds of dealer transactions of each make and model in recent months and years on the wholesale market.

    Hence I don’t have any idea about what my 1999 Jeep Cherokee in particular is worth, and any exit value estimate of my vehicle is pretty much a wild guess relative to what it most likely would cost me to replace it with another 1999 Jeep Cherokee from a random sample selection among 2,000 Jeep dealers across the United States. I merely have to look up the Blue Book price and then estimate what the dealer charges as a mark up if I want to replace my 1999 Jeep Cherokee.

    Since Blue Book pricing is based upon actual trades that take place, it’s far more reliable than exit value sticker prices of vehicles in the sales lots.

     Conclusion
    It is sometimes the replacement market of actual transactions that makes a Blue Book composite replacement cost more reliable than an exit value estimate of what I will pay for a particular car from a particular dealer at retail. Of course this argument is not as crucial to financial assets and liabilities that are not as unique as a particular used vehicle. Replacement cost valuation for accounting becomes more defensible for non-financial assets.

     

    Disadvantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Discovery of accurate replacement costs is virtually impossible in times of changing technologies and newer production alternatives.  For example, some companies are using data processing hardware and software that no longer can be purchased or would never be purchased even if it was available due to changes in technology. Some companies are using buildings that may not be necessary as production becomes more outsourced and sales move to the Internet. It is possible to replace used assets with used assets rather than new assets. Must current costs rely only upon prices of new assets?

     

    ·     Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.

     

    ·     Accurate derivation of replacement cost is very difficult for items having high variations in quality. For example, some ten-year old trucks have much higher used prices than other used trucks of the same type and vintage. Comparisons with new trucks is very difficult since new trucks have new features, different expected economic lives, warranties, financing options, and other differences that make comparisons extremely complex and tedious. In many cases, items are bought in basket purchases that cover warranties, insurance, buy-back options, maintenance agreements, etc. Allocating the "cost" to particular components may be quite arbitrary.
     

    ·     Use of "sector" price indices as surrogates compounds the price-index problem of general price-level adjustments. For example, if a "transportation" price index is used to estimate replacement cost, what constitutes a "transportation" price index? Are such indices available and are they meaningful for the purpose at hand? When FAS 33 was rescinded in 1986, one of the major reasons was the error and confusion of using sector indices as surrogates for actual replacement costs.

     

    ·     Current costs tend to give rise to recognition of holding gains and losses not yet realized.
     
    Bob Jensen

    Hi Again Tom,

    I would not trash a lawn mower under warranty even if I bought the new one. My motto for warranty providers is to make them pay and pay for the lemons they sell to me.

    In my case it was a pain for Sears and (less for me) to have to keep returning to my home to fix my snow thrower. But in the process, my stubborn nature paid off for millions of consumers who had trouble with their chute-cable freeze ups on snow throwers.I think that Craftsman is mostly a boiler plate for put on snow throwers manufactured for a variety of retail distributors. In any case, engineers finally solved the chute cable problem by simply shortening the cables from about four feet to two feet. Now my snow thrower works terrific. If you had persisted with your lawn mower problem, maybe engineers would have discovered a miracle solution.

    The key is to have an onsite warranty. If you have to haul the item to a service center, the hassle is too much of a pain in the tail.

    What I wonder about your IFRS comment below is what constitutes “adequate” accumulated depreciation? Obviously, “adequate” cannot mean the full cost of replacement. It could mean the cost of replacement depreciated over the current fraction of estimated useful life, but this would be tantamount to replacement cost accounting. I don’t think IFRS has abandoned historical cost accounting in favor of replacement cost accounting.

    Therefore, I’ve very confused as to how “adequate” is defined in your message below.

    As to my recommendation for financial statements, I think the only practical solution is M2M for financial items and historical cost for non-financial items still in use (with LCM only for permanently-impaired inventory). Something like FAS 33 requiring supplemental disclosures of entry and exit values with price level adjustments would be great, but the requirements for measurement would have to be far more accurate than crude sector price index adjustments.

    I think that unrealized gains and losses due to M2M should not impact current earnings. These should be deferred in AOCI or something equivalent.

    Bob Jensen

    Hi again Tom,

     I agree with what you state about covariances of replacement cost estimates, but it is important to note that replacement cost accounting is really a cost allocation process rather than a valuation process for non-financial items subject to depreciation and amortization. Depreciation and amortization allocation formulas use such arbitrary estimates of economic lives, salvage values, and cost allocation patterns that it’s not clear why additive aggregation is any more meaningful under replacement cost aggregations than it is under historical cost aggregations. Neither one aggregates to anything we can meaningfully call value in use.

     Companies are no longer required to generate FAS 33-type comparisons.  The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances.  For example, price-level adjustments may be required for operations in hyperinflation nations.  Exit value accounting is required for firms deemed highly likely to become non-going concerns.  Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people).  Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities.  Exit value accounting is required for impaired items such as damaged inventories and inoperable machinery.

    Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting.  Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

    The FASB and the IASB state that "value in use" is the ideal valuation measure if it can be measured reliably at realistic estimation costs. Exit value and economic (discounted cash flow) generally do not meet these two criteria for value in use of non-financial items. There is nearly always no practical means of estimating higher order covariances. and additivity aggregations are meaningless without such covariances.  In the case of economic valuation, estimation of future cash flows and discount rates enters the realm of fantasy for long-lived items. Alsoreliable exit value estimation of some items like all the hotel properties of Days Inns can be very expensive, which is a major reason Days Inns only did it once for financial reporting purposes in 1987. Accordingly, "value in use" is an ideal which cannot be practically achieved under either exit or economic valuation methods.

    The FASB and the IASB state that "value in use" is the ideal valuation measure, but this ideal can never be achieved with cost allocation methods. Both historical cost and replacement (current, entry) value "valuation" methods are not really valuation methods at all. These are cost allocation methods that for items subject to depreciation or amortization in value are reliant upon usually arbitrary estimates of non-financial item useful lives, value decline assumptions such as straight line or double declining balance declines, and salvage value estimates. Under historical cost, the book value thus becomes an arbitrary residual of the rationing of original cost by arbitrary cost allocation formulas. Under replacement (current, entry) cost allocation the estimated current replacement costs are subjected to n arbitrary residual of the rationing of replacement cost by arbitrary cost allocation formulas.

    Although both historical and replacement cost allocations over time avoid covariance problems in additive aggregations of book values, the meanings of such aggregations are of very dubious utility to investors and other decision makers. For example suppose the $10 million 2008 book value of a fleet of passenger vans is added to the $200 million 2008 book value of Days Inn hotel properties, what does the $210 million aggregation mean to anybody?

    Both the passenger vans and hotel buildings have been subjected to arbitrary estimates of economic lives, salvage values, and depreciation patters such as double declining balance depreciation for vans and straight-line depreciation for hotel buildings. This is the case whether historical cost or current replacement costs have been allocated by depreciation formulas.

    Hence it is not clear that for going concern companies that have heavy investments in non-financial assets that any known addition of individual items makes any sense under economic, exit, entry, or historical cost book value estimation process. Aggregations might make some sense for financial items with negligible covariances, but for non-financial items. Attempts to estimate total value itself basted upon stock market marginal trades are misleading since marginal trades of a small proportion of shares ignores huge blockage factors valuations, especially blockage factors that carry managerial control along with the blockage purchase. Countless mergers and acquisitions repeatedly illustrate that estimations of total values of companies are generally subject to huge margins of error, especially when intangibles play an enormous part of the value of an enterprise.

    Both the FASB and the IASB require in many instances that exit value accounting be used for financial items. In part that is because for financial items it is often more reasonable to assume zero covariances among items. The recent banking failures caused by covariance among toxic mortgage investments lends some doubt to this assumption, but the issue of David Li’s faltering and infamous Gaussian copula function is being ignored by both the IASB and the FASB in recommending exit value accounting for many (most) financial items --- http://en.wikipedia.org/wiki/Gaussian_copula#Gaussian_copula
    For how the defect in this formula contributed to the 2008 fall of many banks see
    ---
    http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html 

    I might add that Bob Herz and the FASB as a whole recognize that additive aggregation in financial statement items is probably more misleading than helpful. This is why a very radical proposal is underway in the FASB to do away with aggregations, including the presentation of net income and earnings-per-share bottom liners --- http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

    The above link also discusses the vehement disagreement between Bob Herz and the financial community on the proposal to do away with the bottom line.

    This bottom line aggregation problem is also bound up in the “quality of earnings” controversy --- http://faculty.trinity.edu/rjensen/Theory01.htm#CoreEarnings
    However, the concept of reporting core earnings is not nearly as controversial as the proposal not to report any bottom lines

    Bob Jensen's threads on fair value accounting are at various other links:

    Fair Value Accounting Controversies --- http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue

    Return on Investment Theory --- http://faculty.trinity.edu/rjensen/roi.htm

    Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
    http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

     

     

    Market Value Accounting: Entry Value (Current Cost, Replacement Cost) Accounting

    One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
    www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, Price Level Adjusted (PLA) Historical Cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies complained heavily that users did not obtain value that justified the cost of implementing FAS 33. Analysts complained that the FASB allowed such crude estimates that the FAS 33 schedules were virtually useless, especially the Current Cost estimates. The FASB rescinded FAS 33 when it issued FAS 89 in 1986.

    Current cost accounting by whatever name (e.g., current or replacement cost) entails the historical cost of balance sheet items with current (replacement) costs. Depreciation rates can be re-set based upon current costs rather than historical costs. 

    Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies are no longer required to generate FAS 33-type comparisons. The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. Exit value accounting is required for firms deemed highly likely to become non-going concerns. Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people). Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities. Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting. Beginning in January 2005, all nations in the European Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

    Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Conforms to capital maintenance theory that argues in favor of matching current revenues with what the current costs are of generating those revenues. For example, if historical cost depreciation is $100 and current cost depreciation is $120, current cost theory argues that an excess of $20 may be wrongly classified as profit and distributed as a dividend. When it comes time to replace the asset, the firm may have mistakenly eaten its seed corn.

     

    ·     If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price level adjustments are avoided.

     

    ·     Avoids to some extent booking the spread between selling price and the wholesale "cost" of an item. Recording a securities “inventory” or any other inventory at exit values rather than entry values tends to book unrealized sales profits before they’re actually earned. There may also be considerably variability in exit values vis-à-vis replacement costs.
     

    Although I am not in general a current cost (replacement cost, entry-value) advocate, I think you and Tom are missing the main theory behind the passage of the now defunct FAS 33 that leaned toward replacement cost valuation as opposed to exit valuation.

    The best illustration in favor of replacement cost accounting is the infamous Blue Book used by automobile and truck dealers that lists composite wholesale trading for each make and model of vehicle in recent years. The Blue Book illustration is relevant with respect to business equipment currently in use in a company since virtually all that equipment is now in the “used” category, although most of it will not have a complete Blue Book per se.

    The theory of Blue Book pricing in accounting is that each used vehicle is unique to a point that exit valuation in particular instances is very difficult since no two used vehicles have the same exit value in a particular instances. But the Blue Book is a market-composite hundreds of dealer transactions of each make and model in recent months and years on the wholesale market.

    Hence I don’t have any idea about what my 1999 Jeep Cherokee in particular is worth, and any exit value estimate of my vehicle is pretty much a wild guess relative to what it most likely would cost me to replace it with another 1999 Jeep Cherokee from a random sample selection among 2,000 Jeep dealers across the United States. I merely have to look up the Blue Book price and then estimate what the dealer charges as a mark up if I want to replace my 1999 Jeep Cherokee.

    Since Blue Book pricing is based upon actual trades that take place, it’s far more reliable than exit value sticker prices of vehicles in the sales lots.

    Conclusion
    It is sometimes the replacement market of actual transactions that makes a Blue Book composite replacement cost more reliable than an exit value estimate of what I will pay for a particular car from a particular dealer at retail. Of course this argument is not as crucial to financial assets and liabilities that are not as unique as a particular used vehicle. Replacement cost valuation for accounting becomes more defensible for non-financial assets.

    Disadvantages of Entry Value (Current Cost, Replacement Cost) Accounting

    ·     Discovery of accurate replacement costs is virtually impossible in times of changing technologies and newer production alternatives.  For example, some companies are using data processing hardware and software that no longer can be purchased or would never be purchased even if it was available due to changes in technology. Some companies are using buildings that may not be necessary as production becomes more outsourced and sales move to the Internet. It is possible to replace used assets with used assets rather than new assets. Must current costs rely only upon prices of new assets?

    ·     Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.

    ·     Accurate derivation of replacement cost is very difficult for items having high variations in quality. For example, some ten-year old trucks have much higher used prices than other used trucks of the same type and vintage. Comparisons with new trucks is very difficult since new trucks have new features, different expected economic lives, warranties, financing options, and other differences that make comparisons extremely complex and tedious. In many cases, items are bought in basket purchases that cover warranties, insurance, buy-back options, maintenance agreements, etc. Allocating the "cost" to particular components may be quite arbitrary.

    ·     Use of "sector" price indices as surrogates compounds the price-index problem of general price-level adjustments. For example, if a "transportation" price index is used to estimate replacement cost, what constitutes a "transportation" price index? Are such indices available and are they meaningful for the purpose at hand? When FAS 33 was rescinded in 1986, one of the major reasons was the error and confusion of using sector indices as surrogates for actual replacement costs.

    ·     Current costs tend to give rise to recognition of holding gains and losses not yet realized.

    Tom Selling wrote the following at
    http://accountingonion.typepad.com/theaccountingonion/2009/04/replacement-cost-rebound.html

     

     

    ***********Begin Quote
    The most straightforward way to determine replacement cost to meet the wealth measurement objective is to ask oneself what would be the least amount one would have to pay for an asset (or a similar asset that provided the same utility), if one did not actually already own it. It seems to me that real estate appraisers make estimates for specific properties on that basis as a matter of course. Often, their best estimate is the result of making somewhat objective adjustments to 'comparables' for age, floor space and even location.

    Having said that, I would allow for any number of approaches to approximating replacement cost, so long as they adequately answered the question I posed in the previous paragraph.  Like FAS 157, the greater the subjectivity in the estimates, the more detailed would be the disclosures.  However, in all cases, I would require reconciliations of the changes in balance sheet accounts in sufficient detail to make all assumptions, and changes in assumptions, transparent.
    ***********End Quote

     

    True Story
    Bob Jensen has a Sears Craftsman snow thrower purchased in 2006 for $1,800 with a five-year onsite warranty for all parts and labor. If he decides to replace the machine every five years, he’s really not concerned with physical deterioration if he assumes that the salvage value is after five years is $300 for a perfectly working machine maintained by Sears mechanics at his beckoning call. There is historical cost depreciation of $300 per year assuming the decline in value on the used snow machine market is strictly linear. Assume that replacement cost depreciation is $$350 per season.

    True StoryBob’s good friend Helmut Gottwick survived four years as an engineer and machinist on a German U-Boat in World War II. After arriving in New Hampshire in 1950 he bought a used snow thrower for $24. It was made by Studebaker in 1937. Unlike Bob Jensen who has no mechanical skills whatsoever, Helmut can make most old machines work perfectly as long as he is still of sound mind and body to work in the machine shop in his garage. He’s totally rebuilt the Studebaker snow thrower engine two times, including the making of virtually all new parts in his shop. Assuming that his remaining life expectancy was 60 years in 1950, the depreciation on his snow thrower is $0.40 per year for the rest of his life. Assume replacement cost depreciation is $350 per season.

    Fiction Added
    Suppose Bob and Helmut clear driveways for neighbors for an average of $1,000 per season net of gasoline expense (there’s a lot of snow in these mountains). Replacement cost write ups of Bob Jensen’s snow machine and depreciations of $350 per year make some sense on Capital Maintenance Theory. If Bob Jensen used historical cost accounting and declared a $700 dividend to himself each season, he would not have sufficient retained earnings to cover the cost of a new snow thrower every five years. It makes some sense, therefore, for Bob to only declare a $650 dividend for wild women and booze. If he saves an amount of cash equal to retained earnings each season, he will have sufficient savings to buy that new snow thrower after every five year period.

    But suppose we impose a replacement cost accounting rule on Helmut Gottwick’s snow throwing business. If he can only declare a $650 dividend every year the fact of the matter is that for 60 years he’s have been deprived of a lot of wild women and booze (in reality he’s a very devoted husband and opa). His reported earnings also distort the fact that, because of his machinist skills, he's a heck of a lot better business man than Bob Jensen who must settle for older women and younger whiskey.

    The Point of the Story
    Replacement cost accounting can distort reported assets and earnings under totally different maintenance and replacement policies. Over 60 years, the CPA auditing firm might uselessly force Helmut Gottwick to retain $350 per year for a machine that cost him $24 in 1950 and has a useful life of 60 years in his situation, Capital maintenance theory makes no sense in Helmut’s case since during his lifetime the old Studebaker snow thrower will work as well or better than a new snowthrower. In Bob Jensen’s situation, capital maintenance theory makes much more sense.

    In truth Helmut would not be required to take $350 replacement cost depreciation for 60 years, because he would only be required to bring book value up to depreciated replacement value each year. But I thought my exaggeration above made a better story.


    Question
    What causes asset price bubbles?

    "Asset-Price Bubbles," by Richard Posner, Becker-Posner Blog, May 16, 2010 ---
    http://uchicagolaw.typepad.com/beckerposner/2010/05/assetprice-bubblesposner.html

    "Social Interactions and Bubbles," by Nobel Laureate Gary Becker, Becker-Posner Blog, May 16, 2010 ---
    http://uchicagolaw.typepad.com/beckerposner/2010/05/social-interactions-and-bubbles-becker.html

     


    Accounting Greats George Oliver May and William Andrew Paton were two of the first scholars admitted into the Accounting Hall of Fame (in 1950) --- http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/

    ·      http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/george-oliver-may/
     

    ·     http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/william-a.-paton/

    May believed that accounting is not logical; it is fundamentally conventional and utilitarian.1 The test of good accounting lies in whether it is useful, not to one particular group, but to society as a whole. He viewed corporation accounting as just one aspect of the corporate form of organization, which he considered to have been created to serve a useful social purpose.2 In a 1928 memorandum concerned with the question of the usefulness of corporate financial statements to investors and others interested in corporation securities, he cautioned that one must recognize the limitations on their significance. He often stated that the individual items in financial statements are not statements of fact, but expressions of opinion after the application of judgment and accounting methods to the relevant facts. May believed that there was room for considerable improvement in the presentation of financial information of corporations. He reasoned that the primary purpose should be to satisfy the investor’s need for knowledge, rather than the accountant’ssense of form
    Henry Francis Stabler and Norman X. Dressel,. "MAY AND PATON: TWO GIANTS REVISITED," Accounting Historians Journal, Fall 1981 ---
    http://umiss.lib.olemiss.edu:82/articles/1000260.334/1.PDF

    Income Determination
    May believed that the emphasis placed on a single figure of net income was regrettable. The effort to simplify the information had resulted in the concealment of essential information and tended to deceive investors; therefore, it was necessary to educate the public as to the inadequacy of the information on which it based its conclusions.

    Paton saw accounting from the point of view of two parties: owners and management. His theoretical development of the entity concept in relation to accounting is well known. He saw the business as an economic entity and knowledge about the return on the entire fund of capital employed was essential for managerial decisions.

    As contrasted with Paton’s position, May believed that it was not the function of accounting to measure earning power. He took exception to the definition of “income” as stated in Accounting Terminology Bulletin No. 2, which he interpreted as including capital gains and losses. The use of the term “earnings,” as synonymous to “net income,” was considered confusing because net income may be more, or less, than net earnings. The proper use of the term “net earnings” was a description of the balance remainingafter deducting from gross earnings the cost of securing them.11 He believed that it was impossible to establish any universal rule as to whether capital gains and losses should enter into the computation of net income.12 In the opinion of May, the value of a business enterprise was dependent, in the main, on its earning capacity. The primary use of the income statement was to determine the capital value of the investment by applying a multiplier to the earnings shown. It was extremely important that this multiplier be applied only to the earnings produced in the ordinary course of business.

    May believed that a major need was to formulate a broad concept of business income.14 He considered business income to be a rather indefinite concept which had not been clearly defined by anyone outside the accounting profession.15 Paton’s views were somewhat similar to those of May. He defined income over the entire life of the business without periodic matching of revenues and cost and expense, and also saw income as the return on capital after periodic cost of recovery of such capital costs. However, he accepted the view of the practicing accountant, that is, periodic matching of revenues and revenue deductions.16

    In the opinion of May, there was no accounting method for determination of income of a complex business organization for a year which could properly be considered valid. The financial statements were based on conventions and were correct only in the sense that they conformed to some particular standard. He often said that “annual accounts . . . would be indefensible if they were not indispensable.”

    For the accountant, the job of income determination is a complex one. As considered by both May and Paton, the source of such income depends not only on one’s definition of income, but also on one’s approach to valuation. Since many cost items are related to asset expiration, the valuation basis used in the financial statements is crucial.

    . . .

    Valuation
    Many accounting theorists have expressed distrust for the historical basis. Few have been bold enough to agitate aggressively for alternatives. Both May and Paton came forth with sound denunciations of the accepted basis of historical cost. They were both vocal on this score from the beginning of their writings.

    Departures from unadjusted historical cost are primarily twofold.  First, “replacement cost” considers the current input equivalent cost rather than the actual cost assumed at acquisition. This method considers, then, the current cost of specifically identifiable items of assets. “Price level adjustment” accounting, on the other hand, is not related directly to specific items. Instead, the historical cost of the investment in assets (current nonmonetary, as well as plant and equipment items) is updated by price level indexes in order to reflect the price level changes. May and Paton were both very vocal in these two areas. Probably this innovation in the “stream of accounting thought” has identified both of them as “renegades” in the pre-1950 era. Thereafter, the tide slowly, but steadily, changed. Today they are both highly respected for their positivepositions on the subject.

    Paton was a staunch defender of both “replacement cost” and “price level adjustment” accounting. He saw the advantages and limitations of replacement cost clearly. Current economic value, he believed, influences the decision process more strongly than past recorded costs. However, in connection with plant and equipment accounting, he thought the method would be somewhat inexpedient to apply. In addition,

    . . . the price system is not uniformly sensitive throughout, and that for considerable periods selling prices may not move in harmony with changing costs of production. Selling prices, moreover, are not fixed by costs to the particular concern—whatever the basis on which such cost may be computed.

    Since replacement cost bases are of major importance to business management, they should be considered in making decisions.

    May had reservations about the replacement cost basis. Instead, he believed the monetary unit unsuitable for the purpose of serving as the accounting symbol; however he considered it to be virtually the only available one. He believed that, as a result of governmental policy directed at changes in the value of the monetary unit, rather than at maintaining its stability, its adaptability was impaired.20

    With regard to asset valuation, Paton alluded to severe price movements and pleaded for consideration of economic values in his 1922 book mentioned earlier. To him this meant “current value.”21 He believed that the changing value of the monetary unit was a serious limitation to accounting data presented in financial statements. To him, the real basis of accounting is value.

    Furthermore, “costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions.” He indicates that assets which pass through the entity in a relatively short time span may be represented by original cost. But, in the case of assets possessing long lives, strict adherence to historical cost may result in “unreliable or even misleading”23 information for management. Obviously, results of operation based on such distortion of values would misstate both the value of the entity and its earning power. He considers cost as an amount of economic sacrifice incurred, or “economic force expended or committed.”

    May believed that changes in the value of the dollar had created problems for the accounting profession and had left it with two alternatives. The first was to adhere to established conventions and admit that financial statements had lost some of their former significance. The second was to seek to establish new principles which would make the reported amounts more significant. It was his opinion that the second alternative was followed, for example, in the case of inventories when the last-in, first-out method of valuation was employed. The first alternative was followed in respect to capital assets since charges for depreciation did not recognize changes in the price level. It was an inconsistency, and the profession faced the task of rectifying it. He reasoned that two objectives should be kept in mind when considering this problem. These were:

    1. Expressing revenues and charges against revenues as nearly as possible in units of equal purchasing power;

    2. Placing the burden of decline in the value of the monetary unit as equally as possible on investments in monetary claims and investments in tangible capital assets.26

    May regarded the LIFO inventory idea as being a compromise between accounting theory, accounting practicability, and convenience. Its significance lay in the recognition of the objective of relating cost to revenue more nearly on the same price level, rather than in the extent or manner of achievement of that objective.” Paton, on the other hand, had severe reservations regarding LIFO. He challenges the procedure in the following manner:

    The adoption of last-in, first-out is sometimes defended by reference to the view that in determining true profit the revenues of the period should be charged with costs measured by the level of prices obtaining at the end of the period. Is there any substantial merit in this line of argument?

    Answer in the negative seems to be called for. In the first place not very much of a case can be made for measuring profit in the manner indicated. In the revenues of the period are represented the prices of product in effect from day to day, and the costs to be charged to such revenues are the actual costs which have been incurred throughout the period and earlier which are reasonably assignable to the various batches of product sold. . . .

    In the second place the use of last-in, first-out does not result in charging revenues with costs based on year-end prices.

    . . . where there is a continuous pricing of goods issued under last-in, first-out procedure the total cost of issues for the period may not coincide with the cost of the most recent acquisitions in corresponding quantity. In the third place it may be urged that for managerial purposes it is more useful to apply the relatively recent costs to the goods on hand than to goods sold. Completed sales and the related costs are “water under the bridge,” closed transactions. Utilization of the inventory, on the other hand, lies in the future and in planning such utilization the current level of costs is especially significant.

    May believed that whether a change in procedure should be made to bring the cost for depreciation into account at approximately the same price level as revenues depended in part on the importance of the amounts involved. He considered the problem to be of sufficient magnitude to warrant further study.

    . . .

    This continuing emphasis on valuation clearly demonstrates the farsightedness of these two accounting pioneer giants, George Oliver May and William Andrew Paton, who were well ahead of their time in this aspect of accounting. Their influence will continue to be felt for generations.

    Jensen Comment
    I think that both of these pioneers underestimated the exploding role the bottom line net income would have in security analysis and financial contracting and labor contracting.

    ·         "Replacement Cost:  Member of the Family, Welcome Guest, or Intruder," by Stephen A. Zeff, The Accounting Review, October 1962. Steve was an Assistant Professor of Accounting at Tulane at the time he wrote this paper.
    Stable URL: http://www.jstor.org/stable/242348 

    Bob Jensen's threads on accounting history ---
    http://faculty.trinity.edu/rjensen/theory01.htm


    I was afraid it would come to this.

    We’ve driven Tom Selling to drink!
    And all he can afford is the cheap stuff --- beer.

    I might note that replacement cost accounting has historically been associated with inflation --- Click Here
    Readings in Financial Management by Rajat Joseph

    It would be a great idea if it just was not accompanied by so much uncertainty, especially for non-financial assets --- http://faculty.trinity.edu/rjensen/theory01.htm#BasesAccounting

    From: noreply+feedproxy@google.com [mailto:noreply+feedproxy@google.com] On Behalf Of The Accounting Onion
    Sent: Wednesday, September 02, 2009 8:42 AM
    To: Jensen, Robert
    Subject: The Accounting Onion

     

    The Accounting Onion

     


    Accounting for Economic Earnings: Inflation-Adjusted Replacement Cost

    by Tom Selling
    Posted: 02 Sep 2009 12:15 AM PDT

    I am going to cap off the topic of loan accounting, which occupied my last three posts (here, here and here), with a 'proof' and further explanation of my solution to the simple problem I introduced in the first post of the series. I am doing this because some of you have asked me to explain my numbers further. Questions may also still remain regarding how the effects of inflation can be incorporated into a double-entry system of accounts. The answer is, of course, that they can, but there are a few new tricks that some might have not seen before. How exciting… new debits and credits!!

    Kidding aside, even this simple example contains some mind-expanding elements for both professionals and advanced students.

    For your convenience, this is a repetition of the problem statement:

    § On December 31, 20x0, Lender Company invested $10,000 in a bond issued on that date with the same face amount $10,000. To keep things really simple for now (and to defer discussing differences between replacement cost and fair value), there are no transaction costs.

    § The terms of the bond provide for two payments: $1,000 on December 31, 20x1, and $11,000 on December 31, 20x2. Both payments were made in full.

    § Lender Company had only one other asset on December 31, 20x0: cash in the amount of $1,000. It had incurred no liabilities, and engaged in no transactions, except those related to the bond, through December 31, 20x2.

    § As a rudimentary, yet sufficient, substitute for real-world measurements of inflation, we will blissfully imagine that there is only one consumption good in the world: beer. As of December 31, 20x0, a keg of beer cost $100. Immediately after the two payments on the bond, the price per keg rose to $110 and $121, respectively. (It would be perfectly legitimate to remove the dollar signs on the keg prices, and imagine that they are values of the Consumer Price Index.)

    No matter, which basis of accounting you choose, the December 31, 20x0 balance sheet for Lender Company, stated in units of purchasing power as of that date will be as follows: 

    Openingbalancesheet

    I will now provide you with the T-account entries to derive the balances that are used to prepare the December 31, 20x1 financial statements, stated in units of purchasing power on that date:

    T-acctsforx1 

     

    Here are the explanations (I abbreviate "units of purchasing power" as "UP"):

    Explanationsx1

    And, here are the financial statements at the end of the first year:

    Yearonefinancialstatements

     

    Notice that the beginning balance sheet has been restated to reflect units of purchasing power as of 12/31/x1 (i.e., multiplied by 110/100)  even though the date of the balance sheet is one year earlier.

    Finally, here are the T-accounts, explanations and financial statements as of the end of the second year:

    T-accountsforx2

    Explanationsx2

    Financialsyear2

    Notice once again the treatment of the comparative periods:  20x0 has been inflated for two years (i.e., multipled by 121/100), and 20x1 for one year (i.e., multiplied by 121/110). 

    To close, I'd like to remind you that reliable reporting of the effects of inflation on an entity can materially affect the financial statements, even when the inflation rate is pretty low. But, unfortunately, comprehensive inflation-adjusted replacement cost got an undeservedly bad rap when it was required by FAS 33 on a disclosure basis only. Among other things, very few accountants and analysts took the time to understand the numbers, because the patchwork implementation of some admittedly sticky issues were overly accomodating to issuers; and as a result, did not result in high-quality information.

    I am hoping that inflation-adjusted replacement cost can at least begin a comeback as the FASB seeks to improve loan accounting. One thing they should know: substantial progress is possible even if inflation accounting and replacement cost measurements are not applied to all assets and liabilities. But, loan accounting, especially because interest rates are inextricably linked to expected inflation, would be a very good place to start. The implementation issues are much less problematic than, for example, hedge accounting.

    http://feeds.feedburner.com/~ff/typepad/theaccountingonion?d=yIl2AUoC8zAhttp://feeds.feedburner.com/~ff/typepad/theaccountingonion?d=7Q72WNTAKBAhttp://feeds.feedburner.com/~ff/typepad/theaccountingonion?i=YW-gZeZ62Mk:6e4nsJ-t_Co:V_sGLiPBpWU

    http://feeds.feedburner.com/~r/typepad/theaccountingonion/~4/YW-gZeZ62Mk

     


    Market Value Accounting: Exit Value (Liquidation, Fair Value) Accounting

    Suppose we look at the financial statements of a company at a given point in time. The big problem with exit value accounting is that it values items at their worst possible use (unloading them in the used item market). Hence the company in question will have the same balance sheet if it is about to go bankrupt versus about to prosper. What do investors gain from exit value accounting if the company is about to propser?

    Whereas entry value is what it will cost to replace an item, exit value is the value of disposing of the item. It can even be negative in some instances where costs of clean up and disposal make to exit price negative. Exit value accounting is required under GAAP for personal financial statements (individuals and married couples) and companies that are deemed likely to become non-going concerns. See "Personal Financial Statements," by Anthony Mancuso, The CPA Journal, September 1992 --- http://www.nysscpa.org/cpajournal/old/13606731.htm 

    Some theorists advocate exit value accounting for going concerns as well as non-going concerns. Both nationally (particularly under FAS 115 and FAS 133) and internationally (under IAS 32 and 39 for), exit value accounting is presently required in some instances for financial instrument assets and liabilities. Both the FASB and the IASB have exposure drafts advocating fair value accounting for all financial instruments.

    FASB's Exposure Draft for Fair Value Adjustments to all Financial Instruments
    On December 14, 1999 the FASB issued Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value.

    If an item is viewed as a financial instrument rather than inventory, the accounting becomes more complicated under FAS 115. Traders in financial instruments adjust such instruments to fair value with all changes in value passing through current earnings. Business firms who are not deemed to be traders must designate the instrument as either available-for-sale (AFS) or hold-to-maturity (HTM). A HTM instrument is maintained at original cost. An AFS financial instrument must be marked-to-market, but the changes in value pass through OCI rather than current earnings until the instrument is actually sold or otherwise expires.  Under international standards, the IASB requires fair value adjustments for most financial instruments. This has led to strong reaction from businesses around the world, especially banks. There are now two major working group debates. In 1999 the Joint Working Group of the Banking Associations sharply rebuffed the IAS 39 fair value accounting in two white papers that can be downloaded from http://www.iasc.org.uk/frame/cen3_112.htm.

    ·         Financial Instruments: Issues Relating to Banks (strongly argues for required fair value adjustments of financial instruments). The issue date is August 31, 1999.

    ·         Accounting for financial Instruments for Banks (concludes that a modified form of historical cost is optimal for bank accounting). The issue date is October 4, 1999.

    Advantages of Exit Value (Liquidation, Fair Value) Accounting

    ·     In the case of financial assets and liabilities, historical costs may be meaningless relative to current exit values. For example, a forward contract or swap generally has zero historical cost but may be valued at millions at the current time. Failure to require fair value accounting provides all sorts of misleading earnings management opportunities to firms. The above references provide strong arguments in favor of fair value accounting.

    ·     Exit value does not require arbitrary cost allocation decisions such as whether to use FIFO or LIFO or what depreciation rate is best for allocating cost over time.

    ·     In many instances exit value accounting is easier to compute than entry values. For example, it is easier to estimate what an old computer will bring in the used computer market than to estimate what is the cost of "equivalent" computing power is in the new computer market.

    Exit value reporting is not deemed desirable or practical for going concern businesses for a number of reasons that I will not go into in great depth here.

    Disadvantages of Exit Value (Liquidation, Fair Value) Accounting

    ·     Operating assets are bought to use rather than sell. For example, as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility. Who cares if the value of the land went up by $1 million in 1994 and down by $2 million in 1998 if the plant that sits on the land has been in operation for 60 years and no consideration is being given to leaving this plant?

    ·     Some assets like software, knowledge databases, and Web servers for e-Commerce cost millions of dollars to develop for the benefit of future revenue growth and future expense savings. These assets may have immense value if the entire firm is sold, but they may have no market as unbundled assets. In fact it may be impossible to unbundle such assets from the firm as a whole. Examples include the Enterprise Planning Model SAP system in firms such as Union Carbide. These systems costing millions of dollars have no exit value in the context of exit value accounting even though they are designed to benefit the companies for many years into the future.

    ·     Exit value accounting records anticipated profits well in advance of transactions. For example, a large home building company with 200 completed houses in inventory would record the profits of these homes long before the company even had any buyers for those homes. Even though exit value accounting is billed as a conservative approach, there are instances where it is far from conservative.

    ·     Value of a subsystem of items differs from the sum of the value of its parts. Investors may be lulled into thinking that the sum of all subsystem net assets valued at liquidation prices is the value of the system of these net assets. Values may differ depending upon how the subsystems are diced and sliced in a sale.

    ·     Appraisals of exit values are both to expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion. The U.S. Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals is an invitation for massive frauds. Experiments by some, mostly real estate companies, to use exit value-based accounting died on the vine, including well-known attempts decades ago by TRC, Rouse, and Days Inn.

    ·     Exit values are affected by how something is sold. If quick cash is needed, the best price may only be half of what the price can be by waiting for the right time and the right buyer.

    ·     Financial contracts that for one reason or another are deemed as to be "held-to-maturity" items may cause misleading increases and decreases in reported values that will never be realized.  A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates.

    ·         Exit value markets are often thin and inefficient and broken markets.

     

    Hi Pat,

     My main computer that contains the IASB literature is in the shop at the moment. But I will do the best I can with other references.

     The FASB’s concept of “value in use” is entirely different from “use value” conceptualized by Karl Marx --- http://en.wikipedia.org/wiki/Use_value

     Value in use originates in the concept that a firm computing net present value of an asset will use its own optimal use future stream of cash flows where that stream may not be attainable by any other company --- http://en.wikipedia.org/wiki/Value-in-use
    The Glossary of the FASB’s Accounting Standards Database Codification database defines “value in use” as
    The amount determined by discounting the future cash flows (including the ultimate proceeds of disposal) expected to be derived from the use of an asset at an appropriate rate that allows for the risk of the activities concerned”

     All too often Value in Use (VIU) is equated to discounted future cash flows of an item in optimal use. Discounted cash flow estimation may be a fantasyland ideal that is not altogether necessary. For example, if IBM has a factory robot assembling computer components, it is virtually impossible to trace future computer sale cash flows to the portion of cash flows attributed to one assembly robot. Exit value is probably a useless surrogate for an installed factory robot since exit value is absurdly low relative to VIU of the robot. Other surrogate valuations may be much closer to VIU, including the replacement cost appropriately adjusted for differences in economic life of the present robot versus a now robot. The thing about VIU is that, when exit value is highly misleading, then other valuation estimates are possible, including replacement cost based upon current entry values for an IBM purchase of a new robot plus engineering estimates of current installation cost of a replacement robot.

     Exit value is generally considered an exchange price that’s agreed upon by a buyer and a seller. Both buyer and seller may have different values in use such as when Days Inn sells 200 hotels to Holiday Inn. Covariance with brand name and other intangibles means that the value in use of each hotel differs for Days Inn versus Holiday Inn.

     Both the FASB and the IASB generally consider exit value to be the worst possible seller’s use (e.g., forced liquidation) of the item in liquidation rather than use in a going concern. It is very misleading when a going concern owner has zero intention to sell the item. The ideal is value in use rather than exit value for a going concern having an item that is operational. The presumption is that the exit value may be the worst possible use value for the seller but is almost certainly not the best possible use value for the buyer. Otherwise the buyer would not agree on that exchange price.

     Value in Use (VIU) should not be confused with what the FASB calls Value in Exchange (VIE) ---
    http://findarticles.com/p/articles/mi_hb6421/is_2004_July/ai_n29102623/
    A good illustration of VIU versus VIE in the context of FAS 157 is provided at http://www.tncpa.org/Journal/articles/FASB_157.pdf

    In the August 2008 annual American Accounting Association meetings Tom Linsmeier and another speaker from BYU put great emphasis on how exit value is the worst possible value for present owners that are going concerns. They both claimed preference for Value in Use.

     Neither the FASB nor the IASB is entirely consistent on value in use being the ideal. Paragraphs A5-A12 in FAS 157 illustrate how value in use (VIU) may be used in fair value measurement. However, keep in mind that current fair value accounting requirements apply mostly to financial items except in a few isolated instances of non-financial items such as precious metal inventories. VIU measurement controversies are usually much greater for non-financial items such as fixed operating assets and real estate investments. The controversy has and always will be the trade-off between objectivity of valuation versus the possibility that the more objective valuations may be less useful or even very misleading. For example, a forced liquidation exchange value of an item may be very misleading if the owner has zero intention of selling. On the other hand, a VIU that depends heavily on subjective estimates subject to wide measurement error may also highly misleading and make fraud easier.

    A6. Highest and best use is a valuation concept that refers broadly to the use of an asset that would maximize the value of the asset or the group of assets in which the asset would be used by market participants. For some assets, in particular, nonfinancial assets, application of the highest-and-best-use concept could have a significant effect on the fair value measurement.

    Examples 1–3 illustrate the application of the highest-and-best-use concept in situations in which nonfinancial assets are newly acquired.
    Paragraph A6 of FAS 157 --- http://www.fasb.org/pdf/aop_FAS157.pdf

    Traditionally, value in-use fairly reflects the economics of a specific transaction. But the FASB has indicated in recently issued guidelines, that it prefers looking to the market, rather than company-specific valuations. Regardless of which approach is chosen, future income statements will be affected. The value in-use approach will generally result in higher depreciation expense and lower reported earnings. The value in-exchange approach will usually result in more of the initial purchase price being allocated to goodwill, which must be tested for impairment every year.
    “SFAS 141 Impacts Choice of Method Used to Value PP & E” --- http://www.valuationresearch.com/content/Knowledge_center/back_issues/35_2002_2.htm

    C38. In the context of the related guidance included in the Exposure Draft, some respondents referred to possible conflicts between the in-use valuation premise and the exchange notion encompassed within the definition of fair value. In this Statement, the Board clarified that the exchange notion applies regardless of the valuation premise used to measure the fair value of an asset. Whether using an in-use or an in-exchange valuation premise, the measurement is a market-based measurement determined based on the use of an asset by market participants, not a value determined based solely on the use of an asset by the reporting entity (a value-in-use or entity-specific

    measurement).

    Paragraph C38 of FAS 157 --- http://www.fasb.org/pdf/aop_FAS157.pdf

    Jensen Comment
    Hence the FASB offers ambiguous guidance on exchange value versus value in use. The FASB likes exchange value (VIE) in terms of objectivity relative to the dastardly subjectivity of value in use (VIU). At the same time the FASB hates exchange valuation that puts asset values at the worst possible use of the asset, e.g. forced liquidation valuation of an asset that a going concern has every intention of using at much higher value. Also there’s absolutely no forced liquidation value for portions of fixed assets such as enormous installation costs of ERP and other database systems, blast or electric furnaces producing steel, factory robots, and assets requiring millions of dollars in winning governmental permits, many of which are not transferrable in liquidation sales.
    . Of course at present, neither the FASB nor the IASB require fair value accounting for most types of non-financial assets, including steel furnaces, ERP, factory robots, etc. If the FASB extends fair value accounting to all non-financial items, the FASB will most certainly have to back off priority for objective exchange values for items having zero exchange value such as non-transferable components of fixed assets such as installation costs.

    The AICPA provides lots of resources for fair value measurement but the AICPA is of little use in providing resources for estimating value in use.
    T
    he AICPA's Fair Value Accounting Resources --- http://www.journalofaccountancy.com/Web/FairValueResources.htm

    The IASB is as inconsistent as the FASB on issues of VIU versus VIE. The ideal is VIU that can be objectively determined such as an asset or liability with contractual future cash flows and minimal loss risk. As VIU becomes more subjective in terms managerial choices as to the future cash flow stream of 200 hotels in the hands of Days Inns versus Holiday Inns, then VIE is probably going to be preferred by the FASB and the IASB. But this can be misleading, because valuing hotels at a forced liquidation exit value may be more misleading than historical cost book value when there’s no intention whatsoever for the owner to sell the hotel. This would be especially misleading if Holiday Inns had to use forced liquidation exit values in this period of distressed real estate values where owners have no intention of selling out at distressed real estate values. Of course at present, neither the FASB nor the IASB require fair value accounting for most types of non-financial assets, including real estate. If fair value accounting is extended to all non-financial assets, I think that preferences for VIE will have to give way to VIU. VIE likely to be highly misleading (overly conservative) when trying to evaluate investment potential of a successful going concern.

    Value in use issues also rear up in standards involving value impairment tests such as

    Value in use [IAS 36, par. 18; IAS 38, par. 83]

     

    Economic Value (Discounted Cash Flow, Present Value) Accounting

    There are over 100 instances where present GAAP requires that historical cost accounting be abandoned in favor of discounted cash flow accounting (e.g., when valuing pension liabilities and computing fair values of derivative financial instruments). These apply in situations where future cash inflows and outflows can be reliably estimated and are attributable to the particular asset or liability being valued on a discounted cash flow basis.

    Advantages of Economic Value (Discounted Cash Flow, Present Value) Accounting

    ·     Economic value is based upon management's intended use for the item in question rather than upon some other use such as disposal (Exit Value) or replacement (Entry Value).

    ·     Economic value conforms to the economic theory of the firm.
     

    ·     Real options valuation models in place of present value models under uncertainty --- http://faculty.trinity.edu/rjensen/realopt.htm 

    Disadvantages of Economic Value (Discounted Cash Flow, Present Value) Accounting

    ·     How does one allocate a portion of the cash flows of General Motors to a single welding machine in Tennessee? Or how does one allocate the portion of the sales price of a single car to the robot that welded a single hinge on one of the doors? How does one allocate the price of a bond to the basic obligation, the attached warrants, the call option in the fine print, and other possible embedded derivatives in the contract? The problem lies in the arbitrary nature of deciding what system of assets and liabilities to value as a system rather than individual components. Then what happens when the system is changed in some way? In order to see how complex this can become, note the complicated valuation assumptions in a paper entitled "Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components," by M.E. Barth, W.R. Landsman, and R.J. Rendleman, Jr., Accounting Horizons, December 2000, pp. 455-480.

    ·     Cash flows are virtually impossible to estimate except when they are contractually specified. How can Amazon.com accurately estimate the millions and millions of dollars it has invested in online software?

    ·     Even when cash flows can be reliably estimated, there are endless disputes regarding the appropriate discount rates.

    ·     Endless disputes arise as to assumptions underlying economic valuations.

     

    One of the major problems of using financial statements to value firms is that sometimes the unbooked assets and liabilities are much larger than some or all of the booked items.

    SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues

    From IAS Plus, February 16, 2006 --- http://www.iasplus.com/index.htm

    The US Financial Accounting Standards Board has submitted its response to the SEC Staff Report on Off-Balance Sheet Arrangements, Special Purpose Entities, and Related Issues released by the US Securities and Exchange Commission in June 2005. The SEC report was prepared pursuant to the Sarbanes-Oxley Act of 2002 and was submitted to the President and several Congressional committees. The SEC staff report includes an analysis of the filings of issuers as well as an analysis of pertinent US generally accepted accounting principles and Commission disclosure rules. The report contains several recommendations for potentially sweeping changes in current accounting and reporting requirements for pensions, leases, financial instruments, and consolidation:

    • Pensions: The staff recommends the accounting guidance for defined-benefit pension plans and other post-retirement benefit plans be reconsidered. The trusts that administer these plans are currently exempt from consolidation by the issuers that sponsor them, effectively resulting in the netting of assets and liabilities in the balance sheet. In addition, issuers have the option to delay recognition of certain gains and losses related to the retirement obligations and the assets used to fund these obligations.

     

    • Leases: The staff recommends that the accounting guidance for leases be reconsidered. The current accounting for leases takes an 'all or nothing' approach to recognizing leases on the balance sheet. This results in a clustering of lease arrangements such that their terms approach, but do not cross, the 'bright lines' in the accounting guidance that would require a liability to be recognized. As a consequence, arrangements with similar economic outcomes are accounted for very differently.

     

    • Financial instruments: The staff recommends the continued exploration of the feasibility of reporting all financial instruments at fair value.

     

    • Consolidation: The staff recommends that the Financial Accounting Standards Board continue its work on the accounting guidance that determines whether an issuer would consolidate other entities – including SPEs – in which the issuer has an ownership or other interest.

     

    • Disclosures: The staff believes that, in general, certain disclosures in the filings of issuers could be better organized and integrated.

    FASB's response discusses a number of "fundamental structural, institutional, cultural, and behavioral forces" that it believes cause complexity and impede transparent financial reporting. FASB provides an update on its activities and projects intended to address and improve outdated, overly complex accounting standards. These areas include accounting for leases; accounting for pensions and other post employment benefits; consolidation policies; accounting for financial instruments; accounting for intangible assets; and conceptual and disclosure frameworks. The FASB also identifies several other initiatives aimed at improving the understandability, consistency, and overall usability of existing accounting literature, through codification, by attempting to stem the proliferation of new pronouncements emanating from multiple sources, and by developing new standards in a 'principles-based' or 'objectives-oriented' approach. Click to download:

    ·         February 2006: FASB Response to the SEC (PDF 48k)

    ·         February 2006: FASB News Release (PDF 78k)

    ·         June 2005: Full Text of SEC Staff Report (PDF 1,241k)

    ·         June 2005: SEC Press Release (PDF 40k)

    ·         June 2005: FASB News Release (PDF 14k)


    A Curious Case of Negative Goodwill
    "NEED PROFIT? BUY SOMETHING!" by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, July 30, 2012 ---
    http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/733

    We first voiced our concern about an obscure accounting rule that allows companies to “create” profits when purchasing other businesses in the “Curious Case of Miller Energy’s 10-K and Its Huge Bargain Purchase.” The offending tenet relates to the treatment of something called “negative goodwill” which purportedly is created when a company makes an acquisition, and pays less than what the assets are worth. This fantastic “bargain purchase” creates a negative goodwill anomaly because the acquirer supposedly gets more assets than it pays for, as in this example:

    Continued in article

    Jensen Comment
    Yet another illustration of how the FASB and IASB made a black hole out of bottom-line earnings.

    Bob Jensen's threads on the radical new changes on the way ---
    http://faculty.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay

     

     


    "FASB Responds to SEC Study," AccountingWeb, February 21, 2006 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=101801

    AccountingWEB.com - Feb-21-2006 - The Financial Accounting Standards Board (FASB) last week responded to the Security and Exchange Commission’s (SEC’s) Off Balance Sheet Report by identifying forces causing complexity and impeding financial transparency, as well as providing an update on the FASB’s activities intended to address complex accounting standards. The FASB also reaffirmed its commitment to improving the transparency and usefulness of financial reporting.

    “The FASB remains fiercely committed to protecting the interests of investors and the capital markets by developing accounting standards that, if faithfully followed, provided relevant, reliable and useful financial information,” FASB Chariman Robert Herz said in a prepared statement. “Along these lines, we remain concerned about the root causes and the effects that complexity continues to have on our financial reporting system and believe that concerted and coordinated action by the SEC, the FASB, and the PCAOB, together with other parties in the financial reporting system, is critical.”

    The FASB has named several areas as key for overcoming the challenges facing the financial reporting system including: accounting for leases; accounting for pensions and other post-employment benefits; consolidation policies; accounting for financial instruments; accounting for intangible assets; and conceptual and disclosure frameworks. Several initiatives have been undertaken to help improve understandability, consistency, and overall usability of existing accounting literature, through codification and by attempting to limit the proliferation of pronouncements from multiple sources and by developing new standards using a principles-based or objectives-oriented approach.

    The FASB Response to SEC Study on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers provides comments on issues and recommendations included in the Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers submitted in June 2005 by the staff of the SEC to the President of the United States, the Senate Committee on Banking, Housing and Urban Affairs and the Committee of Financial Services of the U.S. House of Representatives.

    Bob Jensen's threads on special purpose (variable interest) entities are at http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

    How a firm reports an asset or liability in a balance sheet typically is rooted in one of the following valuation concepts. GAAP in the United States is historical cost by default, but there are countless instances where departures from historical cost are either allowed or required under certain standards in certain circumstances.

    The Cost Approach for Financial Reporting
    From IASPlus on November 21, 2006 --- http://www.iasplus.com/index.htm

    The International Valuation Standards Committee has published Proposed Revisions to International Valuation Guidance Note 8 – The Cost Approach for Financial Reporting {PDF 193k). The proposed revisions are the result of requests for clarification and suggestions of minor improvements to the 2005 version of GN8. Comment deadline is 31 December 2006. The IVSC has also released an update of its work programme:

     

     

     

    The FASB's Statement No. 148

    FAS 148 improves disclosures for stock-based compensation and provides alternative transition methods for companies that switch to the fair value method of accounting for stock options --- http://www.fasb.org/news/nr123102.shtml 
    The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances.  .  Fair value accounting is still optional (until the FASB finally makes up its mind on stock options.)

    FASB Amends Transition Guidance for Stock Options and Provides Improved Disclosures

    Norwalk, CT, December 31, 2002—The FASB has published Statement No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends FASB Statement No. 123, Accounting for Stock-Based Compensation. In response to a growing number of companies announcing plans to record expenses for the fair value of stock options, Statement 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, Statement 148 amends the disclosure requirements of Statement 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.

    Under the provisions of Statement 123, companies that adopted the preferable, fair value based method were required to apply that method prospectively for new stock option awards. This contributed to a “ramp-up” effect on stock-based compensation expense in the first few years following adoption, which caused concern for companies and investors because of the lack of consistency in reported results. To address that concern, Statement 148 provides two additional methods of transition that reflect an entity’s full complement of stock-based compensation expense immediately upon adoption, thereby eliminating the ramp-up effect.

    Statement 148 also improves the clarity and prominence of disclosures about the pro forma effects of using the fair value based method of accounting for stock-based compensation for all companies—regardless of the accounting method used—by requiring that the data be presented more prominently and in a more user-friendly format in the footnotes to the financial statements. In addition, the Statement improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. In the past, companies were required to make pro forma disclosures only in annual financial statements.

    The transition guidance and annual disclosure provisions of Statement 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.

    As previously reported, the FASB has solicited comments from its constituents relating to the accounting for stock-based compensation, including valuation of stock options, as part of its recently issued Invitation to Comment, Accounting for Stock-Based Compensation: A Comparison of FASB Statement No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB Proposed IFRS, Share-based Payment. That Invitation to Comment explains the similarities of and differences between the proposed guidance on accounting for stock-based compensation included in the International Accounting Standards Board’s (IASB’s) recently issued exposure draft and the FASB’s guidance under Statement 123.

    After considering the responses to the Invitation to Comment, the Board plans to make a decision in the latter part of the first quarter of 2003 about whether it should undertake a more comprehensive reconsideration of the accounting for stock options. As part of that process, the Board may revisit its 1995 decision permitting companies to disclose the pro forma effects of the fair value based method rather than requiring all companies to recognize the fair value of employee stock options as an expense in the income statement. Under the provisions of Statement 123 that remain unaffected by Statement 148, companies may either recognize expenses on a fair value based method in the income statement or disclose the pro forma effects of that method in the footnotes to the financial statements.

    Copies of Statement 148 may be obtained by contacting the FASB’s Order Department at 800-748-0659 or by placing an order at the FASB’s website at www.fasb.org .


    From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

    TITLE: And, Now the Question is: Where's the Next Enron? 
    REPORTER: Cassell Bryan-Low and Ken Brown 
    DATE: Jun 18, 2002 PAGE: C1 LINK: http://online.wsj.com/article/0,,SB1024356537931110920.djm,00.html  
    TOPICS: off balance sheet financing, Related-party transactions, loan guarantees, Accounting, Fair Value Accounting, Financial Accounting Standards Board, Regulation, Securities and Exchange Commission

    SUMMARY: In the wake of the Enron accounting debacle, investors are concerned that another Enron-like situation could occur. The article describes steps taken to improve the quality of financial reporting.

    QUESTIONS: 

    1.) Why is it important that investors and other financial statement users have confidence in financial reporting?

    2.) What is a related-party transaction? What accounting issues are associated with related-party transactions? What changes in disclosing and accounting for related party transactions are proposed? Discuss the strengths and weaknesses of the proposed changes.

    3.) What is off-balance sheet financing? How was Enron able to avoid reporting liabilities on its balance sheet? What changes concerning special-purpose entities are proposed? Will the proposed changes prevent future Enron-like situations? Support your answer.

    4.) When are companies required to report loan guarantees as liabilities? What changes are proposed? Do you agree with the proposed changes? Support your answer.

    5.) What is mark to market accounting? How did mark to market accounting contribute to the Enron debacle? Discuss the advantages and disadvantages of proposed changes related to mark to market accounting.

    6.) What are pro forma earnings? How can pro forma earnings be used to mislead investors? What changes in the presentation of pro forma earnings are proposed? Will the proposed changes protect investors?

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

    Controversies over revenue reporting are discussed at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 


    From the Free Wall Street Journal Educators' Reviews for December 6, 2001 

    TITLE: Audits of Arthur Andersen Become Further Focus of Investigation
    SEC REPORTER: Jonathan Weil
    DATE: Nov 30, 2001 PAGE: A3 LINK:
         http://interactive.wsj.com/archive/retrieve.cgi?id=SB1007059096430725120.djm
     
    TOPICS: Advanced Financial Accounting, Auditing

    SUMMARY: This article focuses on the issues facing Arthur Andersen now that their work on the Enron audit has become the subject of an SEC investigation. The on-line version of the article provides three questions that are attributed to "some accounting professors." The questions in this review expand on those three provided in the article.

    QUESTIONS:
    1.) The first question the SEC might ask of Enron's auditors is "were financial statement disclosures regarding Enron's transactions too opaque to understand?" Are financial statement disclosures required to be understandable? To whom? Who is responsible for ensuring a certain level of understandability?

    2.) Another question that the SEC could consider is whether Andersen auditors were aware that certain off-balance-sheet partnerships should have been consolidated into Enron's balance sheet, as they were in the company's recent restatement. How could the auditors have been "unaware" that certain entities should have been consolidated? What is the SEC's concern with whether or not the auditors were aware of the need for consolidation?

    3.) A third question that the SEC could ask is, "Did Andersen auditors knowingly sign off on some 'immaterial' accounting violations, ignoring that they collectively distorted Enron's results?" Again, what is the SEC's concern with whether Andersen was aware of the collective impact of the accounting errors? Should Andersen have been aware of the collective amount of impact of these errors? What steps would you suggest in order to assess this issue?

    4.) The article finishes with a discussion of expected Congressional hearings into Enron's accounting practices and into the accounting and auditing standards setting process in general. What concern is there that the FASB "has been working on a project for more than a decade to tighten the rules governing when companies must consolidate certain off-balance sheet 'special purpose entities'"?

    5.) In general, how stringent are accounting and auditing requirements in the U.S. relative to other countries' standards? Are accounting standards in other countries set in the same way as in the U.S.? If not, who establishes standards? What incentives would the U.S. Congress have to establish a law-based system if they become convinced that our private sector standards setting practices are inadequate? Are you concerned about having accounting and reporting standards established by law?

    6.) The article describes revenue recognition practices at Enron that were based on "noncash unrealized gains." What standard allows, even requires, this practice? Why does the author state, "to date, the accounting standards board has given energy traders almost boundless latitude to value their energy contracts as they see fit"?

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


    CPA2Biz Unveils Business Valuation Resource Center --- http://www.smartpros.com/x31976.xml 

    The BV Center will include resources and information from the American Institute of Certified Public Accountants (AICPA) and industry experts on various factors affecting the value of a business or a transaction, such as mergers and acquisitions; economic damages due to a patent infringement or breaches of contract; bankruptcy or a reorganization; or fraud due to anti-trust actions or embezzlement. The BV Center will provide a comprehensive combination of solutions that meet the professional needs of CPAs practicing business valuation, including those who have achieved the AICPA's Accredited in Business Valuation credential. The BV Center will also provide networking communities for BV practitioners as well as a public forum for discussion of business valuation trends, developments and issues.

    "Tremendous growth in the BV discipline, coupled with a dynamic group of factors affecting business valuation, means that CPAs need a consistent, timely and relevant vehicle through which BV-related information can be disseminated to them," said Erik Asgeirsson, Vice President of Product Management at CPA2Biz. "The BV Center on CPA2Biz will provide them with AICPA books, practice aids, newsletters and software, along with industry expert literature and complementary third-party products and solutions. Because the issues associated with valuation impact CPAs in both public and private sectors -- auditors, tax practitioners, personal financial planners as well as BV specialists -- the BV Center will have a powerful horizontal impact on the profession."

    "I think that CPAs who practice in business valuation ought to go to the BV Center for information and tools that are timely, relevant and easy to obtain," said Thomas Hilton, CPA/ABV, Chairman of the AICPA Business Valuation Subcommittee. "The BV Center is a source CPAs can use to offer their clients a higher level of service, as well as to connect with other CPAs who provide valuation services."

    The CPA2Biz Website is at www.cpa2biz.com/ 

    Selected References on Accounting for Intangibles 
    (most of which were published after the above paper was written)

    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

     

     


    BARUCH LEV'S BOOK Brookings Institution Press issued Baruch's new book, Intangibles: Management, Measurement and Reporting. Regardless of the "dot com" collapse, this subject continues to be high on the corporate executive's agenda. Baruch foresees increasing attention being paid to intangibles by both managers and investors. He feels there is an urgent need to improve both the management reporting and external disclosure about intellectual capital. He proposes that we seriously consider revamping our accounting model and significantly broaden the recognition of intangible assets on the balance sheet. The book can be ordered at https://www.brookings.edu/press/books/intangibles_book.htm 

    Professor Lev's free documents on this topic can be downloaded from  http://www.stern.nyu.edu/~blev/newnew.html 

     

    SSRN's Top 10 Downloads 
    (The abstracts are free, but the downloads themselves are not free,. However, your library may provide you with free SSRN downloads if it subscribes to SSRN)

    One approach to finding the “top” papers is to download the Social Science Research Network (SSRN) Top 10 downloads in various categories --- http://papers.ssrn.com/toptens/tt_ntwk_all.html
    This database is limited to the selected papers included in the database.

    For accounting, SSRN’s Top 10 papers are at http://papers.ssrn.com/toptens/tt_ntwk_204_home.html#ARN 
    The average number of downloads of this top accounting research network paper is 227 per month.  In contrast the top economics network research paper has an average of 2,375 downloads per month.  Downloads in other disciplines depend heavily upon the number of graduate students and practitioners in that discipline.

    The top ten downloads from the accounting network are as follows (note that some authors like Mike Jensen are not accountants or accounting educators):

    16010 A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation
    THEODORE SOUGIANNIS and STEPHEN H. PENMAN
    University of Illinois at Urbana-Champaign and Columbia School of Business
    Date posted to database:March 31, 1997
    10201 Value Based Management: Economic Value Added or Cash Value Added?
    FREDRIK WEISSENRIEDER
    Anelda AB
    Date posted to database:April 5, 1999
    8041 Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure
    Michael C. Jensen, A THEORY OF THE FIRM: GOVERNANCE, RESIDUAL CLAIMS AND ORGANIZATIONAL FORMS, Harvard University Press, Dec. 2000, and The Journal Of Financial Economics, 1976.
    MICHAEL C. JENSEN and WILLIAM H. MECKLING
    The Monitor Company and Deceased, University of Rochester Simon School
    Date posted to database:July 19, 1998
    7607 Evidence on EVA®
    Journal of Applied Corporate Finance, Vol. 12, No. 2, Summer 1999
    GARY C. BIDDLE, ROBERT M. BOWEN and JAMES S. WALLACE
    Hong Kong University of Science & Technology, University of Washington and University of California at Irvine
    Date posted to database:September 20, 1999
    5194 A Generalized Earnings Model of Stock Valuation
    ANDREW ANG and JUN LIU
    Columbia Business School and University of California, Los Angeles
    Date posted to database:July 18, 1998
    5046 Which is More Value-Relevant: Earnings or Cash Flows?
    ERVIN L. BLACK
    Brigham Young University
    Date posted to database:September 2, 1998
    4927 Combining Earnings and Book Value in Equity Valuation
    STEPHEN H. PENMAN
    Columbia School of Business
    Date posted to database:November 5, 1997
    4254 Separation of Ownership and Control
    Michael C. Jensen, FOUNDATIONS OF ORGANIZATIONAL STRATEGY, Harvard University Press, 1998, and Journal of Law and Economics, Vol. 26, June 1983
    EUGENE F. FAMA and MICHAEL C. JENSEN
    University of Chicago and The Monitor Company
    Date posted to database:November 29, 1998
    3843 Value Creation and its Measurement: A Critical Look at EVA
    IGNACIO VELEZ-PAREJA
    Politecnico Grancolombiano
    Date posted to database:May 19, 1999
    3771 Ratio Analysis and Equity Valuation
    DORON NISSIM and STEPHEN H. PENMAN
    Columbia Business School and Columbia School of Business
    Date posted to database:May 11, 1999
     
    Other Links on Accounting for Intangibles

    "ACCOUNTING FOR INTANGIBLES: THE GREAT DIVIDE BETWEEN OBSCURITY IN INNOVATION ACTIVITIES AND THE BALANCE SHEET," by Anne Wyatt, The Singapore Economic Review, Vol. 46, No. 1 pp. 83-117 --- http://www.worldscinet.com/ser/46/sample/S0217590801000243.html 

    "Accounting for Intangibles: The New Frontier" by Baruch Lev (January 11, 2001) --- http://www.nyssa.org/abstract/acct_intangibles.html 

    FAS 141 and 142 Summary (October 22, 2001) --- http://www.aasb.com.au/workprog/board_papers/public/docs/Agenda_paper_9-1_Accounting_for_Intangibles.pdf 

    New Rules Summary by Paul Evans (February 24, 2002) --- http://bloodstone.atkinson.yorku.ca/domino/Html/users/pevans/pewwwdl.nsf/98615e08bc387dd385256709007822b0/ddc242fb07932d4f85256b6a00494e9c?OpenDocument 

    ACCOUNTING FOR INTANGIBLES: A LITERATURE REVIEW, Journal of Accounting Literature, Vol. 19, 2000  
    by Leandro Cañibano Autonomous University of Madrid Manuel García-Ayuso University of Seville Paloma Sánchez Autonomous University of Madrid --- http://www.finansanalytiker.no/innhold/aktiv_presinv/Conf050901/Jal.pdf 

    "‘ACCOUNTING FOR INTANGIBLES’ AT THE ACCOUNTING COURT," by Jan-Erik Gröjer and Ulf Johanson --- http://www.vn.fi/ktm/1/aineeton/seminar/johanback.htm 

    NYU Intangibles Research Project --- http://www.stern.nyu.edu/ross/ProjectInt/about/ 

    "Alan Kay talks with Baruch Lev," (June 19, 2001) --- http://www.kmadvantage.com/docs/Leadership/Baruch%20Lev%20on%20Intangible%20Assets.pdf 

    International Accounting Standard No. 38 --- http://www.iasc.org.uk/cmt/0001.asp?s=1020299&sc={2954EE08-82A0-4BC0-8AC0-1DE567F35613}&sd=928976660&n=982 

    IAS 38: Intangible Assets

    IAS 38, Intangible Assets, was approved by the IASB Board in July 1998 and became operative for annual financial statements covering periods beginning on or after 1 July 1999.

    IAS 38 supersedes:

    • IAS 4, Depreciation Accounting, with respect to the amortisation (depreciation) of intangible assets; and
    • IAS 9, Research and Development Costs.

    In 1998, IAS 39: Financial Instruments: Recognition and Measurement, amended a paragraph of IAS 38 to replace the reference to IAS 25, Accounting for Investments, by reference to IAS 39.

    One SIC Interpretation relates to IAS 38:


    Summary of IAS 38

    IAS 38 applies to all intangible assets that are not specifically dealt with in other International Accounting Standards. It applies, among other things, to expenditures on:

    • advertising,
    • training,
    • start-up, and
    • research and development (R&D) activities.

    IAS 38 supersedes IAS 9, Research and Development Costs. IAS 38 does not apply to financial assets, insurance contracts, mineral rights and the exploration for and extraction of minerals and similar non-regenerative resources. Investments in, and awareness of the importance of, intangible assets have increased significantly in the last two decades.

    The main features of IAS 38 are:

    • an intangible asset should be recognised initially, at cost, in the financial statements, if, and only if:

      (a) the asset meets the definition of an intangible asset. Particularly, there should be an identifiable asset that is controlled and clearly distinguishable from an enterprise's goodwill;

      (b) it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and

      (c) the cost of the asset can be measured reliably.

      This requirement applies whether an intangible asset is acquired externally or generated internally. IAS 38 also includes additional recognition criteria for internally generated intangible assets;

       

    • if an intangible item does not meet both the definition, and the criteria for the recognition, of an intangible asset, IAS 38 requires the expenditure on this item to be recognised as an expense when it is incurred. An enterprise is not permitted to include this expenditure in the cost of an intangible asset at a later date;

       

    • it follows from the recognition criteria that all expenditure on research should be recognised as an expense. The same treatment applies to start-up costs, training costs and advertising costs. IAS 38 also specifically prohibits the recognition as assets of internally generated goodwill, brands, mastheads, publishing titles, customer lists and items similar in substance. However, some development expenditure may result in the recognition of an intangible asset (for example, some internally developed computer software);

       

    • in the case of a business combination that is an acquisition, IAS 38 builds on IAS 22: Business Combinations, to emphasise that if an intangible item does not meet both the definition and the criteria for the recognition for an intangible asset, the expenditure for this item (included in the cost of acquisition) should form part of the amount attributed to goodwill at the date of acquisition. This means that, among other things, unlike current practices in certain countries, purchased R&D-in-process should not be recognised as an expense immediately at the date of acquisition but it should be recognised as part of the goodwill recognised at the date of acquisition and amortised under IAS 22, unless it meets the criteria for separate recognition as an intangible asset;

       

    • after initial recognition in the financial statements, an intangible asset should be measured under one of the following two treatments:

      (a) benchmark treatment: historical cost less any amortisation and impairment losses; or

      (b) allowed alternative treatment: revalued amount (based on fair value) less any subsequent amortisation and impairment losses. The main difference from the treatment for revaluations of property, plant and equipment under IAS 16 is that revaluations for intangible assets are permitted only if fair value can be determined by reference to an active market. Active markets are expected to be rare for intangible assets;

       

    • intangible assets should be amortised over the best estimate of their useful life. IAS 38 does not permit an enterprise to assign an infinite useful life to an intangible asset. It includes a rebuttable presumption that the useful life of an intangible asset will not exceed 20 years from the date when the asset is available for use. IAS 38 acknowledges that, in rare cases, there may be persuasive evidence that the useful life of an intangible asset will exceed 20 years. In these cases, an enterprise should amortise the intangible asset over the best estimate of its useful life and:

      (a) test the intangible asset for impairment at least annually in accordance with IAS 36: Impairment of Assets; and

      (b) disclose the reasons why the presumption that the useful life of an intangible asset will not exceed 20 years is rebutted and also the factor(s) that played a significant role in determining the useful life of the asset;

       

    • required disclosures on intangible assets will enable users to understand, among other things, the types of intangible assets that are recognised in the financial statements and the movements in their carrying amount (book value) during the year. IAS 38 also requires disclosure of the amount of research and development expenditure recognised as an expense during the year; and

       

    • IAS 38 is operative for annual accounting periods beginning on or after 1 July 1999. IAS 38 includes transitional provisions that clarify when the Standard should be applied retrospectively and when it should be applied prospectively.

    To avoid creating opportunities for accounting arbitrage in an acquisition by recognising an intangible asset that is similar in nature to goodwill (such as brands and mastheads) as goodwill rather than an intangible asset (or vice versa), the amortisation requirements for goodwill in IAS 22: Business Combinations are consistent with those of IAS 38.

     


    FASB REPORT - BUSINESS AND FINANCIAL REPORTING, CHALLENGES FROM THE NEW ECONOMY NO. 219-A April 2001 Author: Wayne S. Upton, Jr. Source: Financial Accounting Standards Board --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 
    Upton's book challenges Lev's contention that the existing standards are enormously inadequate for the "New Economy."


    The Garten SEC Report: A press release and an executive summary are available at http://www.mba.yale.edu  
    The Garten SEC Report supports Lev's contention that the existing standards are enormously inadequate for the "New Economy."
    (You can request a copy of the full report using an email address provided at the above URL)

    Trinity University students may access this report at J:\courses\acct5341\readings\sec\garten.doc 


    FEI BUSINESS COMBINATIONS VIDEO PROGRAM http://www.fei.org/confsem/bizcombo2k2/agenda.cfm 

    American Accounting Association (AAA) members may view a replay of a day-long webcast on accounting for business combinations and intangible valuations (SFAS 141 and 142) at half the price that will be charged to other non-FEI members ($149 versus $299). The FEI hopes to use funds generated from AAA members to help the FEI assume sponsorship of a Corporate Accounting Policy Seminar.

    The webcast encompassed five presentations by experts with question-and-answer periods: (1) Overview of SFAS 141/142, by G. Michael Crooch, FASB Board Member; (2) Recognition and Measurement of Intangibles, by Tony Aarron of E&Y Valuation Services and Steve Gerard of Standard and Poors's, (3) Impact on Doing Deals: Structure, Pricing and Process, by Raymond Beier of PWC and Elmer Huh, Morgan Stanley Dean Witter, (4) Testing for Goodwill Impairment, by Mitch Danaher of GE, and (5) Transition Issues and Financial Statement Disclosures, by Julie A. Erhardt of Arthur Andersen's Professional Standards Group.


    As an example (Digital Island Inc.) of the impact of FAS 142 on impairment testing for goodwill, please print the following document: http://www.edgar-online.com/brand/businessweek/glimpse/glimpse.pl?symbol=ISLD 

    Amortization of intangible assets. Amortization expense increased to $153.7 million for the nine months ended June 30, 2001 from $106.4 million for the nine months ended June 30, 2000. This increase was primarily due to a full period

    of amortization of the goodwill and intangibles related to the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed in December 1999, January 2000 and September 2000, respectively. This increase was offset by a decrease in the current quarter's amortization as a direct result of a $1.0 billion impairment charge on goodwill and intangible assets in the quarter ended March 31, 2001. Amortization of intangible assets is expected to decrease in future periods due to this impairment charge.

    Impairment of Goodwill and Intangible Assets. Impairment of goodwill and intangible assets was recorded in the amount of $1,039.2 million. The impairment charge was based on management performing an impairment assessment of the goodwill and identifiable intangible assets recorded upon the acquisitions of Sandpiper, Live On Line and SoftAware, which were completed during the year ended September 30, 2000. The assessment was performed primarily due to the significant decline in stock price since the date the shares issued in each acquisition were valued. As a result of this review, management recorded the impairment charge to reduce goodwill and acquisition-related intangible assets. The charge was determined as the excess of the carrying value of the assets over the related estimated discounted cash flows.


    Forwarded by Storhaug [storhaug@BTIGATE.COM

    To follow up on this list's earlier brief discussion on FASB 141 & 142, below is a bookmark to a site "CFO.COM" which has an excellent compendium of articles and links, all of which help you evaluate these new FASB's.

    http://www.cfo.com/fasbguide 

    "The Goodwill Games How to Tackle FASB's New Merger Rules," by Craig Schneider, CFO.com --- http://www.cfo.com/fasbguide 

    The thrill of victory and the agony of defeat. Chances are senior financial executives will experience a similar range of emotions while wrestling with the Financial Accounting Standards Board's new rules for business combinations, goodwill, and intangibles. Use CFO.com's special report for tips on tackling the impairment test, avoiding Securities & Exchange Commission inquiries, finding valuation experts, and much more. While accounting is not yet an Olympic sport, with the right training, you'll take home the gold. We welcome your questions and comments. E-mail craigschneider@cfo.com.
    Take Your First Steps

    How to Survive the SEC's Second Guessing
    New rules for recording goodwill and intangibles may inadvertently produce more restatements.

    Cramming for the Final
    Get up to speed on the latest accounting rule changes for treating goodwill and intangibles.

    Pool's Closed
    FASB's new merger-accounting rules have already won some fans among deal makers.
    (CFO Magazine)

    Intangibles Revealed
    Once you identify them, how much will the fair value assessments cost?

    Four Ways to Say Goodbye to Goodwill Amortization
    Expert tips for tackling the impairment test.

     

    Congratulations to Baruch Lev from NYU --- http://www.stern.nyu.edu/~blev/main.html 

    Baruch's picture adorns the cover of Financial Executive, March/April 2002 --- http://www.fei.org/magazine/marapr-2002.cfm 

    The cover story entitled "Rethinking Accounting:  Intangibles at a Crossroads:  What Next?" on pp. 34-39 --- http://www.fei.org/magazine/articles/3-4-2002_CoverStory.cfm 
    The concluding passage is quoted below:

    The Inertness and Commoditization of Intangibles 

    Intangibles are inert - by themselves, they neither create value nor generate growth. In fact, without efficient support and enhancement systems, the value of intangibles dissipates much quicker than that of physical assets. Some examples of inertness: uHighly qualified scientists at Merck, Pfizer, or Ely Lilly (human capital intangibles) are unlikely to generate consistently winning products without innovative processes for drug research, such as the "scientific method," based on the biochemical roots of the target diseases, according to Rebecca Henderson, a specialist on scientific drug research, in Industrial and Corporate Change. Even exceptional scientists using the traditional "random search" methods for drug development will hit on winners only randomly, writes Henderson.

    uA large patent portfolio at DuPont or Dow Chemical (intellectual property) is by itself of little value without a comprehensive decision support system that periodically inventories all patents, slates them by intended use (internal or collaborative development, licensing out or abandonment) and systematically searches and analyzes the patent universe to determine whether the company's technology is state-of-the-art and competitive.

    uA rich customer database (customer intangibles) at Amazon.com or Circuit City will not generate value without efficient, user-friendly distribution channels and highly trained and motivated sales forces.

    Worse than just inert, intangibles are very susceptible to value dissipation (quick amortization) - much more so than other assets. Patents that are not constantly defended against infringement will quickly lose value due to "invention around" them. Highly trained employees will defect to competitors without adequate compensation systems and attractive workplace conditions. Valuable brands may quickly deteriorate to mere "names" when the firm - such as a Xerox, Yahoo! or Polaroid - loses its competitive advantage. The absence of active markets for most intangibles (with certain patents and trademark exceptions) strips them of value on a stand-alone basis.

    Witness the billions of dollars of intangibles (R&D, customer capital, trained employees) lost at all the defunct dot-coms, or at Enron, or at AOL Time Warner Co., which in January 2002 announced a whopping write-off of $40-60 billion - mostly from intangibles.

    Intangibles are not only inert, they are also, by and large, commodities in the current economy, meaning that most business enterprises have equal access to them. Baxter and Johnson & Johnson, along with the major biotech companies, have similar access to the best and brightest of pharmaceutical researchers (human capital); every retailer can acquire the state-of-the-art supply chains and distribution channel technologies capable of creating supplier and customer-related intangibles (such as mining customer information); most companies can license-in patents or acquire R&D capabilities via corporate acquisitions; and brands are frequently traded. The sad reality about commodities is that they fail to create considerable value. Since competitors have equal access to such assets, at best, they return the cost of capital (zero value added).

    The inertness and commoditization of most intangibles have important implications for the intangibles movement. They imply that corporate value creation depends critically on the organizational infrastructure of the enterprise - on the business processes and systems that transform "lifeless things," tangible and intangible, to bundles of assets generating cash flows and conferring competitive positions. Such organizational infrastructure, when operating effectively, is the major intangible of the firm. It is, by definition, noncommoditized, since it has to fit the specific mission, culture, and environment of the enterprise. Thus, by its idiosyncratic nature, organizational infrastructure is the major intangible of the enterprise.

    Focusing the Intangibles Efforts 

    Following Phase I of the intangibles work, which was primarily directed at documentation and awareness-creation, it's now time to focus on organizational infrastructure, the intangible that counts most and about which we know least. It's the engine for creating value from other assets. Like breaking the genetic code, an understanding of the "enterprise code" - the organizational blueprints, processes and recipes - will enable us to address fundamental questions of concern to managers and investors, such as those raised above in relation to H-P/Compaq and Enron.

    Organizational Infrastructure By Example: A company's organizational infrastructure is an amalgam of systems, processes and business practices (its operating procedures, recipes) aimed at streamlining operations toward achieving the company's objectives. Following is a concrete example of a business process, part of the organizational infrastructure, which was substantially modified and thereby created considerable value. This was adopted from "Turnaround," Business 2.0, January 2002.

    Nissan Motor Co. Ltd., Japan's third-largest automaker and a perennial loser and debt-ridden producer of lackluster cars, received in March 1999 a new major shareholder, Renault, and a new CEO, Carlos Ghosn, both imported from France. Ghosn moved quickly to transform Nissan into a viable competitor, and indeed, in the fiscal year ending March 2001, the company reported a profit of $2.7 billion, the largest in its 68-year history.

    How was this miracle performed? Primarily by cost-cutting, achieved by a drastic change in the procurement process. Here briefly, is the old process: Nissan's buyers were locked into ordering from keiretsu partners, suppliers in which Nissan owned stock. The guaranteed stream of Nissan orders insulated those suppliers from competition. Suppliers can't specialize and can't sell excess capacity elsewhere. Each supplier was assigned a shukotan, Nissan-speak for a relationship manager. It was the shukotan who would negotiate price discounts - but favors got in the way.

    Here, in brief, is the new procurement process, as drastically changed by Ghosn: Ghosn gave Itaru Koeda, the purchasing chief, authority to place orders without regard to keiretsu relationships - and, more important, insisted that he use it. Then, a Renault executive and Koeda dumped the shukotan system, instead assigning buyers responsibility by model and part. They formed a sourcing committee to review vendor price quotes on a global basis. "This is the best change in our process," Koeda says. "Suppliers are specializing in what they do best, making them more efficient."

    The results? An 18 percent drop in purchasing costs, which was the major contributor to Nissan's transformation from a loss to a profit. Ghosn's next major set of tasks: To change the car design process in order to enhance the top line, sales; to rid Nissan of the myriad design committees and hierarchies that stifle and slow innovation; and to institute an efficient, effective innovative process.

    Baruch's cover story is accompanied by "Fixing Financial Reporting:  Financial Statement Overhaul," by  Robert A Howell, pp. 40-42 --- http://www.fei.org/magazine/articles/3-4-2002_Howell_CoverStory.cfm 

    Financial reporting is broken and has to be fixed - and fast! If it isn't, we will continue to see more cases such as Xerox, Lucent, Cisco Systems, Yahoo! and Enron. Xerox's market value is down 90 percent, or $40 billion, in the past two years. In the same period other market losses include; Lucent, down more than $200 billion; Cisco Systems, off more than $400 billion; Yahoo!, more than $100 billion; and Enron, down more than $60 billion in the largest bankruptcy of all time.

    Some argue that these are extreme examples of "irrational exubuerance." Some in the accounting profession say that such cases represent a small percentage of the aggregate number of statements audited - some 15,000 public company registrants. Perhaps. But a financial reporting framework that permits these companies to suggest that they are doing well, and, by implication, to justify market valuations which, subsequently, cost investors trillions in the aggregate, is unconscionable.

    Financial reporting, especially in the U. S., with its very public capital markets, has reached the point where "accrual-based" earnings are almost meaningless. Reported earnings are driven as much by "earnings expectations" as they are by real business performance. Balance sheets fail to reflect the major drivers of future value creation - the research and product, process and software development that fuel high technology companies, and the brand value of leading consumer product companies. And, cash flow statements are such a hodge-podge of operating, investing and financing activities that they obfuscate, rather than illuminate, business cash flow performance.

    The FASB, in its Concept No. 1, states, "financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions." This is simply not so.

    The primary financial statements - income statement, balance sheet and cash flow statement - which derive their foundation from an industrial age model, need major redesign if they are to serve as the starting point for meaningful financial analysis, interpretation and decision-making in today's knowledge-based and value-driven economy. Without significant redesign, ad hoc definitions such as pro forma earnings, returns and cash flows will continue to proliferate. So will significant reporting "surprises!"

    Starting Point: Market Value Creation
    The objective of a business is to increase real shareholder value - what Warren E. Buffett would call the "intrinsic value" of the firm. It's a very basic idea: Investors get "returns" from dividends and realized market appreciation. Both investments and returns are measured in cash terms, so individuals and investors invest cash in securities with the objective of realizing returns that meet or exceed their criteria. If their judgments are too high, and that later becomes clear, the market value of the firm will drop. If judgments are too low and cash flows turn out to be stronger, market values increase.

    From a managerial viewpoint, the objective of increasing shareholder (market) value really means increasing the net present value (NPV) of the future stream of cash flows. Note, "cash flows," not "profits." Cash is real; profits are anything, within reason, that management wants them to be. If revenues are recognized early - or overstated - and expenses are deferred or, in some cases, accelerated to "clear the decks" for future periods, resulting earnings may show a nice trend, but do not really reflect economic performance.

    There are only three ways management may increase the real market, or "intrinsic," value of a firm. First, increase the amount of cash flows expected at any point in time. Second, accelerate cash flows; given the time value of money, cash received earlier has a higher present value. Third, if a firm is able to lower the discount rate that it applies to its cash flows - which it frequently can - it can raise its NPV.

    Given that cash flows drive market value, financial statements should put much more emphasis on cash flows. The statement of cash flows now prescribed by the accounting community and presented by management is not easily related to value creation. Derived from the income statement and balance sheet, it's effectively a reconciliation statement for the change in the balance of the cash account. A major overhaul of the cash flow statement would directly relate to market valuations.

    Cash Earnings and Free Cash Flows
    Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."

    With negative cash flows - frequently the case for young startups and high-growth companies - a business must raise more capital in the form of debt or equity. The sooner it gets its free cash flows positive, the sooner it'll begin to create value for shareholders. Positive free cash flows provide resources to pay interest and pay down debt, to return cash to shareholders (through stock repurchases or dividends) or to invest in new business areas.

    The traditional cash flow statement purportedly distinguishes between operating, investing and financing cash flows, and has as its "bottom line" the change in cash and cash equivalents. In fact, the operating cash flows include the results of selling activities, investing in working capital and interest expense, a financing activity. Investing cash flows include capital expenditures, acquisitions, disposals of assets and the purchase and sale of financial assets. Financing cash flows consist of what's left over.

    Indeed, the bottom-line change in cash is not a useful number, other than to demonstrate that it may be reconciled with the change in the cash account. If one wants a positive change in cash, simply borrow more. These free cash flows ultimately drive market value, and should be the focus of managers and investors alike.

    Replacing Income With Cash Earnings
    The traditional "profit and loss," or "income," statement needs modification in three ways, two of which are touched on above, along with a name-change, to "Operating Statement." That would suggest a representation of the business' current operations, without the emphasis on accrual-based profits.

    Interest expense (income) should be eliminated from the statement, as it represents a financing cost rather than an operating cost. A number of companies do this internally to determine "net operating profit after taxes" (NOPAT). Also, NOPAT needs to be adjusted for the various non-cash items, such as depreciation, amortization, gains and losses on the sale of assets, tax-timing differences and restructuring charges - which affect income but not cash flows. The resultant "cash earnings" better represents the current economic performance of a business than accrual income and, very importantly, is much less susceptible to manipulation.

    A third adjustment is the order in which the classes of expenses are displayed. Traditional income statements report cost of goods sold or product costs first, frequently focus on product gross margins, and then deduct, as a group, other expenses such as technical, selling and administrative expenses. This order made sense in the industrial age when product costs dominated. It does not for many of today's high-tech or consumer product companies. It would be more useful for companies to report expenses in an order that reflects the flow of the business activities. One logical order that builds on the concept of a business' value chain, is to categorize costs into development costs, product (service) conversion costs, sales and customer support costs and administrative costs.

    Reinvesting in the Business
    For most companies - especially those with significant investments that are being depreciated or amortized - cash earnings will be significantly higher than NOPAT. Unfortunately, cash earnings are not free cash flows because most businesses have to reinvest in working capital, property, plant and equipment and intangible assets, just to sustain - let alone increase - their productive capabilities.

    As a business grows in sales volume, assuming that it offers credit to its customers who pay with the same frequency, accounts receivable will increase proportionately. As sales volumes increase, so, too, will product costs, inventories and accounts payable balances. Working capital - principally receivables, inventories, and payables - will tend to increase proportionately with sales growth, and will require cash to finance it. The degree to which it grows is a function of receivables terms and collection practices, inventory management and payables practices.

    Companies such as Dell Computer Corp. collect payments up front, turn inventories in a few days and pay their vendors when due. The net effect is that as Dell grows it actually throws off cash, rather than requiring it to support increases in working capital. Most companies are not as efficient; the amount of cash needed to support increases in working capital can be as much as 20-25 percent of any sales increase. The degree to which working capital increases as sales increase is an important performance metric. Lower is better, which absolutely flies in the face of such traditional measures of liquidity as "working capital" and "quick" ratios, for which higher has been considered better.

    Balance sheets ought to reflect investments that represent future value. What drives value for many businesses in today's knowledge-based economy - pharmaceuticals, high technology, software and brand-driven consumer product companies - is the investments in R&D, product, process and software development, brand equity and the continued training and development of the work force. Yet, based on generally accepted accounting principles (GAAP) accounting, these "investments" in the future are not reflected on balance sheets, but, rather, expensed in the period in which they are incurred.

    A frequent argument for "expensing" is the unclear nature of the investments' future value. Apparently, investors believe otherwise, evidenced by the ratio of market values to book values having exploded in the past 25 years. In 1978, the average book-to-market ratio was around 80 percent; today it is around 25 percent. In the early 1970s, when accounting policies were established for R&D, product lines were narrower and life cycles longer, resulting in R&D being a much less significant element of cost. Expensing was less relevant. Now, with intangible assets having become so central and significant, expensing - rather than capitalizing and amortizing them over time - results in an absolute breakdown of the principle of "matching," which is at the heart of accrual accounting. The world of business has changed; accounting practices must also change.

    Financial Statement Overhaul
    Financial statements need marked overhaul to be useful for analysis and decision-making in today's knowledge-driven and shareholder value-creation environment. The proposed changes fall into three categories:

    First - Move to a much more explicit shareholder (market) value creation and cash orientation, and away from accrual accounting profits and return on investment calculations predicated on today's accounting policies. Start with a shareholder perspective for cash flows, then reconstruct the statement of cash flows to clearly provide the free cash flows that the business' operations are generating. Cash earnings and reinvestments in the business comprise free cash flows.

    Second - Expand the definition of investments to include intangibles, which should be capitalized as assets and amortized according to some thoughtful rules. This will better reflect investments that have potential future value.

    Third - Change the title to "operating statement" and other "housekeeping" of financial statements, to include categorizing costs in a more logical "value chain" sequence and aggregating all financial transactions, such as interest and the purchase and sale of securities, as financing activities.

    Value creation is ultimately measured in the marketplace, so it stands to reason that if a firm's market value increases consistently, over time, and can be supported by improvements in its cash generation performance, real value is being created. For this to happen, the place to start is by fixing the financial statements. 

    Bob Jensen's threads on accounting theory are at http://faculty.trinity.edu/rjensen/theory.htm 

     


    The Shareholder Action On-Line Handbook (1993) (history, finance, investing, law)--- http://www.ethics.fsnet.co.uk/0home.htm 

    These Web pages are the on-line version of The Shareholder Action Handbook, first published in paperback 1993 by New Consumer. The Handbook aims to give practical advice to individuals about how they may use shares to make companies more accountable. The need for such a guide is now stronger than ever. Public concern in Britain about the accountability of company directors has risen to the extent that the subject makes regular appearances in debates in the House of Commons. While there are many obstacles to taking shareholder action, shareholders can do much to alter the course of corporate behaviour. Indeed, since the original version of the guide appeared there have been a number of successful shareholder action campaigns. However, there is considerable need both for new legislation to make it easier for shareholders to hold companies to account, and for the large institutional shareholders who own much of global industry to take their responsibilities as shareholders rather more seriously.


    Online Resources for Business Valuations

    Go to http://faculty.trinity.edu/rjensen/roi.htm


    Fade, Gain, and Cost Shifting Analysis  in gross profit analysis in construction accounting

    September 25, 2009 message from William Brighenti, CPA [accountantscpahartford@GMAIL.COM]

    If anyone has detailed information including an illustration of a fade analysis for contractors, please email me or post it.  I've posted one on my website:  http://www.cpa-connecticut.com/fade-analysis.htmlHowever, I suspect there may be other formats available allowing for better analysis.  Please email all suggestions, comments, and formats to accountantscpahartford@gmail.com.

    Thank you,

    William Brighenti, CPA,
    Accountants CPA Hartford

    http://www.cpa-connecticut.com

    September 25, 2009 reply from Bob Jensen

    Hi William,

    There can be “gains” as well as “fades.” Also check under the contractors “cost shifting” behavior from contract to contract.

    Here are a few links to look at::

    http://www.eurojournals.com/irjfe_28_04.pdf

    Click Here
    http://www.dglcpas.com/wp-content/uploads/2009/07/cost_shifting.pdf

    Click Here
    http://blog.skodaminotti.com/blog/cleveland-construction-accounting/0/0/the-importance-of-gainfade-analyses

    Click Here
    http://blog.skodaminotti.com/blog/real-estate-and-construction-blog-5

    Click Here (CPE Course)
    http://www.cpa2biz.com/AST/Main/CPA2BIZ_Primary/Tax/PRDOVR~PC-186319/PC-186319.jsp

    Click Here
    http://www.thetfmshow.com/Assets/Content/doc/TU13%20-%20Financial%20Fundamentals%20pt%202.pdf

    Hope this helps.

    There is also an unrelated concept of fade analysis in game theory ---

    Parrondo's Paradox --- http://en.wikipedia.org/wiki/Parrondo%27s_paradox

     Bob Jensen


    "Critical Thinking:  Why It's So Hard to Teach," by Daniel T. Willingham ---
    http://www.aft.org/pubs-reports/american_educator/issues/summer07/Crit_Thinking.pdf

    Also see Simorleon Sense --- http://www.simoleonsense.com/critical-thinking-why-is-it-so-hard-to-teach/

    “Critical thinking is not a set of skills that can be deployed at any time, in any context. It is a type of thought that even 3-year-olds can engage in—and even trained scientists can fail in.”

    “Knowing that one should think critically is not the same as being able to do so. That requires domain knowledge and practice.”

    So,  Why Is Thinking Critically So Hard?
    Educators have long noted that school attendance and even academic success are no guarantee that a student will graduate an effective thinker in all situations. There is an odd tendency for rigorous thinking to cling to particular examples or types of problems. Thus, a student may have learned to estimate the answer to a math problem before beginning calculations as a way of checking the accuracy of his answer, but in the chemistry lab, the same student calculates the components of a compound without noticing that his estimates sum to more than 100 percent. And a student who has learned to thoughtfully discuss the causes of the American Revolution from both the British and American perspectives doesn’t even think to question how the Germans viewed World War II. Why are students able to think critically in one situation, but not in another? The brief answer is: Thought processes are intertwined with what is being thought about. Let’s explore this in depth by looking at a particular kind of critical thinking that has been studied extensively: problem solving.

    Imagine a seventh-grade math class immersed in word problems. How is it that students will be able to answer one problem, but not the next, even though mathematically both word problems are the same, that is, they rely on the same mathematical knowledge? Typically, the students are focusing on the scenario that the word problem describes (its surface structure) instead of on the mathematics required to solve it (its deep structure). So even though students have been taught how to solve a particular type of word problem, when the teacher or textbook changes the scenario, students still struggle to apply the solution because they don’t recognize that the problems are mathematically the same.

    Thinking Tends to Focus on a Problem’s “Surface Structure”
    To understand why the surface structure of a problem is so distracting and, as a result, why it’s so hard to apply familiar solutions to problems that appear new, let’s first consider how you understand what’s being asked when you are given a problem. Anything you hear or read is automatically interpreted in light of what you already know about similar subjects. For example, suppose you read these two sentences: “After years of pressure from the film and television industry, the President has filed a formal complaint with China over what U.S. firms say is copyright infringement. These firms assert that the Chinese government sets stringent trade restrictions for U.S. entertainment products, even as it turns a blind eye to Chinese companies that copy American movies and television shows and sell them on the black market.”

    With Deep Knowledge, Thinking Can Penetrate Beyond Surface Structure
    If knowledge of how to solve a problem never transferred to problems with new surface structures, schooling would be inefficient or even futile—but of course, such transfer does occur. When and why is complex,5 but two factors are especially relevant for educators: familiarity with a problem’s deep structure and the knowledge that one should look for a deep structure. I’ll address each in turn. When one is very familiar with a problem’s deep-structure, knowledge about how to solve it transfers well. That familiarity can come from long-term, repeated experience with one problem, or with various manifestations of one type of problem (i.e., many problems that have different surface structures, but the same deep structure). After repeated exposure to either or both, the subject simply perceives the deep structure as part of the problem description.

    "Critical Thinking: Distinguishing Between Inferences and Assumptions," The Critical Thinking Community ---
    http://www.criticalthinking.org/articles/ct-distinguishing-inferencs.cfm 

    To be skilled in critical thinking is to be able to take one’s thinking apart systematically, to analyze each part, assess it for quality and then improve it. The first step in this process is understanding the parts of thinking, or elements of reasoning.

    These elements are: purpose, question, information, inference, assumption, point of view, concepts, and implications. They are present in the mind whenever we reason. To take command of our thinking, we need to formulate both our purpose and the question at issue clearly. We need to use information in our thinking that is both relevant to the question we are dealing with, and accurate. We need to make logical inferences based on sound assumptions. We need to understand our own point of view and fully consider other relevant viewpoints. We need to use concepts justifiably and follow out the implications of decisions we are considering. (For an elaboration of the Elements of Reasoning, see a Miniature Guide to the Foundations of Analytic Thinking.)

    In this article we focus on two of the elements of reasoning: inferences and assumptions. Learning to distinguish inferences from assumptions is an important intellectual skill. Many confuse the two elements. Let us begin with a review of the basic meanings:

    1. Inference: An inference is a step of the mind, an intellectual act by which one concludes that something is true in light of something else’s being true, or seeming to be true. If you come at me with a knife in your hand, I probably would infer that you mean to do me harm. Inferences can be accurate or inaccurate, logical or illogical, justified or unjustified.

       
    2. Assumption: An assumption is something we take for granted or presuppose. Usually it is something we previously learned and do not question. It is part of our system of beliefs. We assume our beliefs to be true and use them to interpret the world about us. If we believe that it is dangerous to walk late at night in big cities and we are staying in Chicago, we will infer that it is dangerous to go for a walk late at night. We take for granted our belief that it is dangerous to walk late at night in big cities. If our belief is a sound one, our assumption is sound. If our belief is not sound, our assumption is not sound. Beliefs, and hence assumptions, can be unjustified or justified, depending upon whether we do or do not have good reasons for them. Consider this example: “I heard a scratch at the door. I got up to let the cat in.” My inference was based on the assumption (my prior belief) that only the cat makes that noise, and that he makes it only when he wants to be let in.

    We humans naturally and regularly use our beliefs as assumptions and make inferences based on those assumptions. We must do so to make sense of where we are, what we are about, and what is happening. Assumptions and inferences permeate our lives precisely because we cannot act without them. We make judgments, form interpretations, and come to conclusions based on the beliefs we have formed.

    If you put humans in any situation, they start to give it some meaning or other. People automatically make inferences to gain a basis for understanding and action. So quickly and automatically do we make inferences that we do not, without training, notice them as inferences. We see dark clouds and infer rain. We hear the door slam and infer that someone has arrived. We see a frowning face and infer that the person is upset. If our friend is late, we infer that she is being inconsiderate. We meet a tall guy and infer that he is good at basketball, an Asian and infer that she will be good at math. We read a book, and interpret what the various sentences and paragraphs — indeed what the whole book — is saying. We listen to what people say and make a series of inferences as to what they mean.

    As we write, we make inferences as to what readers will make of what we are writing. We make inferences as to the clarity of what we are saying, what requires further explanation, what has to be exemplified or illustrated, and what does not. Many of our inferences are justified and reasonable, but some are not.

    As always, an important part of critical thinking is the art of bringing what is subconscious in our thought to the level of conscious realization. This includes the recognition that our experiences are shaped by the inferences we make during those experiences. It enables us to separate our experiences into two categories: the raw data of our experience in contrast with our interpretations of those data, or the inferences we are making about them. Eventually we need to realize that the inferences we make are heavily influenced by our point of view and the assumptions we have made about people and situations. This puts us in the position of being able to broaden the scope of our outlook, to see situations from more than one point of view, and hence to become more open-minded.

    Often different people make different inferences because they bring to situations different viewpoints. They see the data differently. To put it another way, they make different assumptions about what they see. For example, if two people see a man lying in a gutter, one might infer, “There’s a drunken bum.” The other might infer, “There’s a man in need of help.” These inferences are based on different assumptions about the conditions under which people end up in gutters. Moreover, these assumptions are connected to each person’s viewpoint about people. The first person assumes, “Only drunks are to be found in gutters.” The second person assumes, “People lying in the gutter are in need of help.”

    The first person may have developed the point of view that people are fundamentally responsible for what happens to them and ought to be able to care for themselves. The second may have developed the point of view that the problems people have are often caused by forces and events beyond their control. The reasoning of these two people, in terms of their inferences and assumptions, could be characterized in the following way:

     

    Person One
     
    Person Two
     
    Situation: A man is lying in the gutter. Situation: A man is lying in the gutter.
    Inference: That man’s a bum. Inference: That man is in need of help.
    Assumption: Only bums lie in gutters. Assumption: Anyone lying in the gutter is in need of help.

    Critical thinkers notice the inferences they are making, the assumptions upon which they are basing those inferences, and the point of view about the world they are developing. To develop these skills, students need practice in noticing their inferences and then figuring the assumptions that lead to them.
     

    As students become aware of the inferences they make and the assumptions that underlie those inferences, they begin to gain command over their thinking. Because all human thinking is inferential in nature, command of thinking depends on command of the inferences embedded in it and thus of the assumptions that underlie it. Consider the way in which we plan and think our way through everyday events. We think of ourselves as preparing for breakfast, eating our breakfast, getting ready for class, arriving on time, leading class discussions, grading student papers, making plans for lunch, paying bills, engaging in an intellectual discussion, and so on. We can do none of these things without interpreting our actions, giving them meanings, making inferences about what is happening.

    This is to say that we must choose among a variety of possible meanings. For example, am I “relaxing” or “wasting time?” Am I being “determined” or “stubborn?” Am I “joining” a conversation or “butting in?” Is someone “laughing with me” or “laughing at me?” Am I “helping a friend” or “being taken advantage of?” Every time we interpret our actions, every time we give them a meaning, we are making one or more inferences on the basis of one or more assumptions.

    As humans, we continually make assumptions about ourselves, our jobs, our mates, our students, our children, the world in general. We take some things for granted simply because we can’t question everything. Sometimes we take the wrong things for granted. For example, I run off to the store (assuming that I have enough money with me) and arrive to find that I have left my money at home. I assume that I have enough gas in the car only to find that I have run out of gas. I assume that an item marked down in price is a good buy only to find that it was marked up before it was marked down. I assume that it will not, or that it will, rain. I assume that my car will start when I turn the key and press the gas pedal. I assume that I mean well in my dealings with others.

    Humans make hundreds of assumptions without knowing it---without thinking about it. Many assumptions are sound and justifiable. Many, however, are not. The question then becomes: “How can students begin to recognize the inferences they are making, the assumptions on which they are basing those inferences, and the point of view, the perspective on the world that they are forming?”

    There are many ways to foster student awareness of inferences and assumptions. For one thing, all disciplined subject-matter thinking requires that students learn to make accurate assumptions about the content they are studying and become practiced in making justifiable inferences within that content. As examples: In doing math, students make mathematical inferences based on their mathematical assumptions. In doing science, they make scientific inferences based on their scientific assumptions. In constructing historical accounts, they make historical inferences based on their historical assumptions. In each case, the assumptions students make depend on their understanding of fundamental concepts and principles.

    As a matter of daily practice, then, we can help students begin to notice the inferences they are making within the content we teach. We can help them identify inferences made by authors of a textbook, or of an article we give them. Once they have identified these inferences, we can ask them to figure out the assumptions that led to those inferences. When we give them routine practice in identifying inferences and assumptions, they begin to see that inferences will be illogical when the assumptions that lead to them are not justifiable. They begin to see that whenever they make an inference, there are other (perhaps more logical) inferences they could have made. They begin to see high quality inferences as coming from good reasoning.

    We can also help students think about the inferences they make in daily situations, and the assumptions that lead to those inferences. As they become skilled in identifying their inferences and assumptions, they are in a better position to question the extent to which any of their assumptions is justified. They can begin to ask questions, for example, like: Am I justified in assuming that everyone eats lunch at 12:00 noon? Am I justified in assuming that it usually rains when there are black clouds in the sky? Am I justified in assuming that bumps on the head are only caused by blows?

    The point is that we all make many assumptions as we go about our daily life and we ought to be able to recognize and question them. As students develop these critical intuitions, they increasingly notice their inferences and those of others. They increasingly notice what they and others are taking for granted. They increasingly notice how their point of view shapes their experiences.

    This article was adapted from the book, Critical Thinking: Tools for Taking Charge of Your Learning and Your Life, by Richard Paul and Linda Elder.

     

    The Cambridge Handbook of Thinking and Reasoning --- Click Here

    The Miniature Guide To Critical Thinking Concepts & Tools --- Click Here


    Teaching Case
    From The Wall Street Journal Weekly Accounting Review on May 16, 2014

    Studying Philosophy is Good for Business
    by: Marcelo Bucheli and R. Daniel Wadhwani
    May 12, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Education

    SUMMARY: The article is written by two professors, one at the University of Illinoi, Urbana-Champaign and one at the University of the Pacific. The related article is the original report on changes in MBA programs to which these two professors have responded in this letter to the WSJ editors. The professors focus on market-related benefits of broad thinking capabilities. The related article describes employers' concerns about current teaching methods and focus in business programs.

    CLASSROOM APPLICATION: While the articles focus on MBA programs, questions ask students to consider whether these issues apply in accounting programs. The article may be used in any accounting class.

    QUESTIONS: 
    1. (Advanced) What do you understand is the meaning of critical thinking?

    2. (Introductory) What concerns are raised in the main and related articles about development of students' critical thinking skills in business programs?

    3. (Advanced) While the two articles are focused on MBA programs, do you feel that your accounting curriculum helps to develop your critical thinking skills? Support your answer.

    4. (Introductory) Refer to the related article. What do employers cite as a problem with the thinking skills of business school graduates?

    5. (Advanced) Could this issue being raised by employers apply to accounting graduates as well as MBAs? Explain.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Why Some M.B.A.s Are Reading Plato, Kant
    by Melissa Korn
    May 01, 2014
    Page: B6

    "Studying Philosophy is Good for Business," Marcelo Bucheli and R. Daniel Wadhwani, The Wall Street Journal, May 12, 2014 ---
    http://online.wsj.com/news/articles/SB20001424052702303948104579533610289092866

    Most business-school students are gunning for jobs in banking, consulting or technology. So what are they doing reading Plato?

    The philosophy department is invading the M.B.A. program—at least at a handful of schools where the legacy of the global financial crisis has sparked efforts to train business students to think beyond the bottom line. Courses like "Why Capitalism?" and "Thinking about Thinking," and readings by Marx and Kant, give students a break from Excel spreadsheets and push them to ponder business in a broader context, schools say.

    The courses also address a common complaint of employers, who say recent graduates are trained to solve single problems but often miss the big picture.

    "Nobel Thinking," a new elective at London Business School, explores the origins and influence of economic theories on topics like market efficiency and decision-making by some Nobel Prize winners. The 10-week course—taught by faculty from the school's economics, finance and organizational behavior departments—might not make students the next James Watson or Francis Crick, but it aims to give them a sense of how revolutionary ideas arise.

    "It's important to know why we're doing what we're doing," says Ingrid Marchal-Gérez, a second-year M.B.A. who enrolled in Nobel Thinking to balance her finance and marketing classes. "You can start to understand what idea can have an impact, and how to communicate an idea."

    Students write narrative essays to explain how ideas—such as adverse selection, or what happens when buyers and sellers have access to different information—gain currency. Joao Montez, the economics professor leading Nobel Thinking, says he wants students to reflect, if only for a short while, on world-changing thought.

    Career advancement and salary outrank ideas about world peace and humanity's future for many M.B.A.s, but Dr. Montez says LBS students have requested more opportunities to step back and consider big-picture ideas.

    "You can leave the classroom with these ideas in the back of your mind, and then maybe one day it will be useful," he says.

    That's true to a point: Ms. Marchal-Gérez, 38 years old, says she is somewhat concerned she'll "have a good time, but then what?"

    Abstract ideas remain a hard sell for many M.B.A.s.

    Patricia Márquez, an associate professor of management at the University of San Diego's School of Business Administration and an anthropologist by training, has struggled for nearly 20 years to teach M.B.A.s to dream up business solutions for poverty, her area of scholarly focus. Students, she found, needed a great deal of coaching to apply theories from anthropology and ethnography to the business world.

    She eventually replaced theory-based readings with traditional case studies, though she still tries to conduct discussions on abstract topics, such as how cultural stereotypes stymie innovation.

    "I spent six years thinking about the definition of culture. At a business school, culture can be measured through a survey," she says. "It's so solution-oriented. We don't ask, and we don't let them have space to ask better questions."

    To give students room for questions, Bentley University in Waltham, Mass., introduced "Thinking about Thinking" as a unit in its one-year M.B.A. program last year. Students spend two weeks studying art, reading fiction and even meditating.

    "There's too much emphasis in leadership work on understanding followers," says Duncan Spelman, management department chair and co-instructor. "We're really trying to emphasize understanding the self" to make students effective leaders.

    Mariia Potapkina, a 29-year-old Russia native who plans to work in consulting or strategy after graduation, says the class was "a nonstop, 14-day discovery of yourself." For example, she learned that she became more organized in the face of ambiguity.

    But ambiguity can be unsettling for some. Esteban Hunt, an M.B.A. student who hails from Buenos Aires, recalled a class when an artist presented a piece of artwork and asked students to describe what they saw.

    The variety of interpretations, and the realization that there was no single right answer, left him frustrated, Mr. Hunt says, and produced palpable anxiety among his classmates.

    That's the point, says Dr. Spelman, adding that uncertainty is a reality in life and business.

    Expect more abstract ideas in business schools soon.

    To meet student demand, Copenhagen Business School is expanding its 15-year-old master of science in business administration and philosophy program this year, shifting to English-language instruction from Danish and taking in more international students.

    "The tension between the two words business [and] philosophy appeals to quite a lot of young students," says Kurt Jacobsen, program director and a professor of business history. He says students want to better understand market and business dynamics after the extreme economic upheaval of recent years.

    Continued in article


    Critical Thinking:  Why's It So Hard to Teach
    Go to http://faculty.trinity.edu/rjensen/theory02.htm#CriticalThinking

    May 22, 2014 reply from M. Raza

    Hi Bob, thanks for the heads up. One of the interesting books I read on critical thinking is by Roy Van den Brink-Budgen (2010) that looks into the concept from the "asking possible meaning and significance of the claim, be it predictive or evidential," point of view.
    http://www.amazon.co.uk/Critical-Thinking-Students-Analysing-Evaluating/dp/1845283864/ref=sr_1_1/279-2615269-5537961?s=books&ie=UTF8&qid=1400790116&sr=1-1

    The one by Gary Kirby and Jeffery Goodpaster (2007) is also pretty good. Here is an interesting link on critical thinking http://www.criticalthinking.org/pages/research-from-the-center-for-critical-thinking/595 

    Regards,
    Raza

     

     


    Understanding the Issues

    To my knowledge Rashad was the first Accounting Review editor to impose a requirement that authors place an abstract in front of a paper that explains the paper and its significance in non-technical terms --- perhaps to the teenage child of an author. This has been somewhat successful subject to abstract length restrictions. Probably the biggest drawback has been that abstracts often suggest quite general findings that, when subjected to tests of model robustness (often overlooked in the study itself) and limiting assumptions, the findings are about as narrow as the sharp edge of a Samurai sword.

    For example, log-linear models generally seek a parsimonious model that, when put to the test, is not especially robust relative to other parsimonious models vis-a-vis the saturated model --- http://faculty.chass.ncsu.edu/garson/PA765/logit.htm
    Another example of a model that is not robust is Ijiri’s cash flow recovery rate model that’s great in theory but lacks robustness and is too sensitive to even the slightest errors in parameter estimation. In theory it sounds like a tremendous tool for financial analysts. But in practice the model is just not robust. Have you ever seen robustness mentioned in the abstract of a paper? See http://en.wikipedia.org/wiki/Robust

    One thing abstracts often reveal is the trivial nature of the findings when they are explained in plain English rather than statistical significance --- Click Here  
    Another problem with very large samples arises when researchers declare statistical significance to differences that are substantively trivial. When is that last time you saw such a conclusion in an abstract or even the accounting research paper itself?

    I will give you an example of the residual-errors test that is seldom mentioned in an accountics paper abstract or even the paper itself. The example is classic even though it’s not an accounting research finding. This illustration is from a book entitled Credit Derivatives & Synthetic Structures by Janet M. Tavakoli (Wiley, 2001, pp. 2-3),

    Many years ago, my advanced statistics professor, one of the world’s most talented statisticians and statistical modelers, laughingly admitted to model hubris early in his career. He had been asked to participate in a study to model tree trunk wood volumes. He diligently measured the trees and recorded the wood yield data corresponding to the measured trees. He tabulated and graphed the data. He used a computer program and regression analysis. He applied modeling theory and came up with a formula that was closely correlated with tree wood yields. It was magic. Statistics worked.

    The formula looked very much like that for the volume of a cylinder --- with a small fudge factor thrown in. Fudge factors are common. They make up for the fact that the world doesn’t always behave the way we think it should behave. This was in the days before fractal theory. Euclidean geometry always leaves us with the need for fudge factors; we’re used to it.

    We know the world isn’t made up of squares, triangles, circles, and cylinders. Nonetheless, the model was a nice, neat, and intuitive little formula. It had a high correlation coefficient. When you plugged in the trunk width and the height of the tree, the wood volume was pretty much as predicted by the neat little formula. Statistics showed that the formula described the data and predicted future events pretty well. That --- among other things --- is what makes a statistician feel satisfied 

    The formula was perfect.

    We, almost perfect.

    Little things about the formula kept bothering the budding professor. For instance, a plot of the residuals didn’t look random. The residuals, the unexplained data, appeared to have a pattern. Statisticians know that isn’t a good thing. That usually means the neat little formula missed something. But it was so close. The minor error seemed negligible.

    The budding professor was tempted to ignore these pesky residuals and declare the job done. But he kept at it, laboring away, modifying the formula, trying to make the residuals disappear. The cylinderlike formula seemed so right. The professor had a problem. He couldn’t see the formula for the trees.

    Trees do indeed look very much like cylinders. But they look even more like cones. One of the foresters pointed this out one day to the budding professor. This is a moment statisticians and mathematicians both love and hate. They hate it because they get the churning feeling in the pit of their stomachs, which lets them know in their gut that they are wrong. They also love it because now they’ve hit on a better answer.

    In retrospect between 2001 and the credit derivatives fiasco of 2008 (where Wall Street had millions of such contracts) is that Janet M. Tavakoli’s credit derivative models in 2001 looked almost perfect but ignored the Black Swan of 2008 that some might argue helped to bring down the world of finance to the extent that so many credit derivatives were used, in a failing effort, to insure against investment failures. This, of course, was a much larger specification problem than the Euclidean difference between cylinders and cones. I wonder how Ms. Tavokoli is sleeping these days. See http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout  

    Who is Nassim Nicholas Taleb? --- http://en.wikipedia.org/wiki/Taleb
    Many finance professors make students watch some of Taleb's videos, especially the Black Swan ---
    http://video.google.com/videosearch?q=taleb+black+swan+&www_google_domain=www.google.com&emb=0&aq=f&aq=f#
    Black Swan Financial Collapse Black Swan --- http://www.dailymotion.com/video/x720r3_black-swan-paradigm-financial-colla_tech
    (People underestimate the probability of rare events)
    Also see http://www.cnbc.com/id/31706523


    From The Wall Street Journal's Accounting Educator Reviews on January 22, 2002

    TITLE: Deciphering the Black Box 
    REPORTER: Steve Liesman 
    DATE: Jan 23, 2002 PAGE: C1 LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739030177303200.djm  TOPICS: Accounting, Accounting Theory, Creative Accounting, Disclosure, Disclosure Requirements, Earnings Management, Financial Analysis, Financial Statement Analysis, Fraudulent Financial Reporting, Regulation, Securities and Exchange Commission

    SUMMARY: The article discusses several factors that have led to financial reporting that is complex and difficult to understand. Related articles provide specific examples of complicated and questionable financial reporting practices.

    QUESTIONS: 
    1.) What economic factors have led to the complexity of financial reporting? Have accounting standard setters kept pace with the changing economic conditions? Support your answer.

    2.) What determines a company's cost of capital? What is the relation between the quantity and quality of financial information disclosed by a company and its cost of capital? Why are companies reluctant to disclose financial information?

    3.) Explain the difference between earnings management and fraudulent financial reporting? Is either earnings management or fraudulent financial reporting illegal? Is either unethical? Could earnings management ever improve the usefulness of financial reporting? Explain.

    4.) Discuss the advantages and disadvantages of allowing discretion in financial reporting.

    5.) Refer to related articles. Briefly discuss the major accounting or economic situation that has caused complexity in the financial reporting of each of these companies. What can be done to make the financial reporting more useful?

    SMALL GROUP ASSIGNMENT: How much discretion should Generally Accepted Accounting Principles allow in financial reporting? Support your position.

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

    --- RELATED ARTICLES --- 

    TITLE: GE: Some Seek More Light on the Finances 
    REPORTER: Rachel Emma Silverman and Ken Brown 
    PAGE: C1 ISSUE: Jan 23, 2002 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011744147673133760.djm 

    TITLE: AIG: A Complex Industry, A Very Complex Company 
    REPORTER: Christopher Oster and Ken Brown 
    PAGE: C16 ISSUE: Jan 23, 2002 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011740010747146240.djm 

    TITLE: Williams: Enron's Game, But Played with Caution 
    REPORTER: Chip Cummins 
    PAGE: C16 ISSUE: Jan 23, 2002 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739185631601680.djm 

    TITLE: IBM: 'Other Income' Can Mean Other Opinions 
    REPORTER: William Bulkeley 
    PAGE: C16 ISSUE: Jan 23, 2002 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011744634389346680.djm 

    TITLE: Coca-Cola: Real Thing Can Be Hard to Measure 
    REPORTER: Betsy McKay 
    PAGE: C16 ISSUE: Jan 23, 2002 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011739618177530480.djm 

    Bob Jensen's threads on accounting and securities fraud are at http://faculty.trinity.edu/rjensen/fraud.htm 


    From The Wall Street Journal Accounting Educators' Review on June 11, 2004

    TITLE: Outside Audit: Goodyear and the Butterfly Effect 
    REPORTER: Timothy Aeppel 
    DATE: Jun 04, 2004 
    PAGE: C3 
    LINK: http://online.wsj.com/article/0,,SB108629544631828261,00.html  
    TOPICS: Accounting Changes and Error Corrections, Pension Accounting, Restatement

    SUMMARY: Goodyear Tire & Rubber has announced the amount of its restatement from problems identified in 2003. The company as well has announced further restatements due to changes in the discount rate it uses for pension liability calculations.

    QUESTIONS: 
    1.) For what reason is Goodyear Tire & Rubber restating earnings for the last five years?

    2.) What accounting standards require restatements of past financial results? Under what circumstances are restatements required? What other types of accounting changes are possible? How are these categories of accounting changes presented in the financial statements?

    3.) In general, what adjustment is Goodyear Tire & Rubber making to its accounting for defined benefit pension plans?

    4.) Discuss the details of the change in accounting for the defined benefit pension plan. Specifically, define the discount rate in question and state how it is used in pension accounting.

    5.) Had the company not uncovered the issues identified under question #1, do you think they would be making the changes identified in questions #3 and #4? Why or why not?

    6.) Do you think that changes in the discount rate used in pension accounting are made by other companies? When do you think companies might change this rate? In general, what type of accounting treatment would you recommend for such a change? Support your answer.

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

    "Outside Audit: Goodyear And the Butterfly Effect:  A Valuation Rate Is Shaved By Half a Point and Presto, $100.1 Million Goes Poof," by Timothy Aeppel, The Wall Street Journal, June 4, 2004, Page C3 --- http://online.wsj.com/article/0,,SB108629544631828261,00.html

    There's a costly oddity tucked into Goodyear Tire & Rubber Co.'s recent earnings restatement.

    As part of a larger revision reaching back five years, the U.S.'s largest tire maker changed the interest-rate assumptions associated with its domestic retirement plans. The upshot: By slicing half a point off a rate used to value the company's obligations to its pension fund and other post-retirement benefit plans, Goodyear also lopped off a total of $100.1 million in earnings over that period.

    This may be the first time a major company has restated earnings for this reason, although it was just one of several accounting issues the Akron, Ohio, tire maker addressed in its restatement announced May 19. Goodyear has identified a series of accounting irregularities over the past year and is the target of a continuing investigation by the Securities and Exchange Commission.

    "I have a feeling that while they were scrubbing, they decided to scrub everything," says Jack Ciesielski, publisher of Analyst's Accounting Observer.

    Keith Price, a Goodyear spokesman, says the change doesn't mean Goodyear sought to inflate earnings in the past by using an inappropriately high discount rate. Most of the reduction in earnings was the result of Goodyear having to record additional tax expenses, he notes. Mr. Price says Goodyear decided to change its methodology for calculating the rate it uses going forward and, since a broader restatement was already under way, chose to extend the new approach into the past as well.

    The root of Goodyear's problem appears to be that it used an uncommon way of calculating the so-called discount rate it assumes for its traditional pension plan. A discount rate is simply an interest rate companies use to convert future values into their present-day terms. Companies calculate the pension-fund discount rate at the end of every year in order to project cash outflows in their retirement plans. The number changes from year to year. But it also tends to get buried in financial footnotes and overlooked.

    The higher the discount rate, the less the current value of a company's future obligations to its retirees under its plans. So, in Goodyear's case, the older, higher discount rate lowered the company's projected benefit payments -- which also had the effect of raising its pretax income.

    Goodyear's old method of setting the rate was to use a six-month average of corporate-bond rates. That's unusual, though not a violation of generally accepted accounting principles, says Mr. Ciesielski.

    The more common and accurate approach is to pick a discount rate based on rates at a point in time near to when the calculations are being done. That provides a better snapshot of reality, especially in an era when rates are falling, as they have in recent years.

    Sure enough, Goodyear's old methodology resulted in discount rates that were higher than those used by most other companies during the period in question. For instance, in its restatement, Goodyear cut the rate it used in 2001 to 7.5% from 8%. But a study by Credit Suisse First Boston notes that the median discount rate used by S&P-500 component companies that year was a far lower 7.25%. In fact, the study found only seven companies used rates of 8% or higher in 2001.

    Goodyear's numbers are now more in line with other companies' and shouldn't require further adjustment, say analysts. But like many old-line companies with a relatively large cadre of older workers and retirees, Goodyear is expected to face pension problems for years to come, since its plans are underfunded by about $2.8 billion.

    While Goodyear's pension concerns are not unique, Mr. Ciesielski says it is unlikely other companies will rush to restate earnings to reflect a new discount-rate assumption. Besides, coming up with the rate is still far from an exact science.

    David Zion, CSFB's accounting analyst, says even companies that use identical methodologies can arrive at sharply different discount rates. Those with fiscal years ending in June would have different rates than those with years ending in December, for example. And multinational companies face another complication: "The discount rate for a Japanese pension plan will be different than the discount rate in Turkey," Mr. Zion points out.

    In its restatement, Goodyear decreased overall pretax income by $18.9 million for the past five years as a result of its reassessment of the discount rate. And since Goodyear's pension plan is underfunded, the cut in the discount rate also magnified that negative condition. As a result, Goodyear had to add $160.9 million in liabilities to its balance sheet. The new liabilities forced Goodyear to record $81.2 million in additional tax expenses for 2002.

    This restatement comes at a time Goodyear's accounting is still under heavy scrutiny. The company launched an internal probe last year after it said it found problems in internal billing and the implementation of a new computer system. It later said it had identified serious misdeeds by top managers in Europe and cases in which U.S. plants understated workers' compensation liabilities.


    Hi Robert,

    I added your document to http://faculty.trinity.edu/rjensen/theory/WalkerToFarrington.htm 

    I would not say that we are so much timid as we are squashed by lobbying pressures from industry.

    Bob Jensen

    Bob

    I wish to ask you a favour again. I have written the attached as a submission to a review of the New Zealand Financial Reporting Act 1993. It is currently under review due to the imminent adoption of the IASB's standards. It has thrown New Zealand's application of differential reporting into confusion. My submission deals with the way in which accounting must be the pivot upon which creditor protection functions. What I would hope Americans find interesting is the degree to which we have played out your laws - the corporate solvency test and GAAP - in a way you are too timid to do.

    The Government's discussion document to which the submission is a response is on this link:

    http://www.med.govt.nz/buslt/bus_pol/bus_law/corporate-governance/financial-reporting/part-one/media/minister-20040315.html 

    The letter is self-contained aside from the specific commentary at the end. Could you find space for it on your web-site?

    Robert B Walker


    Stock Option Valuation Research Database

    From Syllabus News on December 13, 2002

    Wharton School Offers Stock Data Via the Web

    The University of Pennsylvania's Wharton business school is offering financial analysts access to historical information on stock options over the Internet. The data, supplied by research firm OptionMetrics's Ivy database, covers information on all U.S. listed index and equity options from January1996. The Ivy database adds to the 1.5 terabyte storehouse of financial information from a range of providers now available through Wharton Research Data Services (WRDS). The university said that by making data from the Center for Research in Security Prices, Standard & Poor's COMPUSTAT, the Federal Deposit Insurance Corporation, the New York Stock Exchange, and other data vendors accessible from a simple Web-based interface, WRDS hopes to become the preferred source among university scholars for data covering global financial markets.

    Note from Jensen:  the Wharton Research Data Services (WRDS) home page is at http://www.wharton.upenn.edu/research/wrds.html 

    Wharton Research Data Services, a revolutionary Internet-based research data service developed and marketed by the Wharton School, has become the standard for large-scale academic data research, providing instant web access to financial and business datasets for almost all top-tier business schools (including 23 of the top 25 schools as ranked by Business Week magazine).

    Subscribers to Wharton Research Data Services (WRDS) gain instant access to the broadest array of business and economic data now available from a single source on the Web. From anywhere and at any time, WRDS functions as an application service provider (ASP) to deliver information drawn from 1.2 terabytes of comprehensive financial, accounting, management, marketing, banking and insurance data.

    Launched in July 1997, the unique data service's client list of over 60 institutions now includes Stanford University, Harvard University, Columbia University, Yale University, Northwestern University, London Business School, INSEAD, University of Chicago, Massachusetts Institute of Technology and dozens of other institutions. Subscribers to WRDS need only PCs or even less-expensive Web terminals to endow their units with supercomputer capabilities and tap a massive, constantly updated source of data. Users click on the WRDS database and interactively select data to extract. The requested information is instantly returned to the web browser, ready to be pasted into a spreadsheet or any other application for analysis.

    To learn more about WRDS or to get licensing information, contact: Nicole Carvalho, Marketing Director Wharton Research Data Services 400 Steinberg Hall-Dietrich Hall 3620 Locust Walk Philadelphia, PA 19104-6302

    1-877-GET-WRDS (1-877-438-9737)


    Knowledge@Wharton is a free source of research reports and other materials in accounting, finance, and business research --- http://knowledge.wharton.upenn.edu/ 


     

    Forwarded by Robert B Walker [walkerrb@ACTRIX.CO.NZ

    FASB Understanding the Issues: Vol 4 Series 1 --- 

    I refer to the monograph on credit standing & liability measurement written by Crooch & Upton. --- http://accounting.rutgers.edu/raw/fasb/statusreport_articles/vol4_series1.html  

    The article seems to suggest you wish to have feedback on this and other matters. Accordingly, I send my thoughts on this matter.

    I would begin by observing that I think Concepts Statement 7 is inconsistent with the earlier 1996 study from which it was derived. I found that study utterly persuasive so I do not now find CS-7 persuasive. In moments of cynicism, I think that Mr Upton’s apparent epiphany is related more to the politics of accountancy than to its conceptual purity.

    By this I mean that the measurement of liabilities at risk free interest rate rather than at a rate reflecting credit standing would be so anathema to the generality of accountants that it is futile to suggest it. Indeed the Crooch & Upton begin by stating a basic premise of axiomatic significance to their case – no gain or loss should arise when engaging in simple borrowing. The idea that no sooner one entered a loan agreement than a loss would arise (because it would invariably be a loss) would have most accountants in a state of high dudgeon.

    The issue then is one of gain or loss. But then that is only if you perceive the world from an income orientation perspective. I don’t, primarily because of the influence of the conceptual framework. This is reinforced by my work as a liquidator of companies. I see the world purely from a balance sheet perspective and one subject to realisable value at that. In other words, I see the utility of accounting only in terms of solvency determination with all that entails in regard to the going concern assumption.

    Unlike the United States, in the jurisdiction in which I live accounting has been rendered central to creditor protection in our corporate law. Central to this law, in turn, is the conceptual framework (at least in my view and to test the hypothesis I have a case before the courts now). I am then caused considerable misgiving as the final consequence of FASB’s view is the effective emasculation of our law built, essentially, on American conceptual development.

    The ultimate consequence of what FASB propose is that as a company slides toward insolvency its liability value declines, the value of its net worth increases. Presumably as it has no credit standing at all because it is insolvent, it has no liabilities. This may be practically true when the creditors miss out but in my jurisdiction at least it is not legally true because those responsible for the creditors loss are held accountable, the impediments of the legal system notwithstanding.

    I note that Crooch & Upton make reference in a footnote to the theory of Robert Merton in which it is implied that the residual assets are able to be ‘put’ to satisfy the claims of creditors. That may be true in an economist’s fantasy but it is not true in law, a rather more important arena.

    I say perceiving a decline in the value of a liability is considerably more counter-intuitive than the problem of accelerating the recognition of cost of debt. This is a mere triviality by comparison. After all the same amount of charge is recognised over time. The advantage of accelerating loss is that it causes an entity to be more inhibited in its distribution policy as it has less equity to draw upon. That is to the advantage of creditors.

    It seems to me that there needs to be an objective value at which to determine the value of a liability, this being central to the ability to liquidate. Mr Upton in his 1996 study demonstrates that such a value will represent the price the debtor has to pay to have the liability taken away. That price will be determined by the seller providing sufficient resources to the buyer to ensure that the buyer will avoid any risk. The resources would need to be enough to acquire a risk free asset with the same maturity profile as the liability.

    The effect of perceiving the ‘price’ of a liability in this way is to necessitate that it is discounted at a risk free rate.

    I note that the only way to make CS-7 coherent is to assume that such transfers of assets are always made between parties of the same credit standing. This pertains to one of the major practical difficulties of reflecting credit standing in accounting measurement – that is knowing what it is. It may be easily determined in the publicly listed world in which Crooch & Upton inhabit. It is not in the small, closely held corporate world in which I operate. For accounting to have long term validity it must be applicable in all circumstances.

    I think it fair to note that there is another dimension to this that tends to undermine what I believe. I have a theoretical notion that the world upon consolidation nets to nil. That is to say, my financial asset and your financial liability must have the same value in our respective records. Call this a principle of reciprocity.

    Theoretically, so far as I understand it a lender will discount the face value of a zero discount bond at the risk free rate after having adjusted for the probability of receiving nothing at all. The effect of doing that is, at the inception of an advance, to carry the value of the asset at the cash value paid at that time. If the application of the principle of reciprocity was applied when the liability was revalued in the books of the debtor, the creditor would take up a gain that denied any risk existed.

    I find this inconvenient as it causes me to abandon a notion in which I fundamentally believe. I will just have to suffer cognitive dissonance, won’t I? But then one should not underestimate the psychology that underlies accounting, particularly in the face of the paradoxes it is capable of generating.


    Also see other articles on related topics at  http://accounting.rutgers.edu/raw/fasb/statusreport_articles/ 

     

    Pro-Forma Earnings (Electronic Commerce, e-Commerce, eCommerce)

    From the Wall Street Journal's Accounting Educators' Reviews, October 4, 2001
    Educators interested in receiving these excellent reviews (on a variety of topics in addition to accounting) must firs subscribe to the electronic version of the WSJ and then go to http://209.25.240.94/educators_reviews/index.cfm 

    Sample from the October 4 Edition:

    TITLE: Sales Slump Could Derail Amazon's Profit Pledge 
    REPORTER: Nick Wingfield 
    DATE: Oct 01, 2001 
    PAGE: B1 
    LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1001881764244171560.djm  
    TOPICS: Accounting, Creative Accounting, Earnings Management, Financial Analysis, Net Income, Net Profit

    SUMMARY: Earlier this year Amazon promised analysts that it will report first-ever operating pro forma operating profit. However, Amazon is not commenting on whether it still expects to report a fourth-quarter profit this year. Questions focus on profit measures and accounting decisions that may enable Amazon to show a profit.

    QUESTIONS: 

    1.) What expenses are excluded from pro forma operating profits? Why are these expenses excluded? Are these expenses excluded from financial statements prepared in accordance with Generally Accepted Accounting Principles?

    2.) List three likely consequences of Amazon not reporting a pro forma operating profit in the fourth quarter. Do you think that Amazon feels pressure to report a pro forma operating profit? Why do analysts believe that reporting a fourth quarter profit is important for Amazon?

    3.) List three accounting choices that Amazon could make to increase the likelihood of reporting a pro forma operating profit. Discuss the advantages and disadvantages of making accounting choices that will allow Amazon to report a pro forma operating profit.

    SMALL GROUP ASSIGNMENT: Assume that you are the accounting department for Amazon and preliminary analysis suggest that Amazon will not report a pro forma operating profit for the fourth quarter. The CEO has asked you to make sure that the company meets its financial reporting objectives. Discuss the advantages and disadvantages of making adjustments to the financial statements. What adjustments, if any, would you make? Why?

    Reviewed 

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

    Bob Jensen's threads on accounting theory can be found at 
    http://faculty.trinity.edu/rjensen/theory.htm
     

    Bob Jensen's threads on real options for valuing intangibles are at http://faculty.trinity.edu/rjensen/realopt.htm 

     


    Baruch Lev has a very good site on accounting for intangibles at http://www.stern.nyu.edu/~blev/intangibles.html 

    Also note Wayne Upton's Special Report for the FASB at http://accounting.rutgers.edu/raw/fasb/new_economy.html 


    E-COMMERCE AND AUDITING FAIR VALUES SUBJECTS OF NEW INTERNATIONAL GUIDANCE The International Federation of Accountants (IFAC) invites comments on two new exposure drafts (EDs): Auditing Fair Value Measurements and Disclosures and Electronic Commerce: Using the Internet or Other Public Networks - Effect on the Audit of Financial Statements. Comments on both EDs, developed by IFAC's International Auditing Practices Committee (IAPC), are due by January 15, 2002. See http://accountingeducation.com/news/news2213.html  

    The IFAC link is at http://www.ifac.org/Guidance/EXD-Download.tmpl?PubID=1003772692151 

    The purpose of this International Standard on Auditing (ISA) is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, this ISA addresses audit considerations relating to the valuation, measurement, presentation and disclosure for material assets, liabilities and specific components of equity presented or disclosed at fair value in financial statements. Fair value measurements of assets, liabilities and components of equity may arise from both the initial recording of transactions and later changes in value.

     

    Download
    "Auditing Fair Value Measurements And Disclosures"
    in MS Word format.

    File Size: 123 Kbytes
    Download
    "Auditing Fair Value Measurements And Disclosures"
    in Adobe Acrobat format.

    File Size: 209 Kbytes

     

     


     

     

    Bob Jensen's threads on independence and professionalism in auditing are at
    http://faculty.trinity.edu/rjensen/fraud001.htm#Professionalism

     

     


    Quality of Earnings, Restatements, and  Core Earnings

    "Predicting Material Accounting Misstatements"
    Patricia M. Dechow University of California, Berkeley - Haas School of Business
    Weili Ge University of Washington - Michael G. Foster School of Business
    Chad R. Larson Washington University, St. Louis
    Richard G. Sloan Haas School of Business, UC Berkeley
    SSRN, November 16, 2009
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=997483

    Abstract:
    We examine 2,190 SEC Accounting and Auditing Enforcement Releases (AAERs) issued between 1982 and 2005. We obtain 676 firms that are alleged to have misstated their quarterly or annual financial statements. We examine the characteristics of misstating firms along five dimensions: accrual quality; financial performance; non-financial measures; off-balance sheet activities; and market-based measures. We compare misstating firms to themselves during non-misstatement years and misstating firms to the broader population of all publicly listed firms. The results reveal that during misstatement years, accruals and cash and credit sales are unusually high, while return on assets and the number of employees are declining. In addition, misstating firms finance more of their assets through operating leases and have relatively less PP&E. We find that market pressures appear to affect incentives to misstate. Misstating firms are raising new financing, have higher market-to-book ratios, and strong prior stock price performance. We develop a model to predict accounting misstatements. The output of this model is a scaled logistic probability that we term the F-Score, where values greater than one suggest a greater likelihood of a misstatement.

    Bob Jensen's threads on cooking the books are at
    http://faculty.trinity.edu/rjensen/fraud001.htm#Cooking


    FAS 160 (minority interest gives way to noncontrolling interest)
    "Noncontrolling Interest: Much More Than a Name Change New consolidation rules for partially owned affiliates: FASB 160," by Paul R. Bahnson, Brian P. McAllister and Paul B.W. Miller, Journal of Accountancy, November 2008 ---
    http://www.journalofaccountancy.com/Issues/2008/Nov/NoncontrollingInterestMuchMoreThanaNameChange.htm

  • Statement no. 141(R) and Statement no. 160 are integrally linked to work together to apply the new acquisition method to consolidated financial statements and reports and thus bring more useful information to the capital markets. With its more extensive and consistent fair value measurements, Statement no. 141(R) will help users assess the future cash flows of the consolidated enterprise. And with its consistent application of entity reporting concepts, Statement no. 160 will help them comprehend the relationship between the controlling and noncontrolling interests. As a result, users can perform more complete and reliable assessments of the prospective future cash flows available to the parent and its shareholders.

    FASB's Summary of FAS 160 ---
    http://www.fasb.org/st/summary/stsum160.shtml


  • Teaching Case on Restatements
    From The Wall Street Journal Accounting Weekly Review on January 24, 2014

    The Big Number: 2%
    by: Emily Chasan
    Jan 21, 2014
    Click here to view the full article on WSJ.com
     

    TOPICS: Accounting Theory, Financial Reporting, Financial Statement Fraud

    SUMMARY: Companies who make financial restatements take many actions: examples include rapidly changing executive teams and even increasing community actions such as charitable giving. The article reports that 94 such companies earned an average 2% share price increase for each action they took following restatements between 1997 and 2006. These results are based on research by an accounting assistant professor at Stanford University, Ed deHaan.

    CLASSROOM APPLICATION: The article can be used to introduce the concept of reliability of financial information and its importance for investor confidence in reporting entities.

    QUESTIONS: 
    1. (Introductory) Define the terms "financial restatement" and "fraud."

    2. (Advanced) Does a "serious" financial restatement occur only after fraud? Support your answer.

    3. (Advanced) Define the concept of reliability according to the FASB/IASB Conceptual Framework. How does this article show this importance of this concept?
     

    Reviewed By: Judy Beckman, University of Rhode Island

    "The Big Number: 2%," by Emily Chasan, The Wall Street Journal, January 21, 2014 ---
    http://online.wsj.com/news/articles/SB20001424052702304603704579327050935222152?mod=djem_jiewr_AC_domainid

    2%

    The average share-price boost from each action a firm takes to rebuild its reputation after a financial restatement

    For companies trying to recover from a serious financial restatement, making rapid changes to their executive team, improving governance, and even stepping up charitable giving, can quickly mend fences and nurse a share price back to health.

    Companies, on average, lose more than a quarter of their market value following a financial restatement or fraud. But researchers at Stanford and Emory universities found that in the year after a restatement, companies often take about 10 actions aimed at repairing their tarnished images. Each action lifts their shares by about 2%.

    After a restatement, "credibility is lost and it can take a long time to build that back up," said Ed deHaan, an assistant professor of accounting at Stanford. "But after one year, firms that are aggressive in taking most of these actions have more or less restored their reputations."

    Shares of Diamond Foods Inc. DMND -0.63% have nearly doubled from a November 2012 low after the company discovered $80 million in payments to walnut growers weren't accounted for correctly. It fired its top executives and launched new marketing campaigns. This month it reached a settlement with the Securities and Exchange Commission without admitting or denying guilt.

    "The company's reputation is paramount," said Diamond Foods' new CFO, Ray Silcock.

    The study, which examined 10,000 news releases following 94 restatements from 1997 to 2006, excluding firms that filed for bankruptcy, found companies usually took less-costly actions, such as charitable donations.


    "Curse of Arthur Andersen Lives On (in Huron Consulting)," by Jonathan Weil, Bloomberg, July 19, 2012 ---
    http://www.bloomberg.com/news/2012-07-19/curse-of-arthur-andersen-lives-on.html

    Huron Consulting Group Inc., a Chicago-based consulting company founded by a group of former Arthur Andersen LLP partners after the accounting firm's 2002 demise, has agreed to pay $1 million to settle Securities and Exchange Commission allegations that it cooked its books.

    The deal caps a remarkable act of corporate self-immolation. One of Huron's main businesses had been providing forensic-accounting advice to other companies, including those under SEC investigation for accounting fraud. Then in 2009 Huron restated more than three years of its financial reports to correct accounting violations, which reduced its earnings by $56 million. The company sold part of its disputes-and-investigations practice in 2010 and shuttered the rest.

    The SEC, which disclosed the accord in a press release late Thursday, also reached settlement deals with Huron's former chief financial officer, Gary Burge, and its former chief accounting officer, Wayne Lipski. They agreed to pay almost $300,000 to resolve the SEC's claims against them.

    Per the usual formalities, the defendants neither admitted nor denied anything. Unlike the conviction against Arthur Andersen for obstructing the government's investigation of Enron Corp., the SEC's order against Huron in this case won't be overturned.

    PS
    This is an illustration of an Audit Committee doing an excellent job. Huron's Audit Committee sniffed out the book cooking.

    Bob Jensen's threads on the Huron Consulting Group's book cooking scandals ---
    http://faculty.trinity.edu/rjensen/Fraud001.htm#Cooking

    Bob Jensen's threads on book cooking ---
    http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

     


    Accounting Teachers About Cooking the Books Get Caught ... er ... Cooking the Books
    The media and blogs are conveniently pinning the Huron debacle on its Andersen roots, and hinting that the Enron malfeasance bled into Huron.

    What I find ironic below is that the Huron Consulting Group is itself a consulting group on technical accounting matters, internal controls, financial statement restatements, accounting fraud, rules compliance, and accounting education. If any outfit should've known better it was Huron Consulting Group ---
    http://www.huronconsultinggroup.com/about.aspx

    Huron Consulting Group was formed in May of 2003 in Chicago with a core set of 213 following the implosion of huge Arthur Andersen headquartered in Chicago. The timing is much more than mere coincidence since a lot of Andersen professionals were floating about looking for a new home in Chicago. In the past I've used the Huron Consulting Group published studies and statistics about financial statement revisions of other companies. I never anticipated that Huron Consulting itself would become one of those statistics. I guess Huron will now have more war stories to tell clients.

    The media and blogs are conveniently pinning the Huron debacle on its Andersen roots, and hinting that the Enron malfeasance bled into Huron.
    Big Four Blog, August 5, 2009 ---
    http://www.blogcatalog.com/blog/life-after-big-four-big-four-alumni-blog/eae8a159803847f6a73af93c063058f9

    "Can hobbled Huron Consulting survive this scandal?" by Steven R. Strahler, Chicago Business, August 4, 2009 ---
    http://www.chicagobusiness.com/cgi-bin/news.pl?id=35019&seenIt=1

    An accounting mess at Huron Consulting Group Inc. that led to the decapitation of top management and the collapse in its share price puts the survival of the Chicago-based firm in jeopardy.

    Huron’s damaged reputation imperils its ability to provide credible expert witnesses during courtroom proceedings growing out of its bread-and-butter restructuring and disputes and investigations practices. Rivals are poised to capture marketshare.

    “These types of firms have to be squeaky clean with no exceptions, and this was too big of an exception,” says Allan Koltin, a Chicago-based accounting industry consultant. “I respect the changes they made and the speed (with which) they made them. I’m not sure they can recover from this.”

    Huron executives declined to comment.

    Late Friday, Huron said it would restate results for the three years ended in 2008 and for the first quarter of 2009, resulting in a halving of its profits, to $63 million from $120 million, for the 39-month period. Revenue projections for 2009 were cut by more than 10%, to a range of $650 million to $680 million from $730 million to $770 million.

    The company said its hand was forced by its recent discovery that holders of shares in acquired firms had an agreement among themselves to reallocate a portion of their earn-out payments to other Huron employees. The company said it had been unaware of the arrangement.

    “The employee payments were not ‘kickbacks’ to Huron management,” the company said.

    Whatever the description, the fallout promises to shake Huron to its core. The company’s stock plunged 70% Monday to about $14 per share, and law firms were preparing to mount class-action shareholder litigation.

    “If the public doesn’t buy that the house is clean, my guess is some of the senior talent will start to move very quickly,” says William Brandt, president and CEO of Chicago-based restructuring firm Development Specialists Inc. “Client retention is all that matters here.”

    Publicly traded competitors like Navigant Consulting Inc. are unlikely to make bids for Huron because of the potential for damage to their own stock. Private enterprises like Mesirow Financial stand as logical employers as Huron workers jump ship.

    “There certainly is potential out there for clients and employees who may be looking at different options, but at this point in the process it’s a little early to tell what impact this will have,” says a Navigant spokesman.

    Huron’s woes led to the resignation last week of Chairman and CEO Gary Holdren and Chief Financial Officer Gary Burge, both of whom will stay on with the firm for a time, and the immediate departure of Chief Accounting Officer Wayne Lipski.

    Mr. Holdren, 59, has a certain amount of familiarity with turmoil.

    He was among co-founders of Huron in 2002, when their previous employer, Andersen, folded along with its auditing client Enron Corp. He told the Chicago Tribune in 2007, “Initially, when we’d call on potential clients, they’d say, ‘Huron? Who are you? That sounds like Enron,’ or ‘Aren’t you guys supposed to be in jail? Why are you calling us?’ ”

    This year, it’s been money issues dogging Huron. In the spring, shareholders twice rejected proposals to sweeten an employee stock compensation plan.

    Mr. Holdren’s total compensation in 2008 was $6.5 million, according to Securities and Exchange Commission filings. Mr. Burge received $1.2 million.

    A Huron unit in June sued five former consultants and their new employer, Sonnenschein Nath & Rosenthal LLP, alleging that the defendants were using trade secrets to lure Huron clients to the law firm. The defendants denied the charges. The case is pending in Cook County Circuit Court.

    "3 executives at Huron Consulting Group resign over accounting missteps Consulting firm announces it will restate financial results for the past 3 fiscal years,"by Wailin Wong, Chicago Tribune, August 1, 2009 ---
    http://archives.chicagotribune.com/2009/aug/01/business/chi-sat-huron-0801-aug01 

    Chief Executive Gary Holdren and two other top executives are resigning from Chicago-based management consultancy Huron Consulting Group as the company announced Friday it is restating financial statements for three fiscal years.

    Holdren’s resignation as CEO and chairman was effective Monday and he will leave Huron at the end of August, the company said in a statement. Chief Financial Officer Gary Burge is being replaced in that post but will serve as treasurer and stay through the end of the year. Chief Accounting Officer Wayne Lipski is also leaving the company. None of the departing executives will be paid severance, Huron said.

    Huron will restate its financial results for 2006, 2007, 2008 and the first quarter of 2009. The accounting missteps relate to four businesses that Huron acquired between 2005 and 2007.

    According to Huron’s statement and a filing with the Securities and Exchange Commission, the selling shareholders of the acquired businesses distributed some of their payments to Huron employees. They also redistributed portions of their earnings “in amounts that were not consistent with their ownership percentages” at the time of the acquisition, Huron said.

    A Huron spokeswoman declined to give the number of shareholders and employees involved, saying the company was not commenting beyond its statement.

    “I am greatly disappointed and saddened by the need to restate Huron’s earnings,” Holdren said in the statement. He acknowledged “incorrect” accounting.

    Huron said the restatement’s total estimated impact on net income and earnings before interest, taxes, depreciation and amortization for the periods in question is $57 million.

    “Because the issue arose on my watch, I believe that it is my responsibility and my obligation to step aside,” said Holdren.

    Huron said the board’s audit committee had recently learned of an agreement between the selling shareholders to distribute some of their payments to a company employee. The committee then launched an inquiry into all of Huron’s prior acquisitions and discovered the involvement of more Huron employees.

    Huron said it is reviewing its financial reporting procedures and expects to find “one or more material weaknesses” in the company’s internal controls. The amended financial statements will be filed “as soon as practicable,” Huron said.

    James Roth, one of Huron’s founders, is replacing Holdren as CEO. Roth was previously vice president of Huron’s health and education consulting business, the company’s largest segment. George Massaro, Huron’s former chief operating officer who is the board of directors’ vice chairman, will succeed Holdren as chairman.

    James Rojas, another Huron founder, is now the company’s CFO. Rojas was serving in a corporate development role. Huron did not announce a replacement for Lipski, the chief accounting officer.

    The company’s shares sank more than 57 percent in after-hours trading. The stock had closed Friday at $44.35. Huron said it expects second-quarter revenues between $164 million and $166 million, up about 15 percent from the year-earlier quarter.

    The company, founded by former partners at the Andersen accounting firm including Holdren, also said that it is conducting a separate inquiry into chargeable hours in response to an inquiry from the SEC.

    Bob Jensen's threads on accounting firm frauds are at
    http://faculty.trinity.edu/rjensen/fraud001.htm

    Bob Jensen's Fraud Updates are at
    http://faculty.trinity.edu/rjensen/FraudUpdates.htm

     


    Question
    What are the primary alleged causes for the rapid increase in revisions to financial statements in the past few years?

    June 14, 2006 message from Denny Beresford [DBeresfo@TERRY.UGA.EDU]

    An official in Washington DC sent me a note today saying that he is " interested in understanding the cause for the increased number of restatements. Can you recommend any good articles or research that explains the root causes, trends, etc?

    Can anyone suggest some good references to pass along?

    Denny Beresford

    June 14, 2006 reply from Ganesh M. Pandit, DBA, CPA, CMA [profgmp@HOTMAIL.COM]

    Perhaps this might help...Financial Restatements: Causes, Consequences, and Corrections By Erik Linn, CPA, and Kori Diehl, CPA, published in the September 2005 issue of Strategic Finance, Vol.87, Iss. 3; pg. 34, 6 pgs.

    Ganesh M. Pandit Adelphi University

    June 15, 2006 reply from Bob Jensen

    Evidence seems to be mounting that Section 404 of SOX is working in uncovering significant errors in past financial statements. This is to be expected in the early phases of 404 implementation. But the revisions should subside after 404 is properly rolling. Companies like Kodak found huge internal control weaknesses that led to reporting errors.

    One of the most popular annual study if restatements is free from the Huron Consulting Group.

    Free from the Huron Consulting Group (Registration Required) --- http://www.huronconsultinggroup.com/

    "Restatements Should Subside as 404, Lease Issues Subside" --- http://www.huronconsultinggroup.com/uploadedFiles/CW-Restatements-021406.pdf

    "2004 Annual Review of Financial Reporting Matters - Summary" --- Click Here
    (I could not yet find the 2005 update, which is understandable since 2005 annual reports were just recently published.)

    There also is an interesting 1999 paper entitled "Accounting Defects, Financial Statement Credibility, and Equity Valuation" by W. Bruce Johnson and D. Shores --- http://www.biz.uiowa.edu/acct/papers/workingpapers/99-01.pdf

    Bob Jensen

    Core Earnings

    Bob Jensen's Overview --- Go to  http://faculty.trinity.edu/rjensen//theory/00overview/CoreEarnings.htm 

    "Beyond The Balance Sheet Earnings Quality," by  Kurt Badanhausen, Jack Gage, Cecily Hall, Michael K. Ozanian, Forbes, January 28, 2005 --- http://www.forbes.com/home/business/2005/01/26/bbsearnings.html 

    It's not how much money a company is making that counts, it's how it makes its money. The earnings quality scores from RateFinancials aim to evaluate how closely reported earnings reflect the cash that the companies' businesses are generating and how well their balance sheets reflect their true economic position. Companies in the winners table have the best earnings quality (they are generating a lot of sustainable cash from their operations), while companies in the losers table have been boosting their reported earnings with such tricks as unexpensed stock options, low tax rates, asset sales, off-balance-sheet financing and deferred maintenance of the pension fund.

    Krispy kreme doughnuts is the latest illustration of the fact that stunning earnings growth can mask a lot of trouble. Not long ago the doughnut maker was a glamour stock with a 60% earnings-per-share growth rate and a multiple to match-70 times trailing earnings. Now the stock is at $9.61, down 72% from May, when the company first issued an earnings warning. Turns out Krispy Kreme may have leavened profits in the way it accounted for the purchase of franchised stores and by failing to book adequate reserves for doubtful accounts. So claims a shareholder lawsuit against the company. Krispy Kreme would not comment on the suit. 

    Investors are not auditors, they don't have subpoena power, and they can't know about such disasters in advance. But sometimes they can get hints that the quality of a company's earnings is a little shaky. In Krispy's case an indication that it was straining to deliver its growth story came three years ago in its use of synthetic leases to finance expansion. Forbes described these leases in a Feb. 18, 2002 story that did not please the company. Another straw in the wind: weak free cash flow from operations. You get that number by taking the "cash flow from operations" reported on the "consolidated statement of cash flows," then subtracting capital expenditures. Solid earners usually throw off lots of positive free cash flow. At Krispy the figure was negative.

     Is there a Krispy Kreme lurking in your portfolio? For this, the fifth installment in our Beyond the Balance Sheet series, we asked the experts at RateFinancials of New York City ( www.ratefinancials.com ) to look into earnings quality among the companies included in the S&P 500 Index. The tables at right display the outfits that RateFinancials puts at the top and at the bottom of the quality scale. The ratings are to a degree subjective and, not surprisingly, some of the companies at the bottom take exception. General Motors feels that RateFinancials understates its cash flow. But at minimum RateFinancials' work warns investors to look closely at the financial statements of the suspect companies. 

    A lot of factors went into the ratings produced by cofounders Victor Germack and Harold Paumgarten, research director Allan Young and ten analysts. A company that expenses stock options is probably not straining to meet earnings forecasts, so it gets a plus. Overoptimistic assumptions about future earnings on a pension fund artificially prop up earnings and thus rate a minus. A low tax rate is a potential indicator of trouble: Maybe the low profit reported to the Internal Revenue Service is all too true and the high profit reported to shareholders an exaggeration. Other factors relate to discontinued operations (booking a one-time gain from selling a business is bad), corporate governance (companies get black marks for having poison pills), inventory (if it piles up faster than sales, then business may be weakening) and free cash flow (a declining number is bad).

    Continued in this section of Forbes

    Included in Standard & Poor's definition of Core Earnings are 

    • employee stock options grant expenses, 
    • restructuring charges from on-going operations, 
    • write-downs of depreciable or amortizable operating assets, 
    • pensions costs 
    • purchased research and development. 

    Excluded from this definition are 

    • impairment of goodwill charges, 
    • gains or losses from asset sales, pension gains, 
    • unrealized gains or losses from hedging activities, merger and acquisition related fees
    • litigation settlements

     


    "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.

     


    The Quality of Earnings Controversy in Accounting Theory

    From The Wall Street Journal Weekly Accounting Review on April 13, 2007

    These Days, Detective Skills Are Key to Gauging a Stock
    by Herb Greenberg
    The Wall Street Journal

    Page: B3
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB117590470676662738.html?mod=djem_jiewr_ac
     

    TOPICS: Accounting, Disclosure, Disclosure Requirements, Earnings Quality, Financial Accounting, Sarbanes-Oxley Act

    SUMMARY: "When Circuit City Stores Inc. reported an unexpected fiscal fourth-quarter loss this past week, with its stock in the doldrums, Victor Germack felt vindicated. Last summer, when quite a few analysts were upgrading their ratings on the electronics retailer's stock, his research firm, RateFinancials, published a report blasting Circuit City for "very poor quality of earnings" and "poor accounting policies, footnotes and management discussion and analysis."" The concerns arose from a "preponderance of year-end lease terminations and the disproportional influence [on earnings from] the sales of extended warranties..." Circuit City's spokesman, Bill Cimino, cites other factors, such as a rapid decline in the price of flat-panel television sets, that impacted the results.

    QUESTIONS: 
    1.) What is the "quality" of a company's earnings?

    2.) What factors raised questions in some analysts' minds about the quality of Circuit City's earnings? List all that you find in the main article and in the related one, and explain the impact of the issue on the notion of "quality of earnings" or "quality of financial reporting."

    3.) Why did this question of quality of earnings not arise the minds of other analysts besides those of RateFinancials Inc.?

    4.) How does the corporate spokesperson address the question of the quality of Circuit City's earnings? How does his answer benefit Circuit City in its dealings with financial markets?
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Circuit City Highlights Doubts About Analysts
    by Steven D. Jones
    Sep 08, 2006
    Online Exclusive
     


    From The Wall Street Journal Accounting Educators' Review on May 27, 2004

    TITLE: J.C. Penney Profit Hurt by Eckerd 
    REPORTER: Kortney Stringer 
    DATE: May 19, 2004 
    PAGE: B4 
    LINK: http://online.wsj.com/article/0,,SB108488326393314408,00.html  
    TOPICS: Accounting, Earnings Quality, Financial Accounting, Financial Analysis, Financial Statement Analysis, Income from Continuing Operations, Net Income, Operating Income

    SUMMARY: Despite an earnings increase, J.C. Penney reported a 33% decline in net income. Questions focus on the components and usefulness of the income statement.

    QUESTIONS: 
    1.) Describe the primary purpose(s) of the income statement. Distinguish between the single-step and multi-step format for the income statement. Which type of statement is more common? Support your answer.

    2.) Explain the components of gross margin, operating income, income from continuing operations, net income, and comprehensive income. What is persistence? Which income statement total is likely to have the greatest persistence? Which income statement total is likely to have the least persistence?

    3.) Where are results from discontinued operations reported on the income statement? Why are results from discontinued operations separated from income from continuing operations?

    4.) What impact does the loss from the sale of Eckerd have on J.C. Penney's expected future net income? What impact does results from continuing operations have on expected future net income?

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


    From The Wall Street Journal Accounting Educators' Review on May 23, 2002

    TITLE: SEC Broadens Investigation Into Revenue-Boosting Tricks; Fearing Bogus Numbers Are Widespread, Agency Probes Lucent and Others 
    REPORTER: Susan Pulliam and Rebecca Blumenstein 
    DATE: May 16, 2002 
    PAGE: A1 
    LINK: http://online.wsj.com/article/0,,SB1021510491566948760.djm,00.html  
    TOPICS: Financial Accounting, Financial Statement Analysis

    SUMMARY: "Securities and Exchange Commission officials, concerned about an explosion of transactions that falsely created the impression of booming business across many industries, are conducting a sweeping investigation into a host of practices that pump up revenue."

    QUESTIONS: 
    1.) "Probing revenue promises to be a much broader inquiry than the earlier investigations of Enron and other companies accused of using accounting tricks to boost their profits." What is the difference between inflating profits vs. revenues?

    2.) What are the ways in which accounting information is used (both in general and in ways specifically cited in this article)? What are the concerns about using accounting information that has been manipulated to increase revenues? To increase profits?

    3.) Describe the specific techniques that may be used to inflate revenues that are enumerated in this article and the related one. Why would a practice of inflating revenues be of particular concern during the ".com boom"?

    4.) "[L90 Inc.] L90 lopped $8.3 million, or just over 10%, off revenue previously reported for 2000 and 2001, while booking the $250,000 [net difference in the amount of wire transfers that had been used in one of these transactions] as 'other income' rather than revenue." What is the difference between revenues and other income? Where might these items be found in a multi-step income statement? In a single-step income statement?

    5.) What are "vendor allowances"? How might these allowances be used to inflate revenues? Consider the case of Lucent Technologies described in the article. Might their techniques also have been used to boost profits?

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

    --- RELATED ARTICLES --- 
    TITLE: CMS Energy Admits Questionable Trades Inflated Its Volume 
    REPORTER: Chip Cummins and Jonathan Friedland 
    PAGE: A1 
    ISSUE: May 16, 2002 
    LINK: http://online.wsj.com/article/0,,SB1021494984503313400.djm,00.html 

    From The Wall Street Journal Accounting Educators' Review on May 27, 2004

    TITLE: SEC Gets Tough With Settlement in Lucent Case
    REPORTER: Deborah Solomon and Dennis K. Berman
    DATE: May 17, 2004
    PAGE: A1
    LINK: http://online.wsj.com/article/0,,SB108474447102812763,00.html 
    TOPICS: Criminal Procedure, Financial Accounting, Legal Liability, Revenue Recognition, Securities and Exchange Commission, Accounting

    SUMMARY: After a lengthy investigation into the accounting practices of Lucent Technologies Inc., the Securities and Exchange Commission is expected to file civil charges and impose a $25 million fine against the company. Questions focus on the role of the SEC in financial reporting.

    QUESTIONS:
    1.) What is the Securities and Exchange Commission (SEC)? When was the SEC established? Why was the SEC established? Does the SEC have the responsibility of establishing financial reporting guidelines?

    2.) What role does the SEC currently play in the financial reporting process? What power does the SEC have to sanction companies that violate financial reporting guidelines?

    3.) What is the difference between a civil and a criminal charge? What is the difference between a class-action suit by investors and a civil charge by the SEC?

    4.) What personal liability do individuals have for improper accounting? Why does the SEC object to companies indemnifying individuals for consequences associated with improper accounting?

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

    Bob Jensen's threads on revenue accounting are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 


    Question
    At this juncture why would IBM spend almost $10 billion for its own shares?

    Hint
    The wildly-popular eps ratio has a denomator.

    "IBM to spend $5 billion more on stock buyback," MIT's Technology Review, October 27, 2009 ---
    http://www.technologyreview.com/wire/23815/?nlid=2465

    IBM Corp. has boosted its stock buyback program by $5 billion, a sign of the company's ability to spit out cash despite the fact the recession has choked off revenue growth.

    The announcement Tuesday brings IBM's pot for stock repurchases to $9.2 billion, and the company, based in Armonk, N.Y., plans to ask for more at a board meeting in April 2010. IBM said it has spent $73 billion on dividends and buybacks since 2003.

    Buybacks are one lever companies pull to meet earnings targets, since they increase earnings per share by reducing the number of shares outstanding. IBM has set aggressive earnings targets, and twice this year raised its profit forecast for 2009, surprising investors since revenue has fallen since last year. IBM has said it sees corporate spending on technology "stabilizing." One way IBM wrings more profit despite lower sales is by using software to automate certain tasks done by humans and focusing on projects like the "smart" power grid that can carry higher profit margins than other services work.

    IBM's current forecasts call for earnings per share of at least $9.85 this year, and the company has maintained that it is "well ahead" of its pace for 2010 earnings of $10 to $11 per share.

    IBM ended the third quarter with $11.5 billion in cash. Free cash flow, a sign of a company's ability to generate more cash, was $3.4 billion, up $1.3 billion from a year ago. Revenue in the past nine months is down nearly 11 percent from a year ago.

    Quality of Earnings Disputes --- http://faculty.trinity.edu/rjensen/theory01.htm#CoreEarnings

    Return on Investment Controversies --- http://faculty.trinity.edu/rjensen/roi.htm

    Bob Jensen's threads on accounting theory --- http://faculty.trinity.edu/rjensen/theory01.htm

     


     


    Standard & Poor's News Release on May 14, 2002 --- http://www.standardandpoors.com/PressRoom/index.html 

    Standard & Poor's To Change System For Evaluating Corporate Earnings

    Widely-Supported "Core Earnings" Approach to be Applied to Earnings Analyses and Forecasts for US Indices, Company Data and Equity Research

    New York, May 14, 2002 -- Standard & Poor's today published a set of new definitions it will use for equity analysis to evaluate corporate operating earnings of publicly held companies in the United States. Release of "Measures of Corporate Earnings" completes a process Standard & Poor's began in August 2001 when the firm began discussions with securities and accounting analysts, portfolio managers, academic research groups and others to build a consensus for changes that will reduce investor frustration and confusion over growing differences in the reporting of corporate earnings. The text of "Measures of Corporate Earnings" may be found at www.standardandpoors.com/PressRoom/index.html

    At the center of Standard & Poor's effort to return transparency and consistency to corporate reporting is a focus on what it refers to as Core Earnings, or the after-tax earnings generated from a corporation's principal business or businesses. Since Standard & Poor's believes that there is a general understanding of what is included in As Reported Earnings, its definition of Core Earnings begins with As Reported and then makes a series of adjustments. As Reported Earnings are earnings as defined by Generally Accepted Accounting Principles (GAAP) which excludes two items - discontinued operations and extraordinary items, both as defined by GAAP.

    Included in Standard & Poor's definition of Core Earnings are employee stock options grant expenses, restructuring charges from on-going operations, write-downs of depreciable or amortizable operating assets, pensions costs and purchased research and development. Excluded from this definition are impairment of goodwill charges, gains or losses from asset sales, pension gains, unrealized gains or losses from hedging activities, merger and acquisition related fees and litigation settlements.

    "For over 140 years, Standard & Poor's has stood for the investor's right to know. Central to that objective is a clear, consistent, definition of a company's financial position," said Leo O'Neill, president of Standard & Poor's. "The increased use of so-called pro forma earnings and other measures to report corporate performance has generated controversy and confusion and has not served investor interests. Standard & Poor's Core Earnings definition will help build consensus and restore investor trust and confidence in the data used to make investment decisions."

    "A number of recent high profile bankruptcies have renewed investors' concerns about the reliability of corporate reporting," said David M. Blitzer, Standard & Poor's chief investment strategist. "From the work we have just completed, our hope is to generate additional public discussion on earnings measures. Once there are more generally accepted definitions, it will be much easier for analysts and investors to evaluate varying investment opinions and recommendations and form their own views of which companies are the most attractive."

    Beginning shortly, Standard & Poor's will include the components of its definition for Core Earnings in its COMPUSTAT database for the U.S., the leading source for corporate financial data. In addition, Core Earnings will be calculated and reported for Standard & Poor's U.S. equity indices, including the S&P 500. Finally, Standard & Poor's own equity research team, which provides opinions on over 1100 stocks, will adopt Core Earnings in its analyses.

    "Core Earnings is an excellent analytical tool for the individual and professional investor alike," said Kenneth Shea, managing director for global equity research at Standard & Poor's. "It allows investors to better evaluate and compare the underlying earnings power of the companies they are examining. In addition, it enhances an investor's ability to construct and maintain investment portfolios that will adhere to a pre-determined set of investment objectives. With Core Earnings, Standard & Poor's equity analysts will be able to provide our clients with even more insightful forecasts and buy, hold and sell recommendations."

    From the outset, Standard & Poor's has sought to achieve agreement surrounding broad earnings measures that address a company's potential for profitability. In addition to emphasizing this approach in its equity analysis, Standard & Poor's will also make Core Earnings a part of its credit ratings analysis. The accuracy of earnings and earnings trends has always been a component of credit analysis and Core Earnings adds value to this process. Earnings are also a major element in cash flow analysis and are therefore a part of Standard & Poor's debt rating methodology.

    Standard & Poor's, a division of The McGraw-Hill Companies (NYSE:MHP), provides independent financial information, analytical services, and credit ratings to the world's financial markets. Among the company's many products are the S&P Global 1200, the premier global equity performance benchmark, the S&P 500, the premier U.S. portfolio index, and credit ratings on more than 220,000 securities and funds worldwide. With more than 5,000 employees located in 18 countries, Standard & Poor's is an integral part of the global financial infrastructure. For more information, visit www.standardandpoors.com


    S&P Main Core Earnings Site (including a Flash Presentation) --- http://snipurl.com/SPCoreEarnings 

    Subtopics
              Standard & Poor's Core Earnings Data
              Latest Standard & Poor's Research
              Previous Standard & Poor's Research
              Press Releases
              Bios
              Media Coverage
              Standard & Poor's Core Earnings Data and Services

     


    S&P PowerPoint Show on Core Earnings

    http://faculty.trinity.edu/rjensen//theory/00overview/corePowerpoint.ppt 

    http://faculty.trinity.edu/rjensen//theory/00overview/corePowerpoint.htm 


    Other Related Core Earnings Files

    Bob Jensen's Overview --- http://faculty.trinity.edu/rjensen//theory/00overview/CoreEarnings.htm 

    Updates, including FAS 133 --- http://faculty.trinity.edu/rjensen//theory/00overview/CoreEarningsMisc.pdf 

    Pensions and Pension Interest --- http://faculty.trinity.edu/rjensen//theory/00overview/CoreEarningsPensions.pdf 


    Question:
    What ten companies have the most "inflated" measures of profit?

    Answer:
    "Shining A New Light on Earnings, BusinessWeek Editorial, June 21, 2002 --- http://www.standardandpoors.com/Forum/MarketAnalysis/coreEarnings/Articles/062102_coredata.html 

    How much does a company truly make? It's hard to tell these days. To boost the performance of their stocks, companies have come up with a slew of self-defined "pro forma" numbers that put their financials in a favorable light. Now ratings agency Standard & Poor's has devised a truer measure known as Core Earnings.

    The Goal: to provide a standardized definition of the profits produced by a company's ongiong operations. Of the three main changes from more traditional measures of profits two reduce earmings: Income from pension funds is excluded and the cost of stock options are deducted as an expense. The other big change boosts earnings by adding back in the charges taken to adjust for overpriced acquisitions. Here are the top 10 losers and winners under Core Earnings:


     


    Enhanced Business Reporting

    EY:  Pro forma financial information A guide for applying Article 11 of Regulation S-X (over 100 pages) ---
    http://www.ey.com/Publication/vwLUAssetsAL/ProForma_06549-171US_30November2017/$FILE/ProForma_06549-171US_30November2017.pdf


    I attended the following CPE Workshop at the AAA Meetings in Orlando

    CPE Session 3: Saturday, August 7, 1:00 PM – 4:00 PM 
    Value Measurement and Reporting—Moving toward Measuring and Reporting Value Creation Activities and Opportunities

    Presenters: William J. L. Swirsky, Canadian Institute of Chartered Accountants  
    Paul Herring, AICPA Director Business Reporting Assurance and Advisory Service 

    Description/Objectives: 
    Content – Presentations and dialogue about measuring the activities and opportunities that drive an entity’s value and, once measured, reporting these value creation prospects, in financial or nonfinancial terms, in addition to current financial information. The session will include information about research by the Value Measurement and Reporting Collaborative (VMRC) that will provide the foundation for the development of a framework of market-driven principles that characterize value measurement and reporting on a global basis.

    Objectives – To continue the dialogue on more transparent, consistent, and reliable reporting of an entity’s value; to provide participants with information about the research being undertaken by VMRC; to talk about disclosure; and to solicit feedback from the attendees about where they see gaps in the current practices on value measurement and reporting.

    Plan – To (1) provide context for value measurement and reporting; (2) describe research to date; and (3) describe reporting initiatives.

    The above workshop focused mainly upon the early stages of the Value Measurement and Reporting Collaborative that evolved into the Enhanced Business Reporting (EBR) Consortium)  for providing more structure, uniformity, and measurement of non-financial information reported to managers and other stakeholders --- http://www.aicpa.org/pubs/cpaltr/nov2002/supps/edu1.htm 
    This initiative that began in 2002 with hope that a collaboration between the AICPA, the Canadian CICA, leading consulting firms, and others could initiate a new business reporting model as follows:

    The Value Measurement and Reporting Collaborative, in which the AICPA is a participant, will play a crucial role in the new business reporting model. VMRC is a global effort of the accounting profession, along with corporate directors, businesses, business associations and organizations, institutional investors, investment analysts, software companies and academics. The key purpose of the collaborative is to help boards of directors and senior management make better strategic decisions using value measurement and reporting. It is anticipated that the current financial reporting model would, over time, migrate to this new model and would be used to communicate a more complete picture to stakeholders.

    Also see Grant Thornton's summary in 2004
    Grant Thornton in the US has posted a new publication of Directors Monthly, which focuses on "Business Reporting: New Initiative Will Guide Voluntary Enhancements." The publication discusses how non-financial information offers a better picture of corporate financial health. 
    Double Entries, September 9, 2004 --- http://accountingeducation.com/news/news5395.html 

    For years researchers and businesses have been attempting to find a better way to report on business performance beyond the traditional financial reporting effort.  Bob Jensen even wrote a 1976 book called Phantasmagoric Accounting --- See Volume 14 at http://accounting.rutgers.edu/raw/aaa/market/studar.htm 

    Studies of reporting on non-financial business performance over the past 50 years have generally been disappointing.  Numbers attached to such things as cost of pollution and value of human capital were generally derived from overly-simplified models that really did not deal with externalities, interaction effects, non-stationarity, and important missing variables.  There is an immense need, especially by managers and lawmakers, for better business reporting that will help making tradeoffs between stakeholders.  At the Orlando workshop mentioned above, we heard a great deal about the need for a new business reporting model.  But when the presenters got down to what had been accomplished to date, I felt like the presentations lacked scholarship, especially in terms of the history of research on this topic over the past 50 years.  What was presented as "new" really had been hashed over many times in the past.  I left the Enhanced Business Reporting Consortium workshop feeling that this initiative is long on hype and short on hope.

    But I do not want to give the impression that the EBR initiative is not important.  Little is gained by the traditional accounting research tradition, especially in academe, of ignoring huge and seemingly intractable problems that seem to defy all known research methodologies.  High on the list of intractable problems are problems of measuring intangibles and human/environmental performance.  If nothing else, the Value Measurement and Reporting Collaborative will help to keep researchers focused on the bigger problems rather than less relevant minutiae.  At a minimum some progress may be made toward standardization of non-financial reporting.  

    You can track the progress of the Enhanced Business Reporting Consortium  at http://www.ebrconsortium.org/ 


    Economic Theory of Accounting
    Including Game Theory

    Prisoner's Dilemma (Game Theory) --- http://en.wikipedia.org/wiki/Prisoner%27s_dilemma

    "They Finally Tested The 'Prisoner's Dilemma' On Actual Prisoners — And The Results Were Not What You Would Expect ," by by Max Nissan, Business Insider, July 21, 2013 ---
    http://www.businessinsider.com/prisoners-dilemma-in-real-life-2013-7

    The "prisoner's dilemma" is a familiar concept to just about everyone who took Econ 101.

    The basic version goes like this: Two criminals are arrested, but police can't convict either on the primary charge, so they plan to sentence them to a year in jail on a lesser charge. Each of the prisoners, who can't communicate with each other, are given the option of testifying against their partner. If they testify, and their partner remains silent, the partner gets three years and they go free. If they both testify, both get two. If both remain silent, they each get one.

    In game theory, betraying your partner, or "defecting" is always the dominant strategy as it always has a slightly higher payoff in a simultaneous game. It's what's known as a "Nash Equilibrium," after Nobel Prize winning mathematician and "A Beautiful Mind" subject John Nash.

     In sequential games, where players know each other's previous behavior and have the opportunity to punish each other, defection is the dominant strategy as well. 

    However, on an overall basis, the best outcome for both players is mutual cooperation.

    Yet no one's ever actually run the experiment on real prisoners before, until two University of Hamburg economists tried it out in a recent study comparing the behavior of inmates and students. 

    Surprisingly, for the classic version of the game, prisoners were far more cooperative  than expected.

    Menusch Khadjavi and Andreas Lange put the famous game to the test for the first time ever, putting a group of prisoners in Lower Saxony's primary women's prison, as well as students, through both simultaneous and sequential versions of the game. 

    The payoffs obviously weren't years off sentences, but euros for students, and the equivalent value in coffee or cigarettes for prisoners. 

    They expected, building off of game theory and behavioral economic research that show humans are more cooperative than the purely rational model that economists traditionally use, that there would be a fair amount of first-mover cooperation, even in the simultaneous simulation where there's no way to react to the other player's decisions. 

    And even in the sequential game, where you get a higher payoff for betraying a cooperative first mover, a fair amount will still reciprocate. 

    As for the difference between student and prisoner behavior, you'd expect that a prison population might be more jaded and distrustful, and therefore more likely to defect. 

    The results went exactly the other way for the simultaneous game, only 37% of students cooperate. Inmates cooperated 56% of the time.

    On a pair basis, only 13% of student pairs managed to get the best mutual outcome and cooperate, whereas 30% of prisoners do. 

    In the sequential game, far more students (63%) cooperate, so the mutual cooperation rate skyrockets to 39%. For prisoners, it remains about the same.

    Continued in article

    Jensen Comment
    In real life there's a huge difference between a sentence of life without parole and three or more years in prison where the prisoner will be set free soon enough to extract revenge on a song bird. Thus in real life the revenge risk must be factored into the payoff. The risk may come from the person serving the longest sentence or from a gang waiting for song birds to be set free.

     

    "Game Theory Versus Practice:  More companies are using game theory to aid decision-making. How well does it work in the real world?" by Alan Rappeport, CFO Magazine, July 15, 2008 --- http://www.cfo.com/article.cfm/11700044?f=search

    When Microsoft announced its intention to acquire Yahoo last February, the software giant knew the struggling search firm would not come easily into the fold. But Microsoft had anticipated the eventual minuet of offer and counteroffer five months before its announcement, thanks to the powers of game theory.

    A mathematical method of analyzing game-playing strategies, game theory is catching on with corporate planners, enabling them to test their moves against the possible responses of their competitors. Its origins trace as far back as The Art of War, the unlikely management best-seller penned 2,500 years ago by the Chinese general Sun Tzu. Mathematicians John von Neumann and Oskar Morgenstern adapted the method for economics in the 1940s, and game theory entered the academic mainstream in the 1970s, when economists like Thomas Schelling and Robert Aumann used it to study adverse selection and problems of asymmetric information. (Schelling and Aumann won Nobel prizes in 2005 for their work.)

    Game theory can take many forms, but most companies use a simplified version that focuses executives on the mind-set of the competition. "The formal stuff quickly becomes very technical and less useful," says Louis Thomas, a professor at the Wharton School of Business who teaches game theory. "It's a matter of peeling it back to its bare essentials." One popular way to teach the theory hinges on a situation called the "prisoner's dilemma," where the fate of two detainees depends on whether each snitches or stays silent about an alleged crime (see "To Squeal or Not to Squeal?" at the end of this article).

    Many companies are reluctant to talk about the specifics of how they use game theory, or even to admit whether they use it at all. But oil giant Chevron makes no bones about it. "Game theory is our secret strategic weapon," says Frank Koch, a Chevron decision analyst. Koch has publicly discussed Chevron's use of game theory to predict how foreign governments and competitors will react when the company embarks on international projects. "It reveals the win-win and gives you the ability to more easily play out where things might lead," he says.

    Enter the Matrix Microsoft's interest in game theory was piqued by the disclosure that IBM was using the method to better understand the motivations of its competitors — including Microsoft — when Linux, the open-source computer operating system, began to catch on. (Consultants note that companies often bone up on game theory when they find out that competitors are already using it.)

    For its Yahoo bid, Microsoft hired Open Options, a consultancy, to model the merger and plot a possible course for the transaction. Yahoo's trepidation became clear from the outset. "We knew that they would not be particularly interested in the acquisition," says Ken Headrick, product and marketing director of Microsoft's Canadian online division, MSN. And, indeed, they weren't; the bid ultimately failed and a subsequent partial acquisition offer was abandoned in June.

    Open Options wouldn't disclose specifics of its work for Microsoft, but in client workshops it asks attendees to answer detailed questions about their goals for a project — for example, "Should we enter this market?" "Will we need to eat costs to establish market share?" "Will a price war ensue?" Then, assumptions about the motives of other players, such as competitors and government regulators, are ranked and different scenarios developed. The goals of all players are given numerical values and charted on a matrix. The exercise is intended to show that there are more outcomes to a situation than most minds can comprehend, and to get managers thinking about competition and customers differently.

    "If you have four or five players, with four actions each might or might not take, that could lead to a million outcomes," comments Tom Mitchell, CEO of Open Options. "And that's a simple situation." To simplify complex playing fields, Open Options uses algorithms to model what action a company should take — considering the likely actions of others — to attain its goals. The result replicates the so-called Nash equilibrium, first proposed by John Forbes Nash, the Nobel prize–winning mathematician portrayed in the movie A Beautiful Mind. In this optimal state, the theory goes, a player no longer has an incentive to change his position.

    As a tool, game theory can be useful in many areas of finance, particularly when decisions require both economic and strategic considerations. "CFOs welcome this because it takes into account financial inputs and blends them with nonfinancial inputs," says Mitchell.

    Rational to a Fault? Some experts, however, question game theory's usefulness in the real world. They say the theory is at odds with human nature, because it assumes that all participants in a game will behave rationally. But as research in behavioral finance and economics has shown, common psychological biases can easily produce irrational decisions.

    Similarly, John Horn, a consultant at McKinsey, argues that game theory gives people too much credit. "Game theory assumes rationally maximizing competitors, who understand everything that you're doing and what they can do," says Horn. "That's not how people actually behave." (Activist investor Carl Icahn said Yahoo's board "acted irrationally" in rejecting Microsoft's bid.) McKinsey's latest survey on competitive behavior found that companies tend to neglect upcoming moves by competitors, relying passively on sources such as the news and annual reports. And when they learn of new threats, they tend to react in the most obvious way, focusing on near-term metrics such as earnings and market share.

    Continued in article


    "What use is game theory?" by Steve Hsu, Information Processing, May 4, 2011 ---
    http://infoproc.blogspot.com/2011/05/what-use-is-game-theory.html

    Fantastic interview with game theorist Ariel Rubinstein on Econtalk. I agree with Rubinstein that game theory has little predictive power in the real world, despite the pretty mathematics. Experiments at RAND (see, e.g., Mirowski's Machine Dreams) showed early game theorists, including Nash, that people don't conform to the idealizations in their models. But this wasn't emphasized (Mirowski would claim it was deliberately hushed up) until more and more experiments showed similar results. (Who woulda thought -- people are "irrational"! :-)

    Perhaps the most useful thing about game theory is that it requires you to think carefully about decision problems. The discipline of this kind of analysis is valuable, even if the models have limited applicability to real situations.

    Rubinstein discusses a number of topics, including raw intelligence vs psychological insight and its importance in economics
    (see also here). He has, in my opinion, a very developed and mature view of what social scientists actually do, as opposed to what they claim to do.

    Continued in article

    Bob Jensen's threads on analytics can be found at
    http://faculty.trinity.edu/rjensen/TheoryTAR.htm#Analytics


    "Do Commodities Speculators Make Things Cost More?" by Justin Fox, Harvard Business Review Blog, July 22, 2013 --- Click Here
    http://blogs.hbr.org/fox/2013/07/do-commodities-speculators-mak.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+harvardbusiness+%28HBR.org%29&cm_ite=DailyAlert-072313+%281%29&cm_lm=sp%3Arjensen%40trinity.edu&cm_ven=Spop-Email 

    Commodities trading, Adam Smith wrote in 1776, was a boon to efficiency and a foe to famine. It was also extremely unpopular, especially in years when harvests were poor (he was writing specifically of trading in corn).
    The popular odium ... which attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter into it; and millers, bakers, mealmen, and meal factors, together with a number of wretched hucksters, are almost the only middle people that ... come between the grower and the consumer.

    Since then, trading in corn and other commodities has gained in respectability — thanks in part to arguments and evidence mustered by economists following in Smith's footsteps. But the suspicion that commodities trading is dominated by wretched hucksters or worse (I don't know what "mealmen" are, but they sure sound bad) has never gone away, with David Kocieniewski's epic examination in Sunday's New York Times of an aluminum storage business owned by Goldman Sachs offering the latest bit of evidence. Kocieniewski describes forklift drivers moving aluminum from warehouse to warehouse in Detroit to profit from rules set by an overseas metals exchange, while delivery times to actual users of aluminum have stretched to 16 months and aluminum prices have been pushed up by the equivalent of a tenth of a U.S. cent per aluminum can.

    The article is less clear about what brought this on. Is it bad rules set by the London Metal Exchange? The involvement of banks such as Goldman and J.P. Morgan in the metals trade? Or is the problem simply that speculators have taken over the market for a crucial commodity?

    It is certainly true that investors, dismayed at the prospect of low returns for stocks and bonds for years to come, have poured money into commodities over the past decade. Markets that existed mainly for the convenience of industry have become dominated by exchange-traded funds, hedge funds, and investment banks.

    By Adam Smith's reasoning, this shouldn't be a bad thing — people of character, or at least fortune, are getting into the trade. And the consensus among economists has for decades been that commodity speculation clearly serves a useful purpose — so more of it can't hurt, right?

    The evidence on this is, frustratingly, not nearly as conclusive as one might hope. The most famous studies have had to do with trading in onion futures, which the Chicago Mercantile Exchange launched in the 1940s and Congress banned in 1958 after a precipitous boom and bust. Agricultural economist Holbrook Working proposed at the time that this presented the opportunity for a natural experiment: if onion prices were more volatile in the absence of futures trading, then the trading probably served a useful economic purpose. If not, then maybe it didn't. The first post-ban study, published in 1963, did indeed find such an effect, and has since been cited widely by economists and editorialists. A 1973 followup, however, was inconclusive.

    When economist David S. Jacks of Simon Fraser University reviewed this evidence a few years ago along with before-and-after data from when futures trading in various commodities started, he still concluded that "futures markets are systematically associated with lower levels of commodity price volatility." So, on balance, having a futures market appears better than not having a futures market.

    What this doesn't tell us, however, is whether certain kinds of commodity futures and spot markets are better than others, or certain kinds of traders are better than others. There's at least some evidence from the great commodities boom of the past decade that the new dominance of financial investors has made a difference, and not necessarily for the better. Three recent research findings:

       
    • Marco J. Lombardi of the European Central Bank and Ine van Robays of Ghent University found that "financial investors did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time."
       
    • Lucia Juvenal and Ivan Petrella of the St. Louis Fed found that speculative forces began to drive oil prices in 2004, "which is when significant investment started to flow into commodity markets."
       
    • Ke Tang of Renmin University of China and Wei Xiong of Princeton University found that prices in non-energy commodities have begun to move in tandem with oil prices, and have become more volatile.
       

    None of these studies blamed speculation for causing all or even most of the price movements. It seems pretty clear that the big rise in oil prices since 2003 has been driven by fundamental forces of supply and demand. But the new commodities market participants may have made things worse, as Kocieniewski's aluminum findings seem to show.

    So what's the solution? I'm guessing it has something to do with adjusting the rules of the game. Commodities-trading rules and customs that date back to the pre-financial era may not fit the more aggressive tactics of hedge funds and investment banks. The London Metals Exchange is already in the midst of changing its warehousing rules, with hard-to-foresee consequences. The Commodity Futures Trading Commission has started using new powers granted it under the Dodd-Frank Act to go after traders whose behavior it deems abusive. And in general, we're in the early stages of a long struggle to put the financial sector back in the position of servant of the economy rather than its master.

    Speculation is, on balance, a good thing. But more of it isn't necessarily always better — and it's too important to leave entirely in the hands of the wretched hucksters.

     

     


    Financial Statements Are Still Valuable Tools for Predicting Bankruptcy
    Despite growing public skepticism over how useful financial statements are in providing information to investors, researchers at Stanford’s Graduate School of Business have found that the value of financial ratios for predicting bankruptcy has not declined significantly over time. Professors Maureen McNichols and William Beaver and graduate student Jung-Wu Rhie have reexamined the usefulness for predicting bankruptcy of financial ratios such as return on assets (net income divided by total assets), cash flow to total liabilities (earnings before interest, depreciation, and taxes divided by both short- and long-term debt), and leverage (total liabilities to total assets). The study explored how three forces have influenced this predictive value over the past 40 years.
    "Financial Statements Are Still Valuable Tools for Predicting Bankruptcy," Stanford Graduate School of Business Newsletter, November 2005 --- http://www.gsb.stanford.edu/news/research/acctg_mcnichols-beaver_bankruptcy.shtml

    "Financial Statements Still Significant In Predicting Bankruptcy," AccountingWeb, May 17, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102159

    Researchers have found that financial ratios are still valuable tools in predicting bankruptcy. The significance of financial ratios found in statements was explored in a study examining their predictive value over the last four decades, according to the Stanford Graduate School of Business (GSB).

    The GSB reported that the premise of the study was motivated by regulatory organizations, such as the Financial Accounting Standards Board and the Securities and Exchange Commission, seeking to increase the usefulness of information found in financial statements.

    The study, completed by Professors Maureen McNichols and William Beaver, with graduate student Jung-Wu Rhie, reexamined the use of financial ratios such as cash flow to total liabilities (earnings before interest, depreciation, and taxes divided by short-term debt plus long-term debt), return on assets (net income divided by total assets), leverage (total liabilities compared to total assets), according to the GSB.

    McNichols is the Marriner S. Eccles Professor of Public and Private Management at the GSB. Beaver is the Joan E. Horngren Professor of Accounting there.

    McNichols told the GSB, “One prediction is that if standard-setters are successful at incorporating additional information about fair values into financial statements, then we might expect their predictive ability for bankruptcy to increase.”

    On the other hand, traditional accounting standards may capture only a portion of current companies’ scope of activities. Also, financial statements may be seen as more “managed” than from other times in the past, according to the GSB.

    “If we look back in the 1960s, intangible assets -– as represented by investments in brands, research and development and technology -– were much less pervasive than they are today. These kinds of transactions are not well captured by our current accounting model,” Professor McNichols told the GSB. Concerning the “management” of financial statements, McNichols said, “Certainly, there is much more documentation of earnings management today than we’ve seen historically.”

    McNichols went on to say that any shift in the economic activities of companies might also offset any improvements in standards and informativeness of financial statements made by regulatory standard-setters, according to the GSB.

    In study results released in March 2005, financial statements were found to be highly significant in predicting bankruptcy over the two periods of the study, according to the GSB. Period 1 was 1962 to 1993 and Period 2 was 1994 to 2002. There was a decline in predictive ability from Period 1 to Period 2, although it was not statistically significant. Companies’ “hazard rate”, reflecting their risk of going bankrupt and using the three ratios, predicted higher risk in the year before bankruptcy, as well as other years before their insolvency. Beaver said, “In fact, we see differences in the ratios of bankrupt and nonbankrupt firms up to five years prior to bankruptcy.”

    The researchers then shifted their predictors toward more market-based values. These were cumulative stock returns over a year; the market capitalization of the firm (or common stock price per share, times the common shares outstanding); and the variability of stock returns. The use of these values was very predictive as well, according to the GSB.

    Predictability actually increased over time. Ninety-two percent of bankrupt companies were in the highest three deciles of Period 1 hazard rates and 93 percent for Period 2. The slight rise was attributed to market prices reflecting broader information, in addition to the information found in financial statements. The GSB reported that the incremental significance of non-financial statement information is reflected in the resulting difference between the two time periods.

    The researchers then merged the financial-ratio and market-based models into a hybrid model. Their results improved, coming up with a 96 percent chance of predicting bankruptcy for Period 1 and 93 percent over Period 2. This seems to show that market prices may compensate for even slight decreases in the predictivity of financial ratios. These results further indicate that the market draws upon additional information not available in financial ratios.

    McNichols told the GSB, “But it’s comforting to know that the behavior of the combined model, over time, is so stable.” The stability of their combined model suggests that bankruptcy can be predicted reliably in capital markets and this ability has not been eroded by changes in reporting.

    Dr. Edward Altman, Ph.D., developed his Z-score formula for predicting bankruptcy in 1968, according to Value Based Management. It consists of three different models, each for specific business organizations, including public manufacturers, private manufacturers and private general firms.

    The American Bankruptcy Institute collects and publishes metrics on bankruptcies. Review their listing of annual business and non-business filings by state (2000-2005) breaks down total bankruptcies into business and non-business numbers, as well as consumer bankruptcies as a percentage of the non-business metrics.

     


    October 30, 2002 message from JerryFeltham [gerald.feltham@commerce.ubc.ca

    Peter Christensen and I are pleased to announce that the first of two volumes on the fundamentals of the economic analysis of accounting has been published by Kluwer. This two volume series is based on two analytical Ph.D. seminars I have taught for several years, and is designed to provide efficient coverage of key information economic models and results that are pertinent to accounting research.

    The first volume is entitled:  Economics of Accounting: Volume I - Information in Markets.

    The attached file provides the table of contents of this volume, plus the preface - which gives a brief overview of the two volumes. The second volume is

    Economics of Accounting: Volume II - Performance Evaluation.

    We expect to complete it in the next few months.

    The two volumes can be used to provide the foundation for Ph.D. courses on information economic research in accounting. Furthermore, it is our hope that analytical researchers, as well as empiricists and experimentalists who use information economic analysis to motivate their hypotheses, will find our book to be a useful reference.

    We plan to maintain a website for the book. It will primarily be used to provide some problems Peter and I have developed in teaching courses based on the two books. In addition, the website will include any errata. The website address is:

    http://people.commerce.ubc.ca/faculty/feltham/economicsofaccounting.html 

    Also attached is a flyer from our publisher Kluwer. It announces a 25% discount in the price if the book is purchased prior to December 31.

    The publisher has also informed us that: "If students buy the book through your university bookstore (6 or more copies) they will receive an adoption price of $79.95 US."

    Information regarding discounts on this book for course use and bulk purchases can be obtained by sending an e-mail message to kluwer@wkap.com  (their customer service department).

    Jerry Feltham 
    Faculty of Commerce 
    University of British Columbia 
    2053 Main Mall 
    Vancouver, Canada V6T 1Z2 
    Tel. 604-822-8397 Fax 604-822-9470
    jerry.feltham@commerce.ubc.ca 


    That Placebo Effect in Research: Dan Ariely on Tennis Shoes and Toilet Paper
    Dan Ariely is James B. Duke Professor of Behavioral Economics at Duke University and is head of the eRationality research group at the
    MIT Media Lab.
    Dan Ariely --- http://en.wikipedia.org/wiki/Dan_Ariely

    Published works

     

    "The Science Behind Exercise Footwear," MIT's Technology Review, January 5, 2010 ---
    http://www.technologyreview.com/blog/post.aspx?bid=355&bpid=24614&nlid=2647

    A few weeks ago Reebok unveiled a walking shoe purported to tone muscles to a greater extent than your average sneaker. All you had to do was slip on a pair of EasyTone and the rest would take care of itself.

    Exercise without exercise? Great!

    Considering the abracadabra-like quality of the shoe, it’s no surprise that it’s been selling like hotcakes. The question of course is “ does it work”?

    According to a recent New York Times article on the topic Reebok has accumulated “15,000 hours’ worth of wear-test data from shoe users who say they notice the difference.” (The company also quotes a study as support, but it’s one they commissioned themselves and only carries a sample size of five.) The two women quoted in the article further echo this sentiment.

    Reebok’s head of advanced innovation (and EasyTone mastermind), Bill McInnis, says the shoe works because it offers the kind of imbalance that you get with stability balls at the gym. Unlike other sneakers, which are made flat with comfort in mind, the EasyTone is purposely outfitted with air-filled toe-and-heal “balance pods” in order to simulate the muscle engagement required to walk through sand. With every step, air shifts from one pod to the other, causing the person’s foot to sink and forcing their leg and backside muscles into a workout.

    But as the Times article proposes at the end (without explicitly using the term), the shoe’s success could instead come from the placebo effect. Thanks to Reebok’s marketing efforts, buyers pick up the shoes already convinced of their success, a mind frame that may then cause them to walk faster or harder or longer, thereby producing the expected workout – just not for the expected reason.

    And there are some reasons to suspect this kind of placebo effect: In a paper by Alia Crum and Ellen Langer. Titled “Mind-Set Matters: Exercise and the Placebo Effect.” In their research they told some maids working in hotels that the work they do (cleaning hotel rooms) is good exercise and satisfies the Surgeon General’s recommendations for an active lifestyle. Other maids were not given this information. 4 weeks later, the informed group perceived themselves to be getting significantly more exercise than before, their weight was lower and they even showed a decrease in blood pressure, body fat, waist-to-hip ratio, and body mass index.

    So, maybe exercise affects health are part placebo?

    Irrationally Yours

    Dan

     

    A One-Hour Video on What it Means to Be Predictably Irrational (July 25, 2008) --- http://financialrounds.blogspot.com/
    The video is also at http://www.youtube.com/watch?v=VZv--sm9XXU
    This is quite interesting!

    From the Financial Rounds Blog on January 25, 2008 --- http://financialrounds.blogspot.com/

    "Dan Ariely (Duke University) - Predictably Irrational

    Here's a video of Dan Ariely (author of "Predictably Irrational") in his recent talk for the Google Authors program. Ariely has written a fascinating book about some of the cognitive and behavioral biases that most of us exhibit. If you listen carefully, you'll find that he even gives a hint about how to increase your student evaluations --- http://financialrounds.blogspot.com/

     

    Summary of what it means to be "predictably irrational" --- http://en.wikipedia.org/wiki/Predictably_Irrational

    New York Times Book Review
    "Emonomics," by David Berreby, The New York Times, March 16, 2008 ---
    http://www.nytimes.com/2008/03/16/books/review/Berreby-t.html?_r=1&oref=slogin

    For years, the ideology of free markets bestrode the world, bending politics as well as economics to its core assumption: market forces produce the best solution to any problem. But these days, even Bill Gates says capitalism’s work is “unsatisfactory” for one-third of humanity, and not even Hillary Clinton supports Bill Clinton’s 1990s trade pacts.

    Another sign that times are changing is “Predictably Irrational,” a book that both exemplifies and explains this shift in the cultural winds. Here, Dan Ariely, an economist at M.I.T., tells us that “life with fewer market norms and more social norms would be more satisfying, creative, fulfilling and fun.” By the way, the conference where he had this insight wasn’t sponsored by the Federal Reserve, where he is a researcher. It came to him at Burning Man, the annual anarchist conclave where clothes are optional and money is banned. Ariely calls it “the most accepting, social and caring place I had ever been.”

    Obviously, this sly and lucid book is not about your grandfather’s dismal science. Ariely’s trade is behavioral economics, which is the study, by experiments, of what people actually do when they buy, sell, change jobs, marry and make other real-life decisions.

    To see how arousal alters sexual attitudes, for example, Ariely and his colleagues asked young men to answer a questionnaire — then asked them to answer it again, only this time while indulging in Internet pornography on a laptop wrapped in Saran Wrap. (In that state, their answers to questions about sexual tastes,, violence and condom use were far less respectable.) To study the power of suggestion, Ariely’s team zapped volunteers with a little painful electricity, then offered fake pain pills costing either 10 cents or $2.50 (all reduced the pain, but the more expensive ones had a far greater effect). To see how social situations affect honesty, they created tests that made it easy to cheat, then looked at what happened if they reminded people right before the test of a moral rule. (It turned out that being reminded of any moral code — the Ten Commandments, the non-existent “M.I.T. honor system” — caused cheating to plummet.)

    These sorts of rigorous but goofy-sounding experiments lend themselves to a genial, gee-whiz style, with which Ariely moves comfortably from the lab to broad social questions to his own life (why did he buy that Audi instead of a sensible minivan?). He is good-tempered company — if he mentions you in this book, you are going to be called “brilliant,” “fantastic” or “delightful” — and crystal clear about all he describes. But “Predictably Irrational” is a far more revolutionary book than its unthreatening manner lets on. It’s a concise summary of why today’s social science increasingly treats the markets-know-best model as a fairy tale.

    At the heart of the market approach to understanding people is a set of assumptions. First, you are a coherent and unitary self. Second, you can be sure of what this self of yours wants and needs, and can predict what it will do. Third, you get some information about yourself from your body — objective facts about hunger, thirst, pain and pleasure that help guide your decisions. Standard economics, as Ariely writes, assumes that all of us, equipped with this sort of self, “know all the pertinent information about our decisions” and “we can calculate the value of the different options we face.” We are, for important decisions, rational, and that’s what makes markets so effective at finding value and allocating work. To borrow from H. L. Mencken, the market approach presumes that “the common people know what they want, and deserve to get it good and hard.”

    What the past few decades of work in psychology, sociology and economics has shown, as Ariely describes, is that all three of these assumptions are false. Yes, you have a rational self, but it’s not your only one, nor is it often in charge. A more accurate picture is that there are a bunch of different versions of you, who come to the fore under different conditions. We aren’t cool calculators of self-interest who sometimes go crazy; we’re crazies who are, under special circumstances, sometimes rational.

    Ariely is not out to overthrow rationality. Instead, he and his fellow social scientists want to replace the “rational economic man” model with one that more accurately describes the real laws that drive human choices. In a chapter on “relativity,” for example, Ariely writes that evaluating two houses side by side yields different results than evaluating three — A, B and a somewhat less appealing version of A. The subpar A makes it easier to decide that A is better — not only better than the similar one, but better than B. The lesser version of A should have no effect on your rating of the other two buildings, but it does. Similarly, he describes the “zero price effect,” which marketers exploit to convince us to buy something we don’t really want or need in order to collect a “free” gift. “FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is,” Ariely writes. None of this is rational, but it is predictable.

    What the reasoning self should do, he says, is set up guardrails to manage things during those many, many moments when reason is not in charge. (Though one might ask why the reasoning self should always be in charge, an assumption Ariely doesn’t examine too closely.)

    For example, Ariely writes, we know our irrational self falls easily into wanting stuff we can’t afford and don’t need. So he proposes a credit card that encourages planning and self-control. After $50 is spent on chocolate this month — pfft, declined! He has in fact suggested this to a major bank. Of course, he knew that his idea would cut into the $17 billion a year that American banks make on consumer credit-card interest, but what the heck: money isn’t everything.

     

    An Experiment With Toilet Paper and Other Messages --- http://www.predictablyirrational.com/

    Other videos on being Predictably Irrational

    "The enduring impact of transient emotions on decision making," by Eduardo B. Andrade and Dan Ariely, Organizational Behavior and Human Decision Processes 109 (2009) 1–8 --- http://www.haas.berkeley.edu/faculty/papers/AndradeAriely2009.pdf

    People often do not realize they are being influenced by an incidental emotional state. As a result, decisions based on a fleeting incidental emotion can become the basis for future decisions and hence outlive the original cause for the behavior (i.e., the emotion itself). Using a sequence of ultimatum and dictator games, we provide empirical evidence for the enduring impact of transient emotions on economic decision making. Behavioral consistency and false consensus are presented as potential underlying processes.

     

    Great Minds in Management:  The Process of Theory Development --- http://faculty.trinity.edu/rjensen//theory/00overview/GreatMinds.htm

     


    Question
    What's "institutional structure?"
    What's the theory entwined in the works of the three 2007 recipients of the Nobel Prize in Economics?

    Hint:
    Nobel Prizes --- http://en.wikipedia.org/wiki/Nobel_Prize
    Nobel Prizes in Economics tend to go to mathematicians and/or conservative market theorists.
    Nobel Peace Prices tend to reflect liberal political biases, perhaps even not-so-hidden Nobel agendas.
    Nobel Prizes for accounting and mathematics are nonexistent, probably since both disciplines are built upon assumptions rather than reality. Actually this is also true for economics, although somehow an exception was made for this branch of astrology.

    "A Market Nobel," by Peter Boettke, The Wall Street Journal, October 16, 2007; Page A21 ---
    http://online.wsj.com/article/SB119249811353060179.html?mod=todays_us_opinion

    Yesterday Leonid Hurwicz, Eric Maskin and Roger Myerson won the Nobel Prize in Economic Science for their pioneering work in the field of "mechanism design." Strangely, some have used this occasion to disparage free-market economics. But the truth is the deserving recipients owe a direct debt to free-market thinkers who came before them.

    Mechanism design is an area of economic research that focuses on how institutional structures can be manipulated by changing the rules of the game in order to produce socially optimal results. The best intentions for the public good will go astray if the institutional arrangements are not consistent with the self-interest of decision makers.

    Mr. Myerson's work on how to design auctions to elicit information about the value of the good being auctioned -- and how to maximize the revenue extracted from the auction -- has informed numerous privatizations of publicly owned assets over the past quarter-century. Mr. Maskin also contributed to auction theory, and applied the idea of mechanism design to assess political institutions such as voting systems.

    Mechanism design theory was established to try to address the main challenge posed by Ludwig von Mises and F.A. Hayek. It all starts with Mr. Hurwicz's response to Hayek's famous paper, "The Use of Knowledge in Society." In the 1930s and '40s, Hayek was embroiled in the "socialist calculation debate." Mises, Hayek's mentor in Vienna, had raised the challenge in his book "Socialism," and before that in an article, that without having the means of production in private hands, the economic system will not create the incentives or the information to properly decide between the alternative uses of scarce resources. Without the production process of the market economy, socially desirable outcomes will be impossible to achieve.

    In the mid-1930s, Hayek published Mises's essay in English in his book, "Collectivist Economic Planning." From there the discussion moved to the U.K. and the U.S. Hayek summarized the fundamental challenge that advocates of socialism needed to come to grips with. Hayek's argument, a refinement of Mises, basically stated that the economic problem society faced was not how to allocate given resources, but rather how to mobilize and utilize the knowledge dispersed throughout the economy.

    Hayek argued that mathematical modeling, which relied on a set of given assumptions, had obscured the fundamental problem. These questions were not being probed since they were assumed away in the mathematical models of market socialism presented by Oskar Lange and, later, Abba Lerner. Milton Friedman, when he reviewed Lerner's "Economics of Control," stated that it was as if economic analysis of policy was being conducted in a vacuum. Lange actually argued that questions of bureaucratic incentives did not belong in economics and were best left to other disciplines such as psychology and sociology.

    Leonid Hurwicz, in his classic papers "On the Concept and Possibility of Informational Decentralization" (1969), "On Informationally Decentralized Systems" (1972), and "The Design of Mechanisms for Resource Allocation" (1973), embraced Hayek's challenge. He developed mechanism-design theory to test the logic of the Mises-Hayek contention that socialism could not possibly mobilize the dispersed knowledge in society in a way that would permit rational economic calculation for the alternative uses of scarce resources. Mises and Hayek argued that replacing the invisible hand of the market with the guided one of government would not work. Mr. Hurwicz wanted to see if they were right, and under what conditions one could say they were wrong.

    Those efforts are at the foundation of the field that was honored by the Nobel Prize committee. To function properly, any economic system must, as Hayek pointed out, structure incentives so that the dispersed and sometimes conflicting knowledge in society is mobilized to realize the gains from exchange and innovation.

    Last year Mr. Myerson acknowledged his own debt to Mr. Hurwicz -- and thus Hayek -- in "Fundamental Theory of Institutions: A Lecture in Honor of Leo Hurwicz." The incentive-compatibility issue has highlighted the problems of moral hazard and adverse selection (perverse behavior due to incentives caused by rules that are supposed protect us and selection problems due to imperfect information). Mr. Hurwicz helped repair a mid-20th century neglect of institutions in economic analysis.

    While we celebrate the brilliance of Messrs. Hurwicz, Maskin and Myerson, we should also remember that Hayek's challenge provided their inspiration. Hayek concluded that the private-property rights that come with the rule of law, freedom of contract, and freedom of association is still the one mechanism design that mobilizes and utilizes the dispersed information in an economy. Furthermore, it does so in a way that tends to capture the gains from trade and innovation so that wealth is continually created and humanity is made better off.

    Mr. Boettke is a professor of economics at George Mason University and the Mercatus Center.

    October 17, 2007 reply from Paul Williams [Paul_Williams@NCSU.EDU]

    Bob, et al.

    As I think I have mentioned before there is no Nobel Prize in economics. Alfred Nobel established his trust fund because of guilt over inventing dynamite. He awarded prizes only to those branches of intellectual endeavor that he believed had the potential to bring "goodness" to human kind and end wars forever (chemistry, physics, medicine, literature, and peace (essentially noble political acts because peace is largely about politics perhaps explaining why right- wingers don't tend to win the Peace Prize).

    In 1964 the Nobel Committee agreed to include within the prizes The Bank of Sweden Prize in Economic Science in Honor of Alfred Nobel, funded not by the Nobel Trust, but by financial interests. This was a political move to bring legitimacy to economic "science" whose scientific prescriptions for policy always manage somehow to benefit financial interests.

    Apparently we have now "scientific" proof that labor is our punishment for the Fall from Grace. Science my a uh foot.

    October 17, 2007 reply from J. S. Gangolly [gangolly@CSC.ALBANY.EDU]

    Paul and Bob,

    The controversies involving the economics prize include:

    1. Theoretical v. Practical: Kantorovich, the Russian mathematician is supposed to have expressed disbelief at receiving one of the earliest economics Nobels (1975), since he had done virtually no work in economics except for laying the groundwork for what later became linear programming. But that was just a footnote in his life's work.

    The same can be said of the work of Reinhard Selten, John Nash, and to an extent Janos Kornai. Later, a number of other theoreticians were also awarded the economics Nobel, leading to grumbling among the applied/ empirical crowd. Probably the series of Nobel's awarded to Milton Friedman and others later were a reaction to this criticism.

    2. Left-wing v. Right-wing: In general, more Nobels have been awarded to quite-a-bit right-of-center economists, and hell has broken loose when one has been awarded to some one even an iota left-of-center. An example was Amartya Sen, who single-handedly revived the fascinating fields of economics of poverty and development.

    Milton Friedman was awarded the prize in 1976 right after the controversy surrounding the 1975 award to Kantorovich.

    I think economics Nobel's have generally tarnished the reputation of Nobels in general, but one feels good when some one like John Nash gets it. I was thrilled that Leonid Hurwicz got it this year, though I am not sure about Maskin and Myerson. With the latter two, it is way down hill from Selten, Nash, Harsanyi, Aumannn, Kantorovich, Arrow, Debreu, ...

    So far as I know, one "accountant" has won the economics Nobel. It is Richard Stone, who worked in the area of national income accounting.

    Incidentally, I stumbled upon a fascinating book titled "Against Mechanism: Protecting Economics from Science" By Philip Mirowski

    One quote from the book:

    "Contrary to popular misconceptions, I shall claim that economics needs protection from science, and especially from scientists such as Richard Feynman, or any other physicist who thinks he knows just what is needed for economists to clean up their act. Economics needs protection from the scientists in its midst, the Paul Samuelsons and the Tjalling Koopmans and all the others who took their training in the physical sciences and parlayed it into easy victories among their less technically inclined colleagues. And worst of all, economics needs protection from itself. For years, economics has enjoyed an impression of superiority over all the other "social sciences" in rigor, precision, and technical expertise. The reason it has been able to assume this mantle is that economics has consistently striven to be the nearest thing to social physics in the constellation of human knowledge."

    Jagdish

     

     


    Socionomic Theory of Finance and Fraud

    From Jim Mahar's Blog on July 21, 2006 --- http://financeprofessorblog.blogspot.com/

    Socionomics and the Enron Scandal

    Right after my posting of the 1952 cartoon, B. C. emailed me the following video that is a documentary on Socionomics and even has Finance Professor John Nofsinger in it speaking about Enron and other scandals!

    What is socionomics?

    From Socionomics.org:
     
    "Socionomics is a new theory of social causality that offers fresh insights into collective human behavior. Over twenty years of empirical research demonstrates that social actions are not causal to changes in social mood, but rather changes in social mood motivate changes in social action."


    For instance, rather than suggesting that a rising economy (or stock market) makes people happy, this takes the related, but reversed, view that the economy improves because people are happy.

    While I do not want to argue the theory (for or against), Nofsinger makes an interesting point by saying that Enron and other scandals may have come when they did (after the tech bubble burst etc), not because of the scandals being worse, but because people were upset and hence "looking for trouble."

    Sort of a chicken or the egg argument that has many finance and economic implications (not least of which might be a predictable component in stock markets--for instance this builds upon the Elliot Wave Theory that was mentioned via Fibonacci sequences in the DaVinci Code.).

    Here is the description from video:

     
    " The Enron and Martha Stewart scandals made headlines at about the same time. It wasn't just coincidence. This four minute clip about socionomics from History's Hidden Engine explains why some scandals make news when they do, while others go unnoticed."

    I have to admit it is a thought provoking idea and it does fit some scenarios, but I am not yet willing to buy into it, although I may buy the book.

    Bob Jensen's theory threads are linked at http://faculty.trinity.edu/rjensen/theory.htm


    From The Wall Street Journal Accounting Weekly Review on September 7, 2012

    Facebook Plays Defense
    by: Geoffrey A. Fowler
    Sep 05, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Executive Compensation, Individual Taxation, Stock Price Effects, Stockholders' Equity

    SUMMARY: "In a regulatory [Form 8-K] filing Tuesday, Facebook said Chief Executive Mark Zuckerberg won't sell any stock in the company for a year, and that two of its directors...have no plans to sell their personal holdings beyond the amount needed to cover their tax liabilities." The discussion in the article emphasizes the company's plans to maintain a relatively constant level of outstanding shares and also mentions tax treatment of individuals receiving the restricted stock.

    CLASSROOM APPLICATION: The article may be used in a tax class to cover the topic of restricted stock and in a financial accounting class covering authorized, issued, and outstanding shares. NOTE: INSTRUCTORS WILL WANT TO REMOVE THE FOLLOWING STATEMENTS AS THEY CONTAIN ANSWERS TO THE QUESTIONS ASKED IN THE REVIEW. Restricted stock is taxed similarly to non-qualified stock options except that employees are taxed on the full fair value of the stock at the vesting date, unless the employee makes an election under section 83(b) to accelerate the date to the grant date. As described in the article from review of an SEC Form 8-K filing, Facebook intends to maintain a similar level of outstanding shares after the vesting of the restricted stock as before the vesting date by repurchasing treasury shares.

    QUESTIONS: 
    1. (Introductory) What is restricted stock? What will happen in October in relation to Facebook's employees' restricted stock units?

    2. (Advanced) How are issuances of restricted stock units treated for tax purposes? In your answer, explain why the two directors mentioned in the article might sell shares because they face tax liabilities if they otherwise do not plan to sell these shares of stock.

    3. (Advanced) Define the terms authorized, issued, and outstanding shares of stock. How will the issuance of the restricted stock affect each of these categories of stock?

    4. (Introductory) According to the article, what will Facebook do to offset the impact of releases of restricted stock previously granted to executives and employees? Again, explain the impact of this action on the three types of stock identified above.

    5. (Advanced) Why is Facebook's action important to shareholders who bought the stock upon its initial public offering?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Facebook Plays Defense," by Geoffrey A. Fowler, The Wall Street Journal, September 5, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443759504577631854230025164.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj

    Facebook Inc. FB +2.00% took steps Tuesday to reassure investors and employees worried about its plummeting stock price, as the social network's shares hit new lows.

    In a regulatory filing Tuesday, Facebook said Chief Executive Mark Zuckerberg won't sell any stock in the company for a year, and that two of its directors—Marc Andreessen and Donald Graham—have no plans to sell their personal holdings beyond the amount needed to cover their tax liabilities.

    Facebook also detailed how it will essentially buy back 101 million shares when it issues previously restricted stock units to its staff in October. At recent prices, it would spend roughly $1.9 billion to keep those shares off the market.

    Together, the steps function like a kind of defensive wall around the Facebook share price. They effectively reduce the amount of Facebook stock in the public market and spread out the amount of shares that could flood the market in November after a lockup period on the stock expires.

    Facebook spokesman Larry Yu said the details in the filing were approved by the company's compensation committee on Aug. 30. "We wanted to get the filing out as soon as we could after that meeting as a measure of clarity and transparency," he said.

    Mr. Yu declined to comment on the impact that the moves might have on investors.

    Facebook's stock has been in a tailspin since the Menlo Park, Calif., company's initial public offering in May. After making their market debut at $38 a share amid much hype that month, they have plunged more than 50% over concerns about how much the company is really worth.

    On Tuesday, Facebook's shares dropped to a fresh low of $17.73 in 4 p.m. trading after analysts at the two biggest underwriters for the company's IPO—Morgan Stanley MS +3.51% and J.P. Morgan Chase JPM +4.08% & Co.—cut their price targets on the stock.

    In after-hours trading following the regulatory filing, Facebook's shares ticked up 1.7% to $18.03.

    Facebook's stock has continued to suffer as share lockups began expiring last month, releasing 271 million shares—or nearly 13% of those outstanding—on the market. More lockup expirations in October, November and December will allow insiders and others to sell more than 1.4 billion shares.

    Enlarge Image image image Julie Jacobson/Associated Press

    Facebook said Mr. Zuckerberg won't sell any shares in the social network for a year. Mr. Zuckerberg, above, in May.

    Last month, director and early investor Peter Thiel sold the majority of his Facebook holdings—some 20.1 million shares—after restrictions on insider selling lifted.

    Facebook has publicly said little about its stock slide but internally is reassuring employees about their shares. In a companywide meeting last month, Mr. Zuckerberg told them it may be "painful" to watch the stock plunge, but that investments Facebook has made will soon bear fruit.

    In its filing, Facebook said Mr. Zuckerberg "has no intention to conduct any sale transactions in our securities for at least 12 months." Mr. Zuckerberg sold Facebook stock in the IPO to cover his tax liabilities, and now holds about 444 million shares of Class B common stock and an option exercisable for an additional 60 million Class B shares.

    A Facebook spokesman declined to make Mr. Zuckerberg available to comment.

    A spokeswoman declined to make Mr. Andreessen available for comment. Mr. Graham declined to comment.

    Facebook also said it plans to withhold 45% of employees' restricted stock units to cover their tax liabilities, paying the obligations, worth about $1.9 billion, in cash and from existing credit facilities. In doing so, it would remove 101 million shares from the market for accounting purposes, about 4% of the shares outstanding. Facebook also said the lockup date for some employees' stock would be Oct. 29, after previously suggesting it might fall on Nov. 14.

    Continued in article

    Bob Jensen's threads on employee stock option accounting ---
    http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on accounting theory ---
    http://faculty.trinity.edu/rjensen/Theory01.htm

     


    Facts Based on Assumptions:  The Power of Postpositive Thinking

    2012 AAA Meeting Plenary Speakers and Response Panel Videos ---
    http://commons.aaahq.org/hives/20a292d7e9/summary
    I think you have to be a an AAA member and log into the AAA Commons to view these videos.
    Bob Jensen is an obscure speaker following the handsome Rob Bloomfield
    in the 1.02 Deirdre McCloskey Follow-up Panel—Video ---
    http://commons.aaahq.org/posts/a0be33f7fc

    My threads on Deidre McCloskey and my own talk are at
    http://www.cs.trinity.edu/~rjensen/temp/DeirdreMcCloskey/StatisticalSignificance01.htm

    September 13, 2012 reply from Jagdish Gangolly

    Bob,

    Thanks you so much for posting this.

    What a wonderful speaker Deidre McCloskey! Reminded me of JR Hicks who also was a stammerer. For an economist, I was amazed by her deep and remarkable understanding of statistics.

    It was nice to hear about Gossett, perhaps the only human being who got along well with both Karl Pearson and R.A. Fisher, getting along with the latter itself a Herculean feat.

    Gosset was helped in the mathematical derivation of small sample theory by Karl Pearson, he did not appreciate its importance, it was left to his nemesis R.A. Fisher. It is remarkable that he could work with these two giants who couldn't stand each other.

    In later life Fisher and Gosset parted ways in that Fisher was a proponent of randomization of experiments while Gosset was a proponent of systematic planning of experiments and in fact proved decisively that balanced designs are more precise, powerful and efficient compared with Fisher's randomized experiments (see http://sites.roosevelt.edu/sziliak/files/2012/02/William-S-Gosset-and-Experimental-Statistics-Ziliak-JWE-2011.pdf )

    I remember my father (who designed experiments in horticulture for a living) telling me the virtues of balanced designs at the same time my professors in school were extolling the virtues of randomisation.

    In Gosset we also find seeds of Bayesian thinking in his writings.

    While I have always had a great regard for Fisher (visit to the tree he planted at the Indian Statistical Institute in Calcutta was for me more of a pilgrimage), I think his influence on the development of statistics was less than ideal.

    Regards,

    Jagdish

    Jagdish S. Gangolly
    Department of Informatics College of Computing & Information
    State University of New York at Albany
    Harriman Campus, Building 7A, Suite 220
    Albany, NY 12222 Phone: 518-956-8251, Fax: 518-956-8247

    Hi Jagdish,

    You're one of the few people who can really appreciate Deidre's scholarship in history, economics, and statistics. When she stumbled for what seemed like forever trying to get a word out, it helped afterwards when trying to remember that word.


    Interestingly, two Nobel economists slugged out the very essence of theory some years back. Herb Simon insisted that the purpose of theory was to explain. Milton Friedman went off on the F-Twist tangent saying that it was enough if a theory merely predicted. I lost some (certainly not all) respect for Friedman over this. Deidre, who knew Milton, claims that deep in his heart, Milton did not ultimately believe this to the degree that it is attributed to him. Of course Deidre herself is not a great admirer of Neyman, Savage, or Fisher.

    Friedman's essay "The Methodology of Positive Economics" (1953) provided the epistemological pattern for his own subsequent research and to a degree that of the Chicago School. There he argued that economics as science should be free of value judgments for it to be objective. Moreover, a useful economic theory should be judged not by its descriptive realism but by its simplicity and fruitfulness as an engine of prediction. That is, students should measure the accuracy of its predictions, rather than the 'soundness of its assumptions'. His argument was part of an ongoing debate among such statisticians as Jerzy Neyman, Leonard Savage, and Ronald Fisher.

    .
    "Milton Friedman's grand illusion," by Mark Buchanan, The Physics of Finance: A look at economics and finance through the lens of physics, September 16, 2011 ---
     http://physicsoffinance.blogspot.com/2011/09/milton-friedmans-grand-illusion.html

    Many of us on the AECM are not great admirers of positive economics ---
    http://faculty.trinity.edu/rjensen/theory02.htm#PostPositiveThinking

    Everyone is entitled to their own opinion, but not their own facts.
    Senator Daniel Patrick Moynihan --- FactCheck.org ---
    http://www.factcheck.org/

    Then again, maybe we're all entitled to our own facts!

    "The Power of Postpositive Thinking," Scott McLemee, Inside Higher Ed, August 2, 2006 --- http://www.insidehighered.com/views/2006/08/02/mclemee

    In particular, a dominant trend in critical theory was the rejection of the concept of objectivity as something that rests on a more or less naive epistemology: a simple belief that “facts” exist in some pristine state untouched by “theory.” To avoid being naive, the dutiful student learned to insist that, after all, all facts come to us embedded in various assumptions about the world. Hence (ta da!) “objectivity” exists only within an agreed-upon framework. It is relative to that framework. So it isn’t really objective....

    What Mohanty found in his readings of the philosophy of science were much less naïve, and more robust, conceptions of objectivity than the straw men being thrashed by young Foucauldians at the time. We are not all prisoners of our paradigms. Some theoretical frameworks permit the discovery of new facts and the testing of interpretations or hypotheses. Others do not. In short, objectivity is a possibility and a goal — not just in the natural sciences, but for social inquiry and humanistic research as well.

    Mohanty’s major theoretical statement on PPR arrived in 1997 with Literary Theory and the Claims of History: Postmodernism, Objectivity, Multicultural Politics (Cornell University Press). Because poststructurally inspired notions of cultural relativism are usually understood to be left wing in intention, there is often a tendency to assume that hard-edged notions of objectivity must have conservative implications. But Mohanty’s work went very much against the current.

    “Since the lowest common principle of evaluation is all that I can invoke,” wrote Mohanty, complaining about certain strains of multicultural relativism, “I cannot — and consequently need not — think about how your space impinges on mine or how my history is defined together with yours. If that is the case, I may have started by declaring a pious political wish, but I end up denying that I need to take you seriously.”

    PPR did not require throwing out the multicultural baby with the relativist bathwater, however. It meant developing ways to think about cultural identity and its discontents. A number of Mohanty’s students and scholarly colleagues have pursued the implications of postpositive identity politics. I’ve written elsewhere about Moya, an associate professor of English at Stanford University who has played an important role in developing PPR ideas about identity. And one academic critic has written an interesting review essay on early postpositive scholarship — highly recommended for anyone with a hankering for more cultural theory right about now.

    Not everybody with a sophisticated epistemological critique manages to turn it into a functioning think tank — which is what started to happen when people in the postpositive circle started organizing the first Future of Minority Studies meetings at Cornell and Stanford in 2000. Others followed at the University of Michigan and at the University of Wisconsin in Madison. Two years ago FMS applied for a grant from Mellon Foundation, receiving $350,000 to create a series of programs for graduate students and junior faculty from minority backgrounds.

    The FMS Summer Institute, first held in 2005, is a two-week seminar with about a dozen participants — most of them ABD or just starting their first tenure-track jobs. The institute is followed by a much larger colloquium (the part I got to attend last week). As schools of thought in the humanities go, the postpositivists are remarkably light on the in-group jargon. Someone emerging from the Institute does not, it seems, need a translator to be understood by the uninitated. Nor was there a dominant theme at the various panels I heard.

    Rather, the distinctive quality of FMS discourse seems to derive from a certain very clear, but largely unstated, assumption: It can be useful for scholars concerned with issues particular to one group to listen to the research being done on problems pertaining to other groups.

    That sounds pretty simple. But there is rather more behind it than the belief that we should all just try to get along. Diversity (of background, of experience, of disciplinary formation) is not something that exists alongside or in addition to whatever happens in the “real world.” It is an inescapable and enabling condition of life in a more or less democratic society. And anyone who wants it to become more democratic, rather than less, has an interest in learning to understand both its inequities and how other people are affected by them.

    A case in point might be the findings discussed by Claude Steele, a professor of psychology at Stanford, in a panel on Friday. His paper reviewed some of the research on “identity contingencies,” meaning “things you have to deal with because of your social identity.” One such contingency is what he called “stereotype threat” — a situation in which an individual becomes aware of the risk that what you are doing will confirm some established negative quality associated with your group. And in keeping with the threat, there is a tendency to become vigilant and defensive.

    Steele did not just have a string of concepts to put up on PowerPoint. He had research findings on how stereotype threat can affect education. The most striking involved results from a puzzle-solving test given to groups of white and black students. When the test was described as a game, the scores for the black students were excellent — conspicuously higher, in fact, than the scores of white students. But in experiments where the very same puzzle was described as an intelligence test, the results were reversed. The black kids scores dropped by about half, while the graph for their white peers spiked.

    The only variable? How the puzzle was framed — with distracting thoughts about African-American performance on IQ tests creating “stereotype threat” in a way that game-playing did not.

    Steele also cited an experiment in which white engineering students were given a mathematics test. Just beforehand, some groups were told that Asian students usually did really well on this particular test. Others were simply handed the test without comment. Students who heard about their Asian competitors tended to get much lower scores than the control group.

    Extrapolate from the social psychologist’s experiments with the effect of a few innocent-sounding remarks — and imagine the cumulative effect of more overt forms of domination. The picture is one of a culture that is profoundly wasteful, even destructive, of the best abilities of many of its members.

    “It’s not easy for minority folks to discuss these things,” Satya Mohanty told me on the final day of the colloquium. “But I don’t think we can afford to wait until it becomes comfortable to start thinking about them. Our future depends on it. By ‘our’ I mean everyone’s future. How we enrich and deepen our democratic society and institutions depends on the answers we come up with now.”

    Earlier this year, Oxford University Press published a major new work on postpositivist theory, Visible Identities: Race, Gender, and the Self,by Linda Martin Alcoff, a professor of philosophy at Syracuse University. Several essays from the book are available at the author’s Web site.

     


    Mike Kearl's great social theory site --- http://faculty.trinity.edu/mkearl/ 
    Nite that Mike died in 2015

    Some sites to stimulate the sociological imagination --- http://faculty.trinity.edu/mkearl/theory.html#imag 

    According to Karl Popper (Logik der Forschung, 1935: p.26), Theory is "the net which we throw out in order to catch the world--to rationalize, explain, and dominate it." Through history, sociological theory arose out of attempts to make sense of times of dramatic social change. As Hans Gerth and C. Wright Mills observed in Character and Social Structure (Harbinger Books, 1964:xiii), "Problems of the nature of human nature are raised most urgently when the life-routines of a society are disturbed, when men are alienated from their social roles in such a way as to open themselves up for new insight." Consider the historical contexts spawning the theoretical insights below:

    Neither the life of an individual nor the history of a society can be understood without understanding both. Yet men do not usually define the troubles they endure in terms of historical change and institutional contradiction. ... The sociological imagination enables its possessor to understand the larger historical scene in terms of its meaning for the inner life and the external career of a variety of individuals. ... The first fruit of this imagination--and the first lesson of the social science that embodies it--is the idea that the individual can understand his own experience and gauge his own fate only by locating himself within this period, that he can know his own chances in life only by becoming aware of those of all individuals in his circumstances. ...We have come to know that every individual lives, from one generation to the next, in some society; that he lives out a biography, and that he lives it out within some historical sequence (The Sociological Imagination, 1959:3-10).

    Judge a man by his questions rather than by his answers. --Voltaire (1694-1778)

    A definition is no proof. --William Pinkney, American diplomat (1764-1822)

    A theory is more impressive the greater the simplicity of its premises, the more different the kinds of things it relates and the more extended its range of applicability. --
    Albert Einstein, 1949

     

    SocioSite: Noted Sociological Theorists and Samplings of their Works

    Alan Liu's Voice of the Shuttle: Great collection of synopses and primary works of the great theorists

    Society for Social Research Page: Classical Sociological Theory. Good site for excerpts from the classics, courtesy of the University of Chicago.

    Serdar Kaya's The Sociology Professor, a portal of social theories and theorists

    Sociolog: many phenomenological links

    Larry Ridener's Dead Sociologists Index: Biographies of and excerpts from those who carved the discipline

    SociologyCafe's "Social Thinkers, Sociologists, and Online Texts" and Theory Outline

    PRAXIS: The Insurgent Sociology Web Site at University of California, Riverside

    Ed Stephan's "A Sociology Timeline from 1600"

    Carl Cuneo's Course on Theories of Inequality

    Marxist Internet Archive

    Marxism/ Leninism

    Marxism Made Simple

    Marx and Engels' Writings

    Engels' The Origin of the Family, Private Property and the State

    Antonio Gramsci site from Queens College 

    Habermas links collected by Antti Kauppinen

    Durkheimian links

    Durkheim Homepage

    Weberian links

    Mannheim Centre for European Social Research

    Charles Horton Cooley's Social Organization: A Study of the Larger Mind

    George Herbert Mead Repository at Brock University

    All Things Simmelian--Georg Simmel Homepage

    Erving Goffman

    Game Theory Society--mathematically modeling "strategic interaction in competitive and cooperative environments"

    Thorsten Veblen's The Theory of the Leisure Class

    Foucault Homepage

    Jean Baudrillard speaks

    Anthony Giddens

    Howard S. Becker's Home Page--replete with recent papers, biographical updates and web recommendations

    Amitai Etzioni's Articles in Professional Journals and Books

    "Contemporary Philosophy, Critical Theory and Postmodern Thought" from the University of Denver

    Norbert Elias site from University of Sydney

    FreudNet: The A.A. Brill Library

    An evolving site to keep an eye on is Jim Spickard's Social Theory Pages, with historical backgrounds and intellectual biographies of the key players

    Need a dictionary for those works of critical theorists and postmodernists? Try the Red Feather Dictionary of Critical Social Science

    Gene Shackman's Social, Economic and Political Change--featuring links to theory, data and research about large scale long term political, economic and social systems change at the national and international level 

    World-Systems Archive
    The Research Committee on Sociocybernetics (of the Intl. Sociological Association)

    Want to see what theories sociologists are currently cooking up? Below is a sampling of sociological journals.

    Electronic Journal of Sociology Home Page
    Sociological Research Online
    Journal of World-Systems Research
    Journal of Mundane Behavior (first issue February 2000)
    Annual Review of Sociology--with 12-years of searchable abstracts
    Sociological Abstracts Home Page
    The Canadian Journal of Sociology
    Tables of Contents for all issues of Postmodern Culture

    Jean-Paul Sartre Breaks Down the Bad Faith of Intellectuals --- Click Here
    http://www.openculture.com/2011/12/jean-paul_sartre_on_the_bad_faith_of_modern_intellectuals.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+OpenCulture+%28Open+Culture%29


    Some Accounting News Sites and Related Links
    Bob Jensen at Trinity University

    Accounting  and Taxation News Sites --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Accounting program news items for colleges are posted at http://www.accountingweb.com/news/college_news.html
    Sometimes the news items provide links to teaching resources for accounting educators.
    Any college may post a news item.

    Also note the Student Zone
    AccountingWeb Student Zone --- http://www.accountingweb.com/news/student_zone.html

    Fraud News --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    XBRL News --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Selected Accounting History Sites --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Hasselback's Accounting Faculty Directory (Online and Hardcopy) ---
    http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Some of Bob Jensen's Pictures and Stories --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Free Tutorials, Videos, and Other Helpers --- http://faculty.trinity.edu/rjensen/AccountingNews.htm

    Bob Jensen's gateway to millions of other blogs and social/professional networks ---
    http://faculty.trinity.edu/rjensen/ListservRoles.htm

     

    Bob Jensen's Threads --- http://faculty.trinity.edu/rjensen/threads.htm

    Bob Jensen's Blogs --- http://faculty.trinity.edu/rjensen/JensenBlogs.htm
    Current and past editions of my newsletter called New Bookmarks --- http://faculty.trinity.edu/rjensen/bookurl.htm
    Current and past editions of my newsletter called Tidbits --- http://faculty.trinity.edu/rjensen/TidbitsDirectory.htm
    Current and past editions of my newsletter called Fraud Updates --- http://faculty.trinity.edu/rjensen/FraudUpdates.htm
    Bob Jensen's past presentations and lectures --- http://faculty.trinity.edu/rjensen/resume.htm#Presentations   

    Free Online Textbooks, Videos, and Tutorials --- http://faculty.trinity.edu/rjensen/ElectronicLiterature.htm#Textbooks
    Free Tutorials in Various Disciplines --- http://faculty.trinity.edu/rjensen/Bookbob2.htm#Tutorials
    Edutainment and Learning Games --- http://faculty.trinity.edu/rjensen/000aaa/thetools.htm#Edutainment
    Open Sharing Courses --- http://faculty.trinity.edu/rjensen/000aaa/updateee.htm#OKI

    Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts of Private Companies ---
    http://faculty.trinity.edu/rjensen/2008Bailout.htm

    Health Care News --- http://faculty.trinity.edu/rjensen/Health.htm

    Bob Jensen's Resume --- http://faculty.trinity.edu/rjensen/Resume.htm

    Bob Jensen's Threads --- http://faculty.trinity.edu/rjensen/threads.htm

    Bob Jensen's Homepage --- http://faculty.trinity.edu/rjensen/