Teaching Case
From The Wall Street Journal Weekly Accounting Review on June 6, 2014

New Rules to Alter How Companies Book Revenue
by: Michael Rapoport
May 28, 2014
Click here to view the full article on WSJ.com
 

TOPICS: Financial Accounting Standards Board, International Accounting Standards Board, Revenue Recognition

SUMMARY: "New rules released Wednesday[, May 28, 2014, jointly by the FASB and IASB] will overhaul the way businesses record revenue...capping a 12-year project....The new standards...will take effect in 2017 [and will cause] ... a broad array of companies...either to speed up or slow down the rate at which they book at least some of their revenue....Companies were cautious in assessing the potential impact of the overhaul...." Many companies are optimistic about eliminating the many inconsistencies across industries in current U.S. revenue recognition requirements. With greater consistency in timing of revenue recognition, the new standard also should help improve reporting issues because "...allegations of improperly speeding up or deferring revenue have been at the heart of many accounting-fraud scandals."

CLASSROOM APPLICATION: The article may be used in any financial accounting course covering revenue recognition. It is more helpful to access information from the FASB's web site to understand the objectives and requirements of the standard. The summary of the Accounting Standards Update (ASU) is linked in the first question. The article focuses more on the expected results and effects across different industries.

QUESTIONS: 
1. (Advanced) Summarize the revenue recognition process in the new accounting standard. You may access the summary of the Accounting Standards Update to help answer this question. It is available on the FASB web site at http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175828814244&blobheader=application%2Fpdf&blobheadername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=1265035&blobheadervalue1=filename%3DASU_2014-09_Section_A.pdf&blobcol=urldata&blobtable=MungoBlobs

2. (Introductory) According to the article, what types of industries or products will be most affected by the new requirements?

3. (Introductory) Review the graphic entitled "On the Books" which compares accounting for software, wireless devices, and automobiles under present GAAP and the new revenue recognition requirements. How do the new requirements move the accounting to be more similar across these three products?

4. (Advanced) Consider the current requirements for revenue recognition in these three products. What was the reasoning behind these differences? That is, what is the determining factor for the point of recognizing a sale and how does it differ across these three products? Cite any source you use in developing your answer.
 

Reviewed By: Judy Beckman, University of Rhode Island

New rules released Wednesday will overhaul the way businesses record revenue on their books, capping a 12-year project that will affect companies ranging from software firms to auto makers to wireless providers.

The new standards, issued jointly by U.S. and global rule makers, will take effect in 2017, prompting a broad array of companies—from software giants like Microsoft Corp. MSFT -0.42% and Oracle Corp. ORCL +0.23% to major appliance makers—either to speed up or slow down the rate at which they book at least some of their revenue.

The rules aim to simplify and inject more uniformity into one of the most basic yardsticks of a company's performance—how well its products or services are selling.

"It's one of the most important metrics for investors in the capital markets," said Russell Golden, chairman of the Financial Accounting Standards Board, which sets accounting rules for U.S. companies and collaborated on the new rules with the global International Accounting Standards Board.

Companies were cautious in assessing the potential impact of the overhaul, but some were optimistic. "We've been waiting for it for a long time," said Ken Goldman, chief financial officer of Black Duck Software Inc., a provider of software and consulting services. "This levels the playing field and takes a lot of the ambiguity out of what are overly restrictive rules."

The rules are designed to replace fragmented and inconsistent standards under which companies in different industries often record their revenue differently and sometimes book a portion of it well before or after the sales that generate it.

"We wanted to make sure there was a consistent method for companies to identify revenue," said the FASB's Mr. Golden.

But the new rules could make corporate earnings more volatile, accounting experts said, by changing the timing of when revenue is recorded. They also could lead to increased costs for companies as they seek to track their performance while providing the additional disclosure the new standards require.

"This has at least the potential to affect every company," said Joel Osnoss, a partner at accounting firm Deloitte & Touche LLP. They "really should look at the standard" and ask how the revenue-rule changes will affect them, he said.

Accounting rule makers have long focused on the question of when businesses should book revenue, because it touches every company and can be an area ripe for fraud. Allegations of improperly speeding up or deferring revenue have been at the heart of many accounting-fraud scandals.

In 2002, for example, Xerox Corp. XRX +0.93% paid a big settlement to the Securities and Exchange Commission to resolve allegations that it had improperly accelerated revenue. Xerox didn't admit or deny the SEC's allegations.

The new rule's impact will be most felt in a handful of industries in which goods and services are "bundled" together and parts of that package are provided long before or after customers pay for them. These include such benefits as maintenance that comes with the purchase of a new car, or software upgrades given to customers who bought the original program.

In such cases, the time at which companies recognize revenue is often out of sync by months or years with when customers get the goods and services associated with it. For instance, when auto and appliance makers sell their products, they typically book the purchase price immediately, but the transactions can also include free maintenance or repairs under warranty that the company might not provide for months or years.

Under the new rules, the manufacturer would book less revenue up front and more revenue later, because some of the revenue from the car or appliance would be assigned to cover future service costs. As a result, some of a company's revenue might be stretched over a longer period.

Conversely, software makers such as Microsoft and Oracle might be able to recognize some revenue more quickly. Software companies now often have to recognize their revenue over time, because they have to wait until all of the software upgrades and other pieces of a sale are delivered to the customer. The new rules will make it easier for companies to value upgrades separately and so recognize more of the software's overall revenue upfront, Mr. Golden said.

Microsoft and Oracle declined to comment.

Similarly, wireless phone companies like Verizon Communications Inc. VZ +0.32% and AT&T Inc. T -0.14% might book some revenue faster under the new rules. Currently, a wireless company books revenue each month, as customers receive wireless services—but none of that revenue is allocated to any phone that customers get free or for a low price.

That will change under the new rules; some of the monthly revenue will be applied to those phones. And since customers get the phone when they first sign up, at the beginning of their contracts, that will have the effect of pulling the revenue forward in time, allowing the company to book it earlier.

Verizon and AT&T didn't have any immediate comment.

Even companies that aren't affected so much by the timing changes will have to disclose more about the nature and certainty of their revenue—something Deloitte & Touche's Mr. Osnoss said will help investors. "I think investors are going to have much more of a view into the company."

But companies may find that providing that information complicates their lives and raises their costs. "For the majority of people, it's going to be difficult," said Peter Bible, chief risk officer for accounting firm EisnerAmper and a former chief accounting officer at General Motors Co. GM +0.39%

Continued in article

Teaching Case
From The Wall Street Journal Weekly Accounting Review on June 6, 2014

"CFO Journal: Finance Chiefs React to New Revenue Recognition Rules," by Maxwell Murphy, The Wall Street Journal, May 28, 2014 ---
http://blogs.wsj.com/cfo/2014/05/28/finance-chiefs-react-to-new-revenue-recognition-rules/?mod=djem_jiewr_AC_domainid

Public companies have until 2017 to prepare for a new global standard for recording revenue, giving finance chiefs ample time to let Wall Street know how the new accounting rules will speed up or draw out their recognition of sales.

Some companies, like software makers and wireless providers, could record revenue more quickly than under current rules, while auto and appliance makers may need to spread the sales over a longer period than they traditionally have. The new standard, developed jointly by the U.S.’s Financial Accounting Standards Board and the International Accounting Standards Board, aims to standardize revenue recognition across industries and streamline comparisons between companies, notes The Wall Street Journal’s Michael Rapoport.

“We’ve been waiting for it for a long time,” said Ken Goldman, CFO of Burlington, Mass.-based Black Duck Software Inc., a closely held provider of open-source software and consulting services. “This levels the playing field and takes a lot of the ambiguity out of what are overly restrictive rules.”

Mr. Goldman said the rules change won’t affect the company until it goes public, which it expects will be two to three years from now, but he said the company will adopt the change before it goes into effect at the end of 2016 if it is able. Some software firms give away their services for free and instead charging more for the software, which allows them to book revenue sooner and “thereby gaming the system,” he added, and “the new rule makes that problem go away.”

Companies shouldn’t ignore the overhaul, even if they expect changes under the new rules will be minor.

Sean Aggarwal, CFO of Trulia Inc., a website for homes for sale, said the new guidance should be easier to implement, but he’s concerned about the “additional disclosures” that will be required. “I’m curious at what point we stop adding new disclosures and instead focus on simplifying redundant portions of the current disclosures.”

Tony Tripeny, corporate controller for glass products maker Corning Inc.GLW -0.09%, said “the real question companies now have to deal with pretty quickly is, when they do adopt this standard, will they go back retroactively and restate prior years, or do they just do a cumulative adjustment,” he said, a matter Corning is currently evaluating.

As BlackLine Systems Inc. eyes an initial public offering in the coming years, the Los Angeles-based provider of software that helps companies close their books already prepares results that are compliant with U.S. generally accepted accounting principles, CFO Charles Best said. He said the Securities and Exchange Commission and the two accounting boards have not yet issued guidance on how to implement the changes, which could affect whether companies choose to restate results or make one cumulative adjustment.

Karan Rai, CFO of ADS Inc., a closely held logistics provider and specialty distributor to the U.S. Defense Department based in Virginia Beach, Va., is upbeat on the new rules. “There are going to be a few companies with aggressive accounting policies that are not going to like it, but I’m in favor of it,” he said.

“If it is good for investors in terms of transparency,” Mr. Rai said, “it’s probably good for the company.”

From the Fitch Ratings Newsletter on January 24, 2014

Revenue to Fall for Some European Corporates Under new IFRS Rules
A new report issued by Fitch Ratings, shows that new IFRS accounting standards which update the rules on group accounting will result in a material fall in reported revenues, assets and liabilities in FY13 for some European corporates. Significantly, IFRS 11 Joint Arrangements prescribes new accounting rules that prohibit proportionate consolidation for what are now defined as 'joint ventures'. A Fitch survey of 24 large European non-financial corporates found that 13 of these entities had been using proportionate consolidation to account for interests in jointly controlled entities. IFRS 11 will force companies to use equity accounting instead for structures that are classified as ‘joint ventures.’

"New e-Accounting Advisor Network Debuts," SmartPros, September 29, 2003 --- http://www.smartpros.com/x40720.xml 

Insynq Inc., a provider of Internet-delivered online accounting solutions and services, has launched an online advisor network to assist the accounting professional by supporting back-office processing requirements on a highly cost-efficient basis.

The e-Accounting Advisor Provider Network (http://eaccounting.cpa-asp.com) has created a new cost-effective resource for practices of all sizes to use to expand their practice, or to provide the opportunity of higher gross margins, Insynq announced. Through the use of business process outsourcers -- such as call centers, payroll and HR processing services -- professional practices are able to improve client services, expand their practices, and improve practice profitability.

"These accountants have gained a comprehensive solution that combines our online accounting technology services with business process outsourcing models," said Insynq president John Gorst. "e-Accounting is one of the few providers in the industry with a service model that encompasses online accounting applications, data management, document management and workflow tools."

Insynq will co-sponsor a series of seminars in the top 25 U.S. markets over the next four months for CPAs, accountants and bookkeepers that explain the online accounting model. These seminars will detail the outsourced accounting opportunity, and demonstrate the benefits of using business process outsourcers in support of practice initiatives.

A whistleblower should really wear a mask, ride a white horse, and have a native American partner to help track the piles of Kemosabi. The William Tell Overture also helps --- http://www.youtube.com/watch?v=qdQomfnCH_0

Bob Jensen's threads on whistleblowers are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing

Support for 'lone ranger'

By LOREN STEFFY
Houston Chronicle, September 25, 2007 ---

I'd like to dedicate this column to lone rangers.

That's the term that a Halliburton lawyer used in a legal proceeding this week to describe Anthony Menendez, a former director of technical accounting research and training at the oil-field-services company.

Menendez claims he was forced to resign from Houston-based Halliburton after he accused the company of using improper accounting to inflate earnings and "distort the timing of billions of dollars in revenue," according to his complaint.

Halliburton says the allegations are untrue.

Menendez is seeking protection under the Sarbanes-Oxley law, which was designed to shield corporate whistle-blowers from retribution.

Congress created that provision of the law after lawmakers found that in the corporate scandals of Enron and WorldCom, employees such as former Enron executive Sherron Watkins faced retaliation for raising concerns about harmful corporate practices.

It's often too easy for companies to dismiss such concerns as an annoyance, as the ranting of someone who's lost touch with reality.

Consider how Halliburton attorney Carl Jordan described Menendez before the judge: "He saw everything in black and white, and he thought he was always right, and everyone else was wrong."

It could be that Menendez misinterpreted the accounting details he questioned. It could be that the more people ignored his concerns, the more determined he became, spinning a web of false obsession into a conspiracy of his own imagination.

But shareholders dismiss such concerns at their own peril. It may not be a major accounting scandal. It may not even be material, in the legal sense, to Halliburton's operations. But something set Menendez off.

And it wasn't just him. A colleague testified on his behalf that company accountants questioned in 2005 how Halliburton was booking revenue for oil-field tools that were sitting in warehouses, yet to be delivered to customers.

Halliburton says it listened to Menendez's concerns and investigated them thoroughly. So did its outside auditors and the Securities and Exchange Commission.

Outside auditors, though, don't have a great track record in ferreting out accounting improprieties, and the SEC has proved far better at punishment than pre-emption.

'Critical' role

If the past seven years have taught us anything, it's that concerns such as Menendez's need to be heard. We've seen the painful consequences of corporate America's deaf ear.

"The role of the whistle-blower is critical because it keeps corporations and management in line and accountable to shareholders," said Philip Hilder, a Houston attorney who represents Watkins and who represented Menendez early in the case. "Whistle-blowers are the first line of defense in discovering fraud. Management in corporations ought to embrace them. To the extent that they uncover wrongdoing, the company can correct any potential problems before they go out of control."

What Menendez did wasn't easy. He challenged his superiors and in the process surrendered a job he liked and to which he'd like to return, according to what he told the Chronicle this summer.

Beyond right or wrong

It's never easy to put conscience ahead of livelihood. It's far easier for employees to keep quiet and let someone else worry about the problem.

In some ways, what matters in this case is not whether Menendez is right or wrong, but that he had the guts to speak up.

"Whistle-blowers tend to come forward out of principle," Hilder said. "It takes courage to buck the system."

That's why the Sarbanes-Oxley law was designed to shield whistle-blowers, though many still face retaliation.

"You need to set a scenario up where individuals feel comfortable and protected in providing information that may be detrimental to the entire company if it's not met head-on," Hilder said.

Money well spent

When the Menendez case is over, regardless of the outcome, Halliburton's shareholders will have benefited. Sure, Halliburton has spent some of their money to defend itself against claims that may be, as the company contends, without merit.

But it's money well spent. Investors will gain reassurance that accounting concerns weren't ignored.

It's easy to paint lone wolves as crazy. Sometimes they may even be wrong. But what if they're right?

Loren Steffy is the Chronicle's business columnist. His commentary appears Sundays, Wednesdays and Fridays. Contact him at loren.steffy@chron.com. His blog is at http://blogs.chron.com/lorensteffy/.

 

Bill-and-Hold Revenue Recognition Tale
Anthony Menedez phoned me several times indicating that he thinks his tale would be interesting for accounting students to study. I think it would be an interesting series of events for a case writer to put into an educational case. The focus of the case, in my viewpoint, should be on a comparison of the KPMG article (quoted below) with the actual bill-in-hold transactions at Halliburton to force students to decide whether KPMG auditors and  Halliburton did or did not violate GAAP on these issues.

A financial press article is also quoted below:
Jonathan Weil, "Halliburton's Accounting Might Make You Wonder," Bloomberg News, July 21, 2007

The case has two really interesting questions:

1. What is the proper accounting (and auditing) for these transactions?
2. Is "whistleblower protection" under the Sarbanes-Oxley law an oxymoron?

June 24, 2007 message from Anthony Menendez [menendez.anthony@gmail.com]

Professor Jensen-

Hello. My name is Tony Menendez. I have enjoyed much of the information you have so generously provided on the web covering accounting issues and financial fraud. I thought you might find my Sarbanes-Oxley whistleblower case interesting. Just in case you have extra time and an interest, I am providing you with my contact information and links to some information concerning my case. I hope you are enjoying retirement but have not given up providing your insight into the ever so important area of accounting and financial fraud.

Sincerely,

Tony (713) 822 3764

Here are a few links to information you can find on the web concerning my case:

http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=am_McfuM6i4o 

You can read Menendez's complaint in three parts (I, II, III) on the following website:
http://www.tpmmuckraker.com/archives/003500.php

Question
In accounting, what do the following terms mean and in what context?
bill-and-hold?
Ship-in-Place?

Answer
"Bill-and-Hold Transactions in the Oilfield Services Sector," John C. Christopher, KPMG LLP --- http://faculty.trinity.edu/rjensen/BillandHold.pdf

Determining and defining appropriate revenue recognition has been a primary focus of companies, regulators, standard setters, and auditors in recent years. Improper revenue recognition has been one of the leading causes of financial statement restatements. Perhaps no area of revenue recognition has received as much scrutiny as "bill-and-hold" transactions. Also known as "ship-inplace" transactions, these transactions generally refer to scenarios where revenue is recognized after a seller has substantially completed its obligations under an arrangement, but prior to the buyer, or a common carrier, taking physical possession of the goods.

Background In a recent interview, former SEC Chairman Arthur Levitt referred to recognizing revenue on bill-and-hold transactions as "hocus pocus accounting." He said, "Companies try to boost revenue by manipulating the recognition of revenue. Think about a bottle of wine.You wouldn't pop the cork on that bottle until it was ready. But some companies are doing this with their revenue --- recognizing it before the sale is complete, before the product is delivered to the customer, or at a time when the customer still has options to terminate, void, or delay the sale.

Although the bill-and-hold transaction is not a GAAP violation, unfortunately it has long been associated with incidents of financial fraud. In its October 2002 Report, the General Accounting Office (GAO) said that revenue recognition is the largest single issue involved in restatements. More than half of financial reporting frauds involve the overstatement of revenue, and restatements for revenue recognition have resulted in the largest drops in market capitalization compared with any other type of restatements. There remains an intense scrutiny around a company's revenue recognition principles for these types of transactions, and management and auditors should be unusually skeptical about the appropriateness of recording revenue for these transactions.

Bill-and-hold scenarios frequently arise in the oilfield services sector. It is important to note that the form. of these transactions is neither illegal nor unethical. In fact, most have very good business or economic purposes. For example, there is currently a trend in the oil and gas industry towards developing fields in the deep waters toward the Gulf of Mexico or other more remote locations throughout the world. Development plans for these large deepwater offshore fields. as well as remote onshore fields throughout the world, will commonly have long timelines; therefore, the oilfield service companies have long lead times for delivery of equipment and products. As the development plan gets under way, many of the original timelines and milestones will change along the way as information about the reservoir becomes better. However, many of the products that the oilfield services companies manufacture and deliver are extremely capital intensive and will be manufactured and ready for their fixed delivery dates without regard to any changes in the development plan. These products are generally very large built-tosuit equipment such as wellhead connection equipment and completion products.

There are certain criteria that companies must meet in order to recognize revenue on bill-and-hold transactions. These criteria relate to the risks of ownership. the commitment and request on the part of the buyer, the business purpose of the transaction, the delivery date, and the performance obligations, among others (these criteria are discussed in more detail in the next section). As an example, an oilfield services company may complete the manufacturing of the customer's requested products, have them shipped to a company-owned warehouse, determine a fixed delivery schedule to the customer's well site, obtain a legal acknowledgement from the customer that the risk of loss has been transferred, and have no additional obligations to perform such as installation of the equipment. All of this may take place prior to the particular point in the well development plan that calls for the installation of the product. In this example, the oilfield services company might (although only based on careful analysis of the SEC and FASB guidance related to bill-and-hold transactions) be able to recognize revenue immediately upon completing the manufacturing process and meeting all of the bill-and-hold revenue recognition criteria.

SEC and FASB Guidance on Revenue Recog'nition and Bill-and-Hold Arrangements
EITf- lssue 00.21: Multiple Elements in a bill-and-hold Arrangement

Companies must first apply the separation model described in ElTF lssue 00-21 , Revenue Arrangements with Multiple Deliveries, to determine the number of units of accounting in the bill-and-hold arrangement. Bill-and-hold arrangements in this industry can include both the sale of products and the performance of certain services, such as warehousing for the product if it is shipped to a company-owned warehouse. If the SEC staff's revenue recognition criteria (discussed in the next section) are met for the product element in the bill-and-hold arrangement, revenue may be recognized on the product element when the company has completed the product only if it is a separate unit of accounting, or if there are any services involved in the transaction (e.g., warehousing), and those services are inconsequential or perfunctory to one unit of accounting. The company may need to consider whether the services are a separate unit of accounting, if they are inconsequential or perfunctory, and whether there are other performance obligations yet to be performed in determining the appropriate revenue recognition policy for the entire arrangement.

Inconsequential or Perfunctory Element

According to SAB No. 104, Revenue Recognition, if the-undelivered element is both inconsequential or perfunctory and not essential to the functionality of the delivered element, it would be appropriate to recognize revenue on the arrangement at the time of delivery and accrue the cost of providing the services related to the undelivered element. However, if the undelivered element is neither inconsequential nor perfunctory or is essential to the functionality of the delivered element, the revenue for the delivered element should be deferred and recognized based on the accounting requirements of the undelivered element. The SEC's guidance on the determination of whether an element is inconsequential or perfunctory is related to whether that element is essential to the functionality of the delivered products.

In addition, remaining activities would not be inconsequential or perfunctory if failure to complete the activities would result in the customer receiving a full or partial refund or rejecting, or a right to a refund or to reject the products delivered. The SEC provided the following factors in SAB No.104, which are not all-inclusive, as indicators that a remaining performance obligation is substantive rather than inconsequential or perfunctory:

• The seller does not have a demonstrated history of completing the remaining tasks in a timely manner and reliably estimating their costs.
• The cost or time to perform the remaining obligations for similar contracts historically has varied significantly from one instance to another.
• The skills or equipment required to complete the remaining activity are specialized or are not readily available in the marketplace.
• The cost of completing the obligation, or the fair value of that obligation, is more than insignificant in relation to such items as the contract fee, gross profit, and operating income allocable to the unit of accounting.
• The period before the remaining obligation will be extinguished is lengthy.
• T he timing of payment of a portion of the sales price is coincident with completing performance of the remaining activity.

. . .

SEC Bill-and-Hold Criteria

The SEC has established specific criteria codified in SAB No. 104 that a seller of goods or equipment must meet to recognize revenue for a bill-and-hold transaction, including:

• The risks of ownership must have passed to the buyer.
• The buyer must have a commitment to purchase, preferably in written documentation.
•  The buyer, not the seller, must originate the request that the transaction be on a bill-and-hold basis.
• The buyer must have a substantial business purpose for ordering the goods or equipment on a bill-and-hold basis.
• Delivery must be for a fixed date and on a schedule that is reasonable and consistent with the buyer's purpose (this requirement will generally be difficult for an oilfield services company to meet due to the variable nature of the movement of timelines and milestones for oilfield development).
• The seller must not retain any significant specific performance obligations under the agreement such that the earnings process is not complete. The goods or equipment must be segregated from the seller's inventory and may not be subject to being used to fill other orders.
• The goods or equipment must be complete and ready for shipment.

The SEC emphasized that that the above criteria are not a simple checklist. A transaction might meet all of the criteria and still fail the revenue recognition guidelines . . .

Continued in article

Jensen Comment
Tony Menendez, while working for Halliburton, encountered what he considered a classic violation of GAAP for bill-an-hold transactions in Halliburton's oilfield operations. He says he first confronted his superiors in the company and then a KPMG auditor, who purportedly agreed with Tony on this issue. But Halliburton countered by saying that since "title passed," revenue could be recognized. The amount in terms of dollars was material in amount.

Since Halliburton did not restate its financial statements, or purportedly, its subsequent accounting for these transactions, Tony then took the added step of blowing the whistle with the SEC. The SEC purportedly turned it back to Halliburton for further internal investigation. Soon thereafter Tony Menendez became an unemployed whistle blower

Bill-and-Hold Revenue Recognition Tale
Anthony Menedez phoned me several times indicating that he thinks his tale would be interesting for accounting students to study. I think it would be an interesting series of events for a case writer to put into an educational case. The focus of the case, in my viewpoint, should be on a comparison of the KPMG article (quoted above) with the actual bill-in-hold transactions at Halliburton to force students to decide whether KPMG auditors at Halliburton did or did not violate GAAP on these issues.

By the way, Mr. Menedez is currently still unemployed and is considering applying for doctoral study in accountancy.

August 8, 2007 message from Anthony Menendez [menendez.anthony@gmail.com]

Please see attached. The very examples described by KPMG as bill-and-hold transactions at a company like Halliburton, were the same transactions, I also believed were bill-and-hold. Interestingly, Halliburton apparantly claims, that these transactions, are not, in fact bill-and-hold and thereby avoiding the bill-and-hold hold criteria which requires that the equipment is ready for its intended use, a fixed delivery date exists for the equipment, and that there are no ongoing obligations on the part of Halliburton ( e.g. installing the equipment and performing the necessary oilfield services, the typical services provided by an "oilfield service" company. Personally, I believe that Halliburton's claim is the most absurb argument I have ever seen and worse yet, I struggle to see how KPMG allows Halliburton to deviate from the very guidance it suggests to companies that are not "Halliburton" should apply. Enjoy.

Best Regards,
Tony

You can read Menendez's complaint in three parts (I, II, III) on the following website: ---
http://www.tpmmuckraker.com/archives/003500.php

Bob Jensen's threads on whistle blowing are at
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing

Bob Jensen's threads on revenue reporting and frauds can be found at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

Here's an older example of bill and hold fraud
Death by Accounting
To get companies to participate in a flu vaccine stockpile the government is dangling tons of new funding. Cash in hand is usually a very strong incentive. But a Clinton administration SEC policy prevents the vaccine makers from recognizing the revenue until the vaccine is delivered to the doctors, countering the very purpose of a stockpile. The Department of Health and Human Services' National Vaccine Advisory Committee concluded in early 2005 that for the stockpile program to be successful, "the revenue recognition issue must be resolved as soon as possible." It all began in late 1999, when the SEC issued "Staff Accounting Bulletin 101," which it painted as a modest clarification "not intended to change current guidance in the accounting literature." But in reality it was a radical change to the way companies could book revenue from "bill and hold" orders. This change would, at its least, lead to hindrances for innovative new companies. At its worst, it would discourage production of lifesaving products like vaccines.
John Berlau, "Death by Accounting?" The Wall Street Journal, October 21, 2005 --- http://online.wsj.com/article/SB112985642561675193.html?mod=opinion&ojcontent=otep

SEC SAB 101 "Revenue Recognition in Financial Statements" --- http://www.sec.gov/interps/account/sab101.htm

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 

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

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

"An Analysis of Restatement Matters: Rules, Errors, Ethics, For the Five Years Ended December 31, 2002," free from the Huron Consulting Group --- http://www.huronconsultinggroup.com//files/tbl_s6News/PDF134/112/HuronRestatementStudy2002.pdf 

********************
 Objective: Analyze issues relating to public companies that filed restated financial statements (10-K/ A's and 10-Q/A's) during the five-year period from January 1, 1998, through December 31, 2002.

Purpose: The purpose of our analysis was to identify common attributes within these restatements including the size of the companies, their industry, and ultimately the underlying accounting error that necessitated the restatement. Procedures:

• Performed a search of all 10K/A and 10Q/A filings in the Edgar database from 1998 through 2002 using the keywords "restate," "restated," "restatement," "revise," and "revised."

• Refined search to include only "restatements" defined as a restatement of financial statements that was the result of an error, as defined in APB 20. Our report excludes restatements due to changes in accounting principles and non-financial related restatements.

• Prepared a database and input relevant information for each restatement identified, including the following fields: Company Name; SIC Code; Annual Revenues (from most recent filing); Footnote Disclosure Describing the Restatement Issue; Classification of Restatement Issue; Restating 10K or 10Q; Auditor of Record (limited to amended annual financial statements). 
*******************

Filed restatements went from 158 in 1998 to 330 in Year 2002. Major accounting issues in all years seem to be Revenue Recognition, Reserves/Accruals/Contingencies, Equity, Acquisition Accounting, and Capitalization/Expense of Assets.

Note the following:

Not only have the number of restatements been on the rise, but also the number of public registrants is actually decreasing, which makes the restatement growth during the past few years even more dramatic.

From The Wall Street Journal's Accounting Educators' Reviews on September 26, 2003

TITLE: Heard on the Street: Analyst Gartner Aims to Convert Mistake Into Future Success 
REPORTER: Ken Brown 
DATE: Sep 19, 2003 
PAGE: C1 
LINK: http://online.wsj.com/article/0,,SB10639190653359500,00.html  
TOPICS: Debt, Financial Accounting, Revenue Forecast, Revenue Recognition

SUMMARY: "Gartner, Inc. makes money by analyzing technology companies and trends." This company issued a $300 million convertible bond to Silver Lake Partners, LP, a private equity firm specializing in technology, at the height of the technology boom, in the spring of 2000. Since the technology bust, that debt has been an onerous drag on the company, because of the debt-equity implications, interest charges, and a critical aspect of the deal: Gartner was required to issue a significantly increasing number of shares under the conversion feature as its share value fell from the fallout of the technology bust. The article discusses a plethora of accounting topics in debt and equity, earnings per share, and even the company's revenue recognition procedures.

QUESTIONS: 
1.) What is convertible debt? Describe the provisions of the agreement between Gartner, Inc. and Silver Lake Partners, LP.

2.) "...Because of the accounting treatment of the bond payoff, Gartner's shareholders' equity will go from negative to positive." In general, what are two possible ways to account for converting bonds into common stock?

3.) Access the company's June 30, 2003, quarterly and 2002 annual financial statements via their web site at www.gartner.com , by scrolling down the page and clicking on "investor relations." Using footnote disclosure about the convertible debt in Note 10 to the annual financial statements, the balance for the debt at 6/30/2003, and other information about the company's stock available in the financial statements, provide the journal entries that the company will record for the bond conversion under each of the two possible methods you gave in question 2. Which of these methods do you think the company will use?

4.) "For Gartner, the implications of putting the bond deal behind it could be major." Why does the author say that the company can extinguish debt without any further dilution of earnings per share beyond current disclosure? Will fully diluted earnings per share be affected by this conversion? Will basic earnings per share be affected? Explain.

5.) "Without any debt on its balance sheet, the company can use $167 million in cash...on hand" to buy back common stock. Why not just use the cash to pay off the debt? Who will receive cash under each of these alternatives? Will Silver Lake Partners receive any cash if they convert the bonds into stock? What would other stockholders' preferences be, do you think?

6.) Describe Gartner, Inc.'s business. Summarize Gartner's revenue recognition practices, as they are described late in the article. What does the author mean when he refers to "contract value"? Where in the accounting records would you find the amounts reported as "contract value" in the article?

7.) What is incremental revenue? Why do you think that "80% to 90% of each incremental dollar of research revenue can fall to the bottom line"? Why does this fact, combined with the changes in the company's capital structure, bode well for next year's earnings?

8.) The author states that revenue was down 2% in the second quarter from the first, and contract value was down 1% on the same basis. How can these results be described as "improvements over the past few quarters"? Why is appropriate to compare results for consecutive quarters, when we usually see comparisons of quarterly results to the same quarter one year earlier?

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

"Using Sales Revenue as a Performance Measure," by Rong Huang, Carol A. Marquardt , and Bo Zhang, SSRN, July 28, 2015 ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2636950 

Abstract:
This study provides the first systematic examination of the compensation contracting relevance of sales revenue. We document an increasing temporal trend in the explicit use of sales revenue as a performance measure in CEO annual bonus contracts, which is mirrored by a similar increase in the relative pay-sensitivity of revenues versus earnings over time. We also predict and find that sales revenue is more likely to be used as an explicit performance measure in annual bonus contracts when sales revenue is relatively more informative about firm value than accounting earnings and when firms follow a growth-focused organizational strategy. In addition, we find that the pay-sensitivity of revenue is significantly more positive for firms that explicitly reward revenue performance, as expected, but also that earnings pay-sensitivity is not significantly different from zero for these firms. This paper extends our current understanding of the selection of performance measures in compensation contract design and raises new questions about the validity of the traditional implicit tests in examining questions related to executive pay.

Jensen Comment
In the tech era it has been extremely common for companies to focus revenue trends when they have nothing to brag about in terms of earnings. This leads to all sorts of game playing in terms of trying to inflate reported earnings and standard setter discouragements of some of the games ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 

Revenue-recognition standard to have far-reaching impact on companies
A number of corporate functions could be affected by the new revenue-recognition standard to be issued by the Financial Accounting Standards Board and the International Accounting Standards Board in the next quarter. Besides the matter of compliance, companies should be aware this standard could affect sales, bank covenants, executive bonuses and the timing of the quarterly tax payments. For more information on the revenue-recognition convergence project, visit the AICPA Financial Reporting Center. CFO.com (3/13)

Jensen Question
How will dealers (cars, furniture, etc.) recognize long-term (e.g., seven year) interest free loans with zero down?

"Six areas where new revenue recognition standard will require judgment," by Ken Tysiac, Journal of Accountancy, August 9, 2013 ---
http://journalofaccountancy.com/News/20138470.htm

From PwC Concerning Proposed Changes to Revenue Recognition Rules

The FASB and IASB (the "boards") met in October to finalize several outstanding issues related to their joint revenue recognition project. Specifically, the boards addressed the constraint on recognizing revenue from variable consideration, accounting for licenses and collectibility.

The boards confirmed that an estimate of variable consideration is included in the transaction price if it is "probable" (U.S. GAAP) or "highly probable" (IFRS) that the amount would not result in a significant revenue reversal. The boards also reintroduced an exception for revenue from sales- or usage-based royalties on licenses of intellectual property (IP).

The boards decided to retain the proposed model for distinct licenses, which distinguishes between two types of licenses - one that provides a right to use IP and one that provides access to IP. Criteria will be provided to help determine the accounting based upon the nature of the license. Lastly, the boards introduced a collectibility threshold. An entity only applies the revenue guidance to contracts when it is "probable" the entity will collect the consideration it will be entitled to in exchange for the goods or services it transfers to the customer.

Continued at
http://click.edistribution.pwc.com/?qs=e7f95a842a29b50c78a17fc062074b2d2a7f6c19bb4e0e3989acf338473615800319bf6dff13f45a

The FAS 140 Lifeboat Leaked

"$99 Million Buys EY Ticket Out Of Private Lehman Litigation, Finally," by Francine McKenna, re:TheAuditors, October 21. 2013 ---
http://retheauditors.com/2013/10/21/99-million-buys-ey-ticket-out-of-private-lehman-litigation-finally/

Last defendant standing. Not an enviable place for EY in the case, In re Lehman Brothers Securities and Erisa Litigation.

Everyone else had folded their tent, paid the price to cross this dog off the list. Lehman underwriters agreed in 2011 to a $426.2 million settlement. UBS, one of the underwriters, held out and settled last August for another $120 million. Even before the UBS and EY settlements, Bernstein Litowitz Berger & Grossmann, attorneys for the plaintiffs, claimed the combined recovery of $516,218,000 is the third largest recovery to date in a case arising from the financial crisis.

The $99 million EY will pay is more than Lehman’s officers and directors, who settled for $90 million. That’s a big deal considering the executives typically say, “The auditors said it was ok,” and the auditors say, “Management duped us.” But it’s not that much considering that EY agreed to pay C$117 million ($117.6 million) last December to settle claims in a Canadian class action suit against Sino-Forest Corp, a Chinese reverse merger fraud. That settlement is the largest by an auditor in Canadian history, according to the the law firms.

And it’s not as much as some thought EY would pay for Lehman. In fact, many thought Lehman would finish off EY for good.

John Carney, now of CNBC, writing for Business Insider at the time:

“The Examiner concludes that sufficient evidence exists to support colorable  claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings.”

That may not sound like a mortal threat against Ernst & Young. But the damages here could be enormous. A successful lawsuit against E&Y could result in a court finding that the failure to properly advise the audit committee prevented Lehman from taking genuine steps to substantially reduce its leverage, which may have saved the firm from bankruptcy. Which is to say, E&Y could find itself blamed for all the losses to Lehman shareholders. That would be a stretch—such a claim would be speculative—but it still should be scaring the heck out of the partners.

When the bankruptcy examiner’s report on Enron came out, the language about Arthur Andersen was quite mild. It merely noted there was “sufficient evidence from which a fact-finder could conclude that Andersen: (1) committed professional negligence in the rendering of accounting services to Enron…” It went on to note that Andersen likely had a strong defense against liability since so many Enron executives were implicated.

“Enron brought down Arthur Andersen,” Felix Salmon notes. “Will Lehman do the same for E&Y?”

In July of 2011, New York Federal Court Judge Lewis Kaplan decided to allow substantially all of the allegations against Lehman executives and at least one of the allegations against Ernst & Young to move forward to discovery and trial. One month later Lehman Brothers executives, including its former chief executive Richard S. Fuld Jr., agreed to pay $90 million to settle. Insurance proceeds paid for their settlement.

What was the remaining allegation against Ernst & Young? That the auditor had reason to know Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

Continued in article

Bob Jensen's threads on Ernst & Young ---
http://faculty.trinity.edu/rjensen/Fraud001.htm

"Should Repurchase Transactions be Accounted for as Sales or Loans?" by  Justin Chircop , Paraskevi Vicky Kiosse , and Ken Peasnell, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 657-679 ---
http://aaajournals.org/doi/full/10.2308/acch-50176 

Abstract
In this paper, we discuss the accounting for repurchase transactions, drawing on how repurchase agreements are characterized under U.S. bankruptcy law, and in light of the recent developments in the U.S. repo market. We conclude that the current accounting rules, which require the recording of most such transactions as collateralized loans, can give rise to opaqueness in a firm's financial statements because they incorrectly characterize the economic substance of repurchase agreements. Accounting for repurchase transactions as sales and the concurrent recognition of a forward, as “Repo 105” transactions were accounted for by Lehman Brothers, has furthermore overlooked merits. In particular, such a method provides a more comprehensive and transparent picture of the economic substance of such transactions.

Bob Jensen's threads on repurchase transactions are at
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Repo

"Revenue recognition when product return and pricing adjustment uncertainties exist," by Stephanie Rasmussen, FASRI, October 31, 2012 ---
http://www.fasri.net/index.php/2012/10/revenue-recognition-when-product-return-and-pricing-adjustment-uncertainties-exist/

My forthcoming paper in Accounting Horizons (Rasmussen 2013; “Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry”) examines the implications of revenue recognition for companies with product return and pricing adjustment uncertainties. Although these uncertainties are typically minimal for sales to end customers, they can pose large risks for sales to distributors. The reason being is that distributors’ product return and pricing adjustment rights often do not lapse until the distributor resells the product to an end customer. In the midst of these risks, companies recognize revenue upon delivery of product to distributors (sell-in), when the distributor resells the product to end customers (sell-through), or under some combination (sell-in for some distributors and sell-through for others).

I examine two implications of revenue recognition for companies with product return and pricing adjustment uncertainties. First, I examine whether the incidence of earnings management is higher for companies that recognize revenue before their product return and pricing adjustment uncertainties are resolved. This expectation is motivated by the fact that more opportunities exist to manage earnings when revenue is immediately recognized under the sell-in method compared to when at least some revenue recognition is deferred under the sell-through and combination methods. Specifically, managers using the sell-in method (1) maintain (and have opportunities to manipulate) product return and pricing adjustment accruals, and (2) can boost earnings through channel stuffing activities.

Second, I examine whether earnings informativeness (proxied for with the earnings response coefficient) differs among the revenue recognition methods used by companies with product return and pricing adjustment uncertainties. On one hand, immediate revenue recognition more quickly incorporates new accounting information into the financial statements. If this new information is useful to the market, earnings should be more informative under the sell-in method compared to the other revenue recognition methods. On the other hand, more opportunities exist for both intentional performance manipulations and unintentional estimation errors when revenue is immediately recognized. Thus, if earnings are (or are perceived to be) more inaccurate under the sell-in method, earnings informativeness should be higher when revenue recognition is deferred until distributors have resold products to end customers.

In order to study these research questions, I limit my sample to semiconductor companies because they sell to distributors and naturally face product return and pricing adjustment uncertainties due to rapid product obsolescence and declining prices over product life cycles. I find that sell-in companies are more likely to meet or beat analysts’ consensus earnings forecast compared to sell-through and combination companies, suggesting that earnings management is more likely when companies immediately recognize revenue for sales to distributors. I also find that the earnings response coefficient is significantly larger (meaning the returns-earnings relationship is stronger) for sell-through companies compared to sell-in and combination companies. This finding suggests that earnings are more informative when revenue recognition is deferred until the distributor has resold the product to end customers. Collectively, these results suggest that revenue recognition should be deferred until all product return and pricing adjustment uncertainties are resolved.

This study should be of interest to the FASB and IASB as they finalize a joint revenue recognition standard. The current exposure draft of the new standard states that revenue recognition should occur when the customer obtains control of the product or service. Control, as described in the exposure draft, is likely to be transferred when a manufacturer delivers product to a distributor except for cases where a consignment agreement exists. At the time control is transferred, the standard directs the manufacturer to estimate variable consideration (e.g., product returns and pricing adjustments), determine the transaction price, and recognize revenue so long as receipt of the estimated transaction price is reasonably assured. Recent technical briefs from the Big 4 accounting firms suggest that the new standard’s provisions regarding variable consideration may require many manufacturers that have historically used the sell-through method to change to the sell-in method. Such a shift is concerning as my findings suggest that earnings management is more likely and earnings informativeness is lower when revenue is recognized at sell-in.

Bob Jensen's threads on revenue recognition issues ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

Teaching Case on Revenue Recognition
From The Wall Street Journal Accounting Weekly Review on June 15, 2012

Dreamliner Hits a Milestone
by: Jon Ostrower
Jun 08, 2012
Click here to view the full article on WSJ.com
 

TOPICS: Financial Reporting, Long-Term Contracts, Managerial Accounting, Revenue Recognition

SUMMARY: "Boeing reported that first-quarter profit at its Commercial Airplanes division more than doubled to $1.08 billion from a year earlier. But the company acknowledges that accounting for the costs of each individual plane would have resulted in a first-quarter loss of $138 million... The losses don't show up on Boeing's bottom line, because accounting rules let the company spread the Dreamliner's costs over years-effectively booking earnings now from future Dreamliners that it expects to produce more profitably. With previous models, Boeing initially spread its costs over 400 planes, but with the Dreamliner it is distributing the costs over 1,100 planes-a number it says reflects unprecedented demand. Boeing already has 854 Dreamliner orders from 57 customers." The losses to date "...are 'larger than anything in the company's history,' said...an aerospace analyst for Barclay's Capital who believes demand for the jet will eventually make up for the losses..." though other analysts believe the company's estimates which lead to the profits currently being recorded may be too optimistic.

CLASSROOM APPLICATION: The article is useful to introduce revenue recognition for long term contracts in a financial accounting class and to discuss the effects of learning curves on costs in a managerial accounting course.

QUESTIONS: 
1. (Introductory) Based on the overall description in the article, what method of revenue recognition do you think Boeing is using for the income statement amounts generated by sales of aircraft? Support your answer.

2. (Advanced) Access the Boeing SEC filing on Form 10-Q of its most recent quarterly financial statements available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=12927&accession_number=0001193125-12-181463&xbrl_type=v# Click on the link to Accounting Policies. Can you confirm your answer to question 1 above? Explain.

3. (Introductory) According to the article, what do analysts estimate as the profitability of the Dreamliners currently being sold? How do you think the analysts make these estimates? Cite the points in the article you use to make this assessment.

4. (Advanced) How do analysts judge the amount of investment in early Dreamliner production that Boeing is making, across time or across companies? Explain your answer with reference to the article.

5. (Advanced) What is a learning curve? How do estimated learning rates affect costs and profits at Boeing?
 

Reviewed By: Judy Beckman, University of Rhode Island

 

"Dreamliner Hits a Milestone," by: Jon Ostrower, The Wall Street Journal, June 8, 2012 ---
http://professional.wsj.com/article/SB10001424052702303296604577452812969126758.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

Boeing Co. BA +1.10% rolled out the first 787 Dreamliner from its main factory that won't need major additional work before delivery, a long-delayed milestone that reflects streamlined manufacturing of the company's flagship passenger jet but also points up the program's enormous costs.

This week's achievement comes as the aerospace giant races to both increase output and cut costs on the Dreamliner program, which Boeing hopes will sustain the company in future decades. Analysts, however, estimate Boeing is now effectively losing more than $100 million for each plane sold. The Dreamliner's accumulated production losses—which analysts say are far larger than any previous Boeing plane—put increasing pressure on Boeing's other commercial jetliners to churn out hefty profits.

Assembling the 787—the first jetliner made from mostly carbon-fiber composites—involves tens of thousands of steps, from installing galleys and complex electrical systems to fusing the wings to the body. Boeing, which started making 787s in 2007, had been sending them out of its main factory in Everett, Wash., with many of those steps—sometimes thousands—unfinished, due to parts shortages and design changes on the advanced new jet. Those planes went to a separate facility in Boeing's giant campus to be completed.

The plane that rolled out this week—Boeing's 66th Dreamliner—skipped that costly step. Workers had only around 300 mostly small assembly tasks left to complete, about 100 more than the company's goal, but far fewer than the roughly 6,000 on the earliest Dreamliners, said a person familiar with the plane.

Boeing, in a statement, confirmed the plane "will be the first airplane to go straight into preflight operations" from the Everett plant. The minor tasks left for plane No. 66 can be handled outside of the factory before being prepared for delivery.

Boeing also makes Dreamliners in North Charleston, S.C., where the first 787 recently rolled out with just under 100 tasks remaining. But that aircraft spent nearly eight months in production, compared to the average of five weeks at the main plant in Everett, which pushes a 787 out of its football-field sized doors every six-to-eight days.

Analysts aren't sure exactly how much Boeing will save by producing finished planes, but they agree it is an important step to reduce costs.

Quickly cutting production costs is essential for Boeing, which spent an estimated $14 billion developing the Dreamliner, according to Barclays Capital, and has already suffered costly delays. UBS analysts estimated last month that Boeing spends about $242 million to build each plane, and sells them for an average of $113 million. They and other analysts estimate that Boeing's losses will sink to at least $20 billion by the time costs fall enough that each Dreamliner sells for a profit, likely in 2014 or later. Boeing doesn't say exactly what year it expects to hit that milestone.

The aggregate losses are "larger than anything in the company's history," said Carter Copeland, an aerospace analyst for Barclays Capital, who believes demand for the jet will eventually make up for the losses. The comparable hole for Boeing's last new twin-aisle jet, the 777, first delivered in 1995, was about $3.7 billion, adjusted for inflation, according to data provided by Boeing.

The losses don't show up on Boeing's bottom line, because accounting rules let the company spread the Dreamliner's costs over years—effectively booking earnings now from future Dreamliners that it expects to produce more profitably. With previous models, Boeing initially spread its costs over 400 planes, but with the Dreamliner it is distributing the costs over 1,100 planes—a number it says reflects unprecedented demand. Boeing already has 854 Dreamliner orders from 57 customers.

Boeing reported that first-quarter profit at its Commercial Airplanes division more than doubled to $1.08 billion from a year earlier. But the company acknowledges that accounting for the costs of each individual plane would have resulted in a first-quarter loss of $138 million—a drop UBS analyst David Strauss says is almost entirely attributable to the Dreamliner.

The Dreamliner's drain on cash is balanced by strong sales of the profitable single-aisle 737 and long-range 777 models. And analysts estimate Boeing is reducing the losses per Dreamliner by about $10 million each quarter. But maintaining the pace of cost reduction gets harder as the simplest problems are solved. Meanwhile, Boeing aims to increase production of Dreamliners to 10 per month at the end of 2013, up from 3.5 per month today—meaning the losses per plane will be magnified, but will also be tempered by the decreasing cost of each jet.

Some analysts believe Boeing's target for cost reduction on the Dreamliner could be too optimistic. Mr. Strauss of UBS says the company appears to be assuming it can reduce its cost 50% faster than it did with the 777. If instead the pace of cost reduction matches the 777, says one of UBS's models, the estimated $20 billion hole could double.

"Dataline 2012-04: Responses are in on the re-exposed proposed revenue standard -- Constituents voice their support...and concerns," PwC, May 30, 2012 ---
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8UTPD8&SecNavCode=TMCB-4L9HAT&ContentType=Content

The FASB and IASB (the "boards") released an updated exposure draft, Revenue from Contracts with Customers, on November 14, 2011 (the "2011 Exposure Draft"). The boards received approximately 360 comment letters in response to the updated exposure draft, down significantly from the nearly 1,000 comment letters received on the exposure draft released in June 2010 (the "2010 Exposure Draft"). Since issuing the updated exposure draft, the boards have continued extensive outreach efforts, including four public and numerous private, industry-focused roundtables.

Through the updated exposure draft and other outreach efforts, the boards asked whether the proposed guidance is clear, and specifically requested feedback on: (1) performance obligations satisfied over time; (2) presentation of the effects of credit risk; (3) recognition of variable consideration and the revenue recognition constraint; (4) the scope of the onerous performance obligation test; (5) disclosures in interim financial reports; and (6) transfer of non-financial assets that are outside an entity's ordinary activities (for example, the sale of property, plant and equipment). Respondents have commented on the questions asked by the boards, but also on a number of other areas, including the application of time value of money, transition, and annual disclosures. Industries have also asked the boards to address or clarify the application of the proposals to certain industry-specific issues.

The Full Article --- Click Here
http://cfodirect.pwc.com/CFODirectWeb/download;jsessionid=GGFFPJ2DlPjBgLmYZCK97bwrF13F8v9dsPXmd54Y79gMd3QXQg1q!-1405366314?sourcetype=contentattachment&content=MSRA-8UTPD8&filename=Dataline%202012-04%20--%20FASB%20%26%20IASB%20revenue%20comments.pdf  ---
 

Revenue Recognition Controversies
"Top 6 challenges with a subscription model," by Craig Vodnik, Venture Beat, November 4, 2013 ---
http://venturebeat.com/2013/11/04/subscription-model-challenges/

Gone are the days of simple one-time transactions with customers as the subscription business model goes mainstream with companies like Dropbox, Netflix, Adobe and Zipcar because it offers a predictable, recurring revenue stream.

The management of these subscription models, however, can be quite complex.

Subscription models used by companies like Salesforce offer customers different levels of functionality for a variety of prices per seat, per month. That, in and of itself, might not be too complicated to calculate and bill. But what happens when a customer upgrades or downgrades in the middle of the billing period and prorated billing must occur? Or the credit card “on file” expires and renewal billings fail? How do you bill customers for actual usage? What’s the tax rate on your product? Can you track each product’s churn rate?

The truth is success with subscriptions entails much more than merely switching from one-time to recurring billing. Whether your company is starting or switching to a subscription-based model, let’s examine six top challenges that you must master.

1. Revenue recognition

The subscription business model is mature enough that Generally Accepted Accounting Principles (GAAP) address it. However:

Subscriptions are at the intersection between software and services, requiring expert judgment as to the “right” revenue recognition approach. It can be unclear how specific GAAP apply to many revenue recognition situations. Subscription pricing model changes (e.g. from a fixed price to actual usage) may be easy to make, but may have revenue recognition implications.

2. Taxation

Worldwide, technology is changing faster than regulations can keep up, resulting in more subscription taxation confusion and turbulence. Let’s discuss just the U.S. first:

What is the taxation method? Sales tax can apply to subscription products, at rates as high as 10 or more percent. In a typical year, thousands of state sales tax rules, jurisdictional and rate changes occur. Can you keep up? It gets worse. Are subscriptions software, services, or other? Most states treat a 100 percent cloud-delivered subscription product as software (often taxable), not a service (usually not taxable). But because jurisdictions apply many different definitions of “software”, knowing this distinction is not enough to accurately assess your taxation situation. For example, if a subscription purchase includes a component defined by states as “services” (e.g. phone support), then additional taxes may apply. Is it taxable? If a company located in one state sells subscription products in other states, then various states may determine if they are taxable using delivery-related factors such as where a company server is located or whether a download is part of the subscription.

Selling internationally amplifies tax calculation, accounting and remittance overhead. In other developed economies, Value-Added Tax (VAT) is imposed, which introduces additional complexity. One example: the selling company can capture taxes already remitted by someone earlier in the value chain.

3. Credit card expiration/payment method changes

One-time transactions using online payment methods like credit cards are simple: either the payment goes through and the customer gets the product, or it doesn’t and they don’t. For subscriptions, you must be able to bill customers repeatedly, and to respond appropriately if payment is not forthcoming.

Because renewals are often billed using payment details provided for the initial purchase, subscription billing is more vulnerable to payment detail changes such as credit card expiration. Renewal billing using prepaid cards (growing in popularity) fails after the card is “spent” unless the customer provides completely new payment details, requiring more effort (and reducing renewals) compared to updating a credit card expiration date.

4. Compliance

If your company is retaining online payment details for subscription renewal billing, then you are subject to PCI regulations. If you are selling only in the U.S. using an enterprise payment gateway (e.g. Chase Paymentech or Braintree), you can outsource PCI compliance challenges. Selling internationally? It is vastly more difficult and costly to negotiate, integrate, and manage multiple payment processor relationships to remain compliant globally.

Compliance challenges unique to subscriptions:

Obtaining customer consent for renewal billing at time of initial purchase: As the rash of lawsuits against software giants Symantec and McAfee attest, many jurisdictions require customer notification during checkout that the subscription entails recurring billing. To settle just one lawsuit for non-compliance in April 2013, Symantec offered $10 refunds or free subscription extensions to 3,900,000 customers Changing a subscription’s renewal billing amount and/or frequency: While EU law is very precise on this topic, many jurisdictions are vague on what constitutes reasonable or effective notification or consent. As courts interpret the law, the definition of “reasonable” can (and likely will) change.

The cost, complexity and risks associated with this challenge escalate with every additional legal jurisdiction in which your company does business.

5. Analytics

Subscription companies can experiment with price, feature, and other product changes more easily than perpetual license software companies. This advantage largely disappears if the profitability, efficiency, and growth impact of such changes cannot be determined. This means that tracking and managing activity in subscription-centric ways — above and beyond traditional, transaction-based reporting — is mission-critical. Without it, a subscription company will be sorely challenged to monetize and optimize their products, predict cash flow or achieve profitability.

6. Lifecycle management

Continued in article

 

From PwC Concerning Proposed Changes to Revenue Recognition Rules

The FASB and IASB (the "boards") met in October to finalize several outstanding issues related to their joint revenue recognition project. Specifically, the boards addressed the constraint on recognizing revenue from variable consideration, accounting for licenses and collectibility.

The boards confirmed that an estimate of variable consideration is included in the transaction price if it is "probable" (U.S. GAAP) or "highly probable" (IFRS) that the amount would not result in a significant revenue reversal. The boards also reintroduced an exception for revenue from sales- or usage-based royalties on licenses of intellectual property (IP).

The boards decided to retain the proposed model for distinct licenses, which distinguishes between two types of licenses - one that provides a right to use IP and one that provides access to IP. Criteria will be provided to help determine the accounting based upon the nature of the license. Lastly, the boards introduced a collectibility threshold. An entity only applies the revenue guidance to contracts when it is "probable" the entity will collect the consideration it will be entitled to in exchange for the goods or services it transfers to the customer.

Continued at
http://click.edistribution.pwc.com/?qs=e7f95a842a29b50c78a17fc062074b2d2a7f6c19bb4e0e3989acf338473615800319bf6dff13f45a

Consolidation Accounting Gimmicks

"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

Teaching Case from The Wall Street Journal Weekly Accounting Review on August 17, 2012

Digging Into Online Coupon Firms' Dealings
by: Rolfe Winkler
Aug 12, 2012
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
 

TOPICS: Revenue Recognition

SUMMARY: Groupon, Inc reported its second quarter earnings after the close of the market on Monday, August 13, 2012. This article, written in advance of that earnings announcement, cautions investors "to dig deeply into the results....Last fall, Groupon started...to sell discounted products, in addition to its core daily deals for restaurants, spas, and [other] such [services]....Notable is how the accounting treatment of this business inflates net revenue growth...[When] Groupon takes the products into inventory [as in 75% of the first-quarter Groupon Goods deals, the company] accounts for sales on a gross basis, not a net basis....As Groupon Goods accounts for more net revenue growth, it could be masking weakness in the core daily deals business." The related article discusses the actual quarterly results that were reported and the video also was prepared after the quarterly filing.

CLASSROOM APPLICATION: The article may be used to introduce topics in revenue recognition, particularly between sales of goods as a principal and offering services as an agent.

QUESTIONS: 
1. (Introductory) From your own knowledge and use of the service or from another source, describe Groupon's business model. Cite any sources you use other than your own knowledge of the business.

2. (Introductory) What new business has Groupon recently launched?

3. (Introductory) As described in the article, compare the accounting treatment for Groupon's newly launched business with its original one.

4. (Advanced) In your opinion, should this difference in accounting treatment exist? Support your answer.

5. (Advanced) Why does the author conclude that "Groupon is making it tough [for investors and other financial statement users] to understand its business"?

6. (Introductory) Refer to the related article. What results shown in the actual financial statement filing are related to the issues discussed in the main article?

7. (Introductory) Refer to the related video prepared after the quarterly financial statement filing. According to the interviewee--Mr. George Stahl, Dow Jones Newswires Deputy Managing Editor--what is "confusing" about the company's revenue?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
The New Deal at Groupon Isn't Enough
by Rolfe Winkler
Aug 14, 2012
Page: C8

"Digging Into Online Coupon Firms' Dealings," by: Rolfe Winkler, The Wall Street Journal, August 12, 2012 ---
http://professional.wsj.com/article/SB10000872396390444900304577581660314854018.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj

Not every dollar of Groupon's GRPN -6.40% revenue is created equal anymore. Will investors get a full explanation when the Internet coupon company reports second-quarter earnings Monday?

Groupon reported a surprising acceleration in its North American business in the first quarter, with net revenue rising 33% from the previous quarter. That was up from the fourth quarter's 11% increase. That improvement, said Chief Executive Andrew Mason, was due to technology that targets customers with coupons they are more likely to buy. That may give investors comfort, because it suggests Groupon isn't relying just on a huge marketing budget to drive growth. Trouble is, it doesn't appear to be the whole story. Related Reading

Groupon Staff Feel the Heat Ahead of Groupon Earnings, Investors Bet on a Big Move

Investors will want to dig deeply into the results, which are expected to show net revenue increased 2% quarter over quarter to $573 million and earnings stayed flat at minus two cents a share. Last fall, Groupon started a business called Groupon Goods to sell discounted products, in addition to its core daily deals for restaurants, spas and such. That business took off in the first quarter, driving roughly 10% of North American gross billings, data provider Yipit says. Notable is how the accounting treatment of this business inflates net revenue growth overall. About 75% of first-quarter Groupon Goods deals were so-called first party deals, Yipit estimates. For these, Groupon takes the products into inventory and accounts for sales on a gross basis, not a net basis.

That contrasts with regular Internet coupons in which net revenue reflects only Groupon's share of what a customer pays, typically about 40%. Analyst Ken Sena of Evercore Partners estimates that Groupon Goods accounted for a bit more than half of first-quarter net revenue growth. As Groupon Goods accounts for more net revenue growth, it could be masking weakness in the core daily deals business. Yipit data suggest Groupon's North American gross billings declined 2% in the second quarter from the first. Considering Europe's slowdown, Groupon's international business—about 60% of the total— may have slowed even more.

Continued in article

"GROUPON’S FEEBLE TAX ASSETS: WE TOLD YOU SO…AGAIN!" by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accoutants Bllog, June 11, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/685

Bob Jensen's threads on Groupon
Search for "Groupon" at
http://faculty.trinity.edu/rjensen/Fraud001.htm

Multiple Teaching Cases About Accounting at Groupon

"Groupon: You Must Have Fallen From The Sky," by Francine McKenna, re:TheAuditors, April 7, 2012 ---
http://retheauditors.com/2012/04/07/groupon-you-must-have-fallen-from-the-sky/

Bob Jensen's threads on Groupon are under Pricewaterhouse Coopers at
http://faculty.trinity.edu/rjensen/Fraud001.htm

"THE “BEAUTY” OF INTERNET COMPANY ACCOUNTING," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, April 9, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/604#more-604

And the same can be said for financial reporting as practiced by internet companies given their “new business models” that require “new accounting.”  Internet company financial statements seem to mean different things to different people, not unlike a piece of artwork.  Unfortunately, some of this accounting “artwork” is junk, as we have recently reported in the case of Groupon (First 10K: April Fool’s!).  At times like this beauty rests in the I of the artist.

How can management and directors and auditors see one thing, when the complete opposite reflects reality?  And why do internet IPOs seem particularly vulnerable? Well, we think the problem is with the accounting “standards” (and we use that term loosely) that apply to these companies.  As we stated in an earlier post:

Internet company accounting is suspect given all the unsupported assertions and assumptions that must be made to comply with generally accepted accounting principles…

Think about it.  The internet company balance sheet is generally dominated by intangible assets whose values are based on assumptions that are works of art themselves.  And then there’s revenue recognition in these companies with management making all kinds of assumptions about primary obligors, selling price hierarchies, and virtual sales.  Yes, what makes internet company accounting “special” is that so many of the applicable accounting rules require major assumptions, many of which could be better characterized as “giant leaps of faith.”  Clearly, the accounting rules used for internet companies should not be called “standards,” as their many judgments make any meaningful comparison an impossibility!  Enough pontificating…

Given Groupon’s recent accounting struggles we thought it might be interesting to see if there were any other internet company accounting issues lurking within today’s “hot” internet companies.  So, we looked at the most recent 10K filings of Demand Media, Facebook, Groupon, Linked In, and Zynga, focusing primarily on revenue and expense recognition, “unusual” accounting issues, and of course some of our favorites: intangible assets, cash flows, and non-GAAP financial metrics.  Here is what we found.

 

Revenue

Two of the five companies (Demand Media and Facebook) generate a significant amount of their revenue from advertising. The way these companies record revenue appears to be relatively straight-forward.  Generally, ad revenue is recognized either when the ad content is delivered, or for click-based ads, when a user clicks on an ad.  Nothing very interesting or complicated here.

Linked In, on the other hand, has a much more subjective revenue recognition method for its hiring and marketing solutions.  Most of the Company’s contractual arrangements include multiple deliverables, i.e., several products packaged together which Linked In swears can’t be pulled apart to record revenue separately.  Gee, if the Company’s cost accounting system keeps track of product and service costs separately, why can’t revenue be estimated separately? Interesting question, huh?  Anyway, Linked In uses convoluted GAAP criteria to record revenue, the relative selling price method, based on a selling price hierarchy.  In short, management decides what revenue will be based on vendor specific evidence, third party evidence, or management’s best estimate of selling price, in that order of priority.  Which one do you thing management likely favors?

Then, there’s our poster child for bad internet company accounting, Groupon.  As you may recall, the Company was busted by the SEC for improper revenue recognition last September. See “Groupon Finally Restates Its Numbers.”  Basically, Groupon ignored accounting guidance (that’s a much better word than “standard”) in Emerging Issues Task Force (EITF) 99-19, as well as SEC Staff Accounting Bulletin 101 (question 10), and recorded the gross amounts it received on Groupon sales as revenues. Since being forced to restate its financial statements, the Company now records revenue at the net amount retained from the sale of Groupons (gross collections less an agreed upon percentage of the purchase price due to the featured merchant excluding any applicable taxes), since it is acting as the merchant’s agent in the transaction.

It should be noted that Demand Media also faces the “gross vs. net” revenue issue discussed in EITF 99-19.  For revenue sharing arrangements in which the Company is considered the primary obligor, it reports revenue on a gross basis.  But for those situations where it distributes its content on third-party websites and the customer acts as the primary obligor, it records revenue on a net basis.

And last, but not least, there is Zynga with its consumable or durable virtual goods! For the sale of consumable virtual goods (goods consumed by player game actions), revenue is recognized as the goods are consumed. On the other hand, revenue from the sale of durable virtual goods (goods accessible to a player over an extended period of time) is recognized ratably over the estimated average playing period of paying players for the applicable game.  Confused yet?  Basically, we have to rely on Zynga to provide us with a best estimate of the lives of both consumable and virtual goods to book revenue. As we indicated in “Zynga’s First 10K: Zestful Zephyrs,” by merely changing the game’s rules, the Company can change what it books as revenue! This is all too arbitrary. Are we really surprised?

So, when it comes to recording revenue, it appears that booking advertising income is relatively easy, compared to the management estimates needed for multiple deliverables (Linked In) and virtual good sales (Zynga), or deciding who the “primary obligor” is (Demand Media and Groupon).  We would not be surprised if some internet companies don’t intentionally complicate their product offerings to make revenue recognition a function of management guesstimates!

 

Cost Capitalization

Given that several of these companies are struggling to achieve or maintain profitability, it is not surprising that they would try to record as an asset what really is an expense.  And sure enough, we find several instances of this.  For example, Demand Media capitalizes many different types of costs including content costs, registration and acquisition costs for undeveloped websites and internally developed software, as well as intangible assets acquired in acquisitions.  How significant is this?  Over 72 percent of the Company’s $590.1 million in total assets are intangible in nature!  Now that takes cost capitalization to a new height…we’d probably try that too if we were losing as much money every year as they are (2011’s net loss was $18.5 million).

Linked In also plays this “game,” but with a new twist.  The Company does do something quite interesting…it defers expensing $13.6 million in commissions already paid on non-cancelable subscription contracts, presumably to match the commission costs with the related revenue streams.  Why stop there?  Couldn’t you make the same argument for a whole host of other expenses as well?  Maybe they did, but Deloitte didn’t buy it.

Groupon and Zynga also have played a slightly different version of the cost capitalization game, by recording tax assets that presumably will lower future tax liabilities.  In recording these tax assets, the companies reduce income tax expense in the income statement, thus improving the bottom line.  The only problem is that a company must have future taxable income in order to use these alleged tax assets!  Well, if the companies did this to mitigate their operating losses, the game has ended for Zynga, and soon will end for Groupon.

In 2011 Zynga recorded a $113.4 million allowance against its deferred tax assets, almost fully reserving these assets, and effectively wiping them off the books.  This suggests that the Company may have had a reality check as to its future prospects, given that it no longer projects a future that includes profitability, more specifically taxable income.

As for Groupon, we highlighted this same tax issue earlier in Groupon’s First 10K: Looking Under the Hood.  In 2011, the Company increased its valuation reserve for deferred tax assets by $72.3 million reducing reported deferred tax assets to $65.3 million.  Although Groupon gave no reason for the increased reserve, it likely was forced to record it for the same reason as Zynga, i.e., little likelihood of generating taxable income in the foreseeable future against which deferred tax assets could be used.  So, who would have thought…the income tax note might actually shed some light on what a company really thinks its profit forecast is (as opposed to the press release)!

 

Other Accounting Issues

Our internet company reviews also turned up a couple of interesting points, which give us insight into managements’ attitude toward financial reporting transparency…and believe it or not, Groupon is NOT involved!

The first involves cash, naturally, and how Demand Media “defines” cash.  You may recall that we first reported on the increasing trend of companies to manipulate reported cash balances in “What’s Up With Cash Balances?”  And, yes, Demand Media is overstating its balance sheet cash by including accounts receivable as cash even though it has yet to receive the monies.  Here is what the Company’s accounting policy note says:

Continued in article

Jensen Comment
In the 1990s tech boom, startup companies in particular were not making any profits and had cash shortage problems. These companies tried to shift the focus to revenues and devised all sort of (mostly fraudulent) schemes to record non-cash revenue. The EITF worked overtime trying to plug the dikes against new revenue reporting schemes ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm 

Various Teaching Cases Featuring Groupon ---
http://faculty.trinity.edu/rjensen/Fraud001.htm
Search on the word "Groupon"

"WHAT IS ZYNGA’S “REAL” GROWTH RATE?" by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants Blog, August 27, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/746

"Groupon, Zynga and Krugman's Frothy Valuations," by Jeff Carter, Townhall, September 2011 ---
http://finance.townhall.com/columnists/jeffcarter/2011/09/13/groupon,_zynga_and_krugmans_frothy_valuations

Bob Jensen's threads about cooking the books ---
http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation

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

Repo sales Gimmicks

"Pressure in Repo Market Spreads," by Katy Burne, The Wall Street Journal, April 2, 2015 ---
http://www.wsj.com/articles/pressure-in-repo-market-spreads-1428013415?mod=djemCFO_h 

A shortage of high-quality bonds is disrupting the $2.6 trillion U.S. market for short-term loans known as repurchase agreements, or “repos,” creating bottlenecks for a key source of liquidity in the financial system and sending ripples through short-term debt markets.

Stresses in the repo market are amplifying price swings in government bonds and related debt markets at a time when many investors are reshuffling their portfolios around new interest-rate expectations, following a period of low volatility, traders and analysts said.

Although traders said the impact so far has been manageable, the broad concern is that scarcity in repos will pressure rates and could complicate efforts by the Federal Reserve to lift interest rates when the time comes.

Problems in the repo markets have been the subject of discussions at the U.S. Treasury, people familiar with the matter said. Since there is typically a strong relationship between repos and overall bond markets, the shifts can influence trading in everything from U.S. Treasurys to commercial paper, short-term IOUs taken on by companies.

“The less repo, the less liquidity in bond and other markets,” said Josh Galper, managing principal at consultancy and research firm Finadium LLC.

Continued in article

Jensen Comment
Recall that it was deceptive repo accounting that got Lehman Bros. in trouble and led to a $99 million settlement by the auditing firm, Ernst & Young.

This led to changed accounting rules restricting booking repo sales as revenue especially when it is certain that all the repo sales will be reversed after the balance sheet date.

"Should Repurchase Transactions be Accounted for as Sales or Loans?" by  Justin Chircop , Paraskevi Vicky Kiosse , and Ken Peasnell, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 657-679. 
http://aaajournals.org/doi/full/10.2308/acch-50176

SYNOPSIS:

In this paper, we discuss the accounting for repurchase transactions, drawing on how repurchase agreements are characterized under U.S. bankruptcy law, and in light of the recent developments in the U.S. repo market. We conclude that the current accounting rules, which require the recording of most such transactions as collateralized loans, can give rise to opaqueness in a firm's financial statements because they incorrectly characterize the economic substance of repurchase agreements. Accounting for repurchase transactions as sales and the concurrent recognition of a forward, as “Repo 105” transactions were accounted for by Lehman Brothers, has furthermore overlooked merits. In particular, such a method provides a more comprehensive and transparent picture of the economic substance of such transactions.

. . .

CONCLUSION

This paper suggests that the current method of accounting for repos is deficient in the sense of ignoring key aspects of the economics of such transactions. Moreover, as shown in the case of Lehman Brothers, under current regulations it may be relatively easy for a firm to design a repo in such a way to accomplish a preferred accounting treatment. For example, a firm wishing to account for a repo as a sale may easily design a bilateral repo with the option not to repurchase the assets should a particular highly unlikely event occur. Such an option would make the repo eligible for sale accounting under SFAS140. In this regard, a standard uniform method of accounting for all repos would reduce the risk of such accounting arbitrage.

Various factors not considered in this paper have probably played a part in the current position adopted by the standard setters regarding repos, including the drive for convergence in accounting standards and the fact that participants in the repo market may be “unaccustomed to treating [repurchase] transactions as sales, and a change to sale treatment would have a substantial impact on their reported financial position” (FASB 2000). It would be a pity if the concerns associated with the circumstances surrounding Lehman's use of Repo 105 prevented proper consideration being given to the possibility of treating all repos in the same manner, one that will reflect the key economic and legal features of repurchase agreements. As lawyers say, hard cases make bad law. But in this case, the Lehman's accounting for its Repo 105 transactions does substantially reflect the economics and legal considerations involved, that is, a sale of an asset with an associated obligation to return a substantially similar asset at the end of the agreement. An alternative approach would be to stick with the current measurement rules but provide additional disclosures. We have offered some tentative suggestions as to what kinds of additional disclosures are needed.

"FASB Aims to Close Another Repo Loophole," by Emily Chason, The Wall Street Journal, January 16, 2013 ---
http://blogs.wsj.com/cfo/2013/01/15/fasb-aims-to-close-another-repo-loophole/?mod=wsjpro_hps_cforeport

Since the Days of Debt Masking by Lehman Bros.:  Round an round repo accounting goes, where she stops nobody knows
"FASB changes course on repurchase agreement project (No. 2013-43)," by PwC, October 4, 2013 --- Click Here
http://www.pwc.com/us/en/cfodirect/publications/in-brief/2013-43-fasb-repurchase-agreement-project.jhtml?display=/us/en/cfodirect/publications/in-brief&j=273182&e=rjensen@trinity.edu&l=553224_HTML&u=12757682&mid=7002454&jb=0

What's new?

At its October 2 meeting, the FASB tentatively decided to retain some aspects of the accounting model for repurchase agreements that it proposed in an exposure draft¹ issued in January 2013 (the “Exposure Draft”). This is a significant change from the Board’s tentative decision in May 2013 when, after reviewing comment letter feedback, it decided not to modify the accounting for transfers of financial assets and only require additional disclosures.

What are the key decisions?

The FASB made the following tentative decisions in regard to the repurchase agreement accounting model:

• Repos-to-maturity²: The Board decided to require repo-to-maturity transactions to be accounted for as secured borrowings.
• Repurchase financings³: Under current guidance, repurchase agreements entered into as part of a repurchase financing may be required to be accounted for on a “linked” basis with the original transfer and analyzed as a single transaction. As a result, the purchaser may account for the transaction as a derivative instrument as opposed to a purchase and a financing. Consistent with the Exposure Draft, the Board decided to eliminate the current model for repurchase financings and require that repurchase agreements be accounted for separate from the original transfer.
• “Substantially the same” guidance: The Board decided to add new implementation guidance to clarify the assessment of the substantially the same characteristics within the effective control model for dollar roll⁴ transactions involving the transfer of an existing agency mortgage-backed security and a forward To Be Announced (TBA) repurchase agreement. The implementation guidance would indicate that a forward TBA dollar roll without trade stipulations would not be expected to result in the return of a substantially the same financial asset, but a forward TBA dollar roll with stipulations might.

When applying the new guidance, certain market standard TBA dollar rolls without stipulations may be accounted for as sales (if the other criteria are satisfied), but a transaction with stipulations would require additional analysis.

• The Board also determined that additional disclosures will be required for certain transfers accounted for as sales by transaction type, including:
  
  -  the carrying amounts of assets derecognized as of the date of the initial transfer in transactions for which an agreement with the transferee remains outstanding at the reporting date,
  
  -  information about the transferor’s ongoing exposure to the transferred financial assets, including a description of the arrangements that result in the transferor retaining exposure to the transferred financial assets, the risks related to those assets to which the transferor remains exposed, and the maximum exposure related to those assets (fair value of assets derecognized), and
  
  -  amounts recorded in the financial statements related to agreements accounted for as sale (i.e., the forward purchase commitment accounted for as a derivative), with a cross reference to the disclosures required by ASC 815, Derivatives and Hedging.

Is convergence achieved?

Convergence is not a stated goal of this project. This is a FASB-only project involving amendments to ASC 860 under which surrendering effective control is required to achieve sale accounting. IFRS requires a different model which is more of a “risk and rewards” approach that generally results in treating repurchase agreements as secured borrowings.

Continued in article

Bob Jensen's threads on repo accounting debt masking and sales gimmicks ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Repo

It's about time!
When I suggested this in a meeting and later in an email message a couple of years ago a FASB board member gave me the brush off.

"FASB WILL TAKE ANOTHER LOOK AT REPO ACCOUNTING," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants, March 22, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/585

The FASB announced yesterday that it will take a look at repo accounting.  Again.  As we don’t expect much improvement, we wonder why it bothers.

Michael Rapoport of The Wall Street Journal reports, “The Financial Accounting Standards Board agreed Wednesday to look at further revisions to how companies must account for their use of repurchase agreements, or ‘repos,’ a form of financing for securities-trading firms, following a previous revision last year. In particular, the board will look at ‘repos to maturity,’ a potentially risky variant that contributed to MF Global’s collapse last year.”

The Lehman Brothers collapse led to some small, insignificant changes in the repo rules.  With the collapse of MF Global, the board thinks it desirable to consider some incremental but insignificant amendments.  As last year’s revision was impotent, we expect more of the same from any revision this year.

What the board should have done a decade or two ago was to focus on the economic substance of the transaction, and the substance of a repurchase agreement is that it is a secured borrowing.  Pure and simple.  Thus, all repurchase agreements should be accounted for as secured borrowings.

The FASB’s statement yesterday says more about it than it does repo accounting.  The board is incredibly slow and, with old age, is slowing down even further.  The board is reactive instead of proactive; apparently, it cannot think about an issue unless there is some type of financial crisis.  The board cannot think simple; instead, it seems to complexify whatever issue is at hand.  Finally, the board seems beholden to banks and has been for some time.  It appears to carry water for bankers, whether the topic is special purpose entities, derivatives, fair value accounting, or repurchase agreements.

Forget reforming repo accounting.  Let’s reform FASB instead. (so say Catanach and Ketz)

Update
Repos Become Collateralized Borrowings Rather Than Sales:  No More Hiding the Extent of Leverage
"In brief: FASB clarifies scope of new repurchase accounting model," by PwC, October 5, 2012 ---
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8YS2LC&SecNavCode=MSRA-84YH44&ContentType=Content

Summary: At its October 3 meeting, the FASB decided to eliminate the existing guidance for evaluating if a repurchase agreement entered into as part of a "repurchase financing" should be considered linked to a previously transferred financial asset. The board's decision means that under its proposed amendments to the existing model, these repurchase agreements will be accounted for as secured borrowings.

The FASB also decided to limit the scope of the proposed amendments to the existing model to transfers of financial assets with an agreement to repurchase assets that are identical or "substantially the same." The scope includes repo to maturity transactions.

This In brief article provides an overview of the FASB's discussions.

 

Repo Scandals When Sales 100% Certain to Be Returned Were Booked as Sales Revenues to Paint a Misleading Picture of Lighter Leverage Risk ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Repo

"FASB Agrees to Tighten Sale Accounting Criteria," by Tammy Whitehouse, Compliance Week, August 10, 2012 ---
http://www.complianceweek.com/fasb-agrees-to-tightens-sale-accounting-criteria/article/254156/

In its continuing quest to sort out when a financial asset transaction is a sale vs. a repurchase agreement or a secured borrowing, the Financial Accounting Standards Board tentatively agreed to a slightly narrower definition of when a transaction qualifies for sale treatment, which enables an asset to be removed from the balance sheet.

During a recent meeting, FASB tentatively decided it will extend an exception to the rules for financial asset sale accounting for certain sale and repurchase agreements. It will require secured borrowings accounting for transactions that involve the sale and purchase of not only identical financial assets, but also financial assets that are substantially similar. The board also decided it will clarify the criteria for determining whether the financial assets to be repurchased are substantially similar to the assets initially transferred. Ultimately, that will have the effect of requiring more transactions to be treated as secured borrowings, which keeps more of them on the balance sheet.

It's a touchy subject in the financial services sector particularly as FASB continues to work through an accounting solution that will prevent another Lehman-like accounting headache. Before it collapsed, Lehman Brothers used repurchase transactions to shuttle some $50 billion in assets on and off the balance sheet around period closing dates to mask the true measure of its debt, according to the firm's bankruptcy examiner.

FASB has decided a secured borrowing transaction can be distinguished by six critical criteria. In addition to the transfer of identical or similar assets, it involves a transfer of existing financial asset at its inception, and the agreement involves both a right and an obligation to repurchase the financial assets. The initial transfer and forward repurchase agreement involves the same counterparty, and the repurchase agreement is linked to the initial transfer.

In addition, the repurchase price is fixed and easily determined, and the financial assets specified under the agreement are identical to the financial assets initially transferred, or at least substantially similar. As for what to do when a given transaction fits most but not all the criteria for a secured borrowing, the board decided it will rely on existing guidance to determine when transactions should be described as secured borrowings vs. sales with forward repurchase agreements.

And, of course, there will be disclosure requirements. The board decided all repurchase agreements and similar transactions should be described in the notes to financial statements with three specific disclosures: the reasons for concluding whether a transaction is a secured borrowing or a sale with a forward repurchase commitment, and the accounting reasoning behind a transaction involving substantially similar but not identical financial assets.

"Should Repurchase Transactions be Accounted for as Sales or Loans?" by  Justin Chircop , Paraskevi Vicky Kiosse , and Ken Peasnell, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 657-679 ---
http://aaajournals.org/doi/full/10.2308/acch-50176 

Abstract
In this paper, we discuss the accounting for repurchase transactions, drawing on how repurchase agreements are characterized under U.S. bankruptcy law, and in light of the recent developments in the U.S. repo market. We conclude that the current accounting rules, which require the recording of most such transactions as collateralized loans, can give rise to opaqueness in a firm's financial statements because they incorrectly characterize the economic substance of repurchase agreements. Accounting for repurchase transactions as sales and the concurrent recognition of a forward, as “Repo 105” transactions were accounted for by Lehman Brothers, has furthermore overlooked merits. In particular, such a method provides a more comprehensive and transparent picture of the economic substance of such transactions.

"Revenue recognition when product return and pricing adjustment uncertainties exist," by Stephanie Rasmussen, FASRI, October 31, 2012 ---
http://www.fasri.net/index.php/2012/10/revenue-recognition-when-product-return-and-pricing-adjustment-uncertainties-exist/

My forthcoming paper in Accounting Horizons (Rasmussen 2013; “Revenue Recognition, Earnings Management, and Earnings Informativeness in the Semiconductor Industry”) examines the implications of revenue recognition for companies with product return and pricing adjustment uncertainties. Although these uncertainties are typically minimal for sales to end customers, they can pose large risks for sales to distributors. The reason being is that distributors’ product return and pricing adjustment rights often do not lapse until the distributor resells the product to an end customer. In the midst of these risks, companies recognize revenue upon delivery of product to distributors (sell-in), when the distributor resells the product to end customers (sell-through), or under some combination (sell-in for some distributors and sell-through for others).

I examine two implications of revenue recognition for companies with product return and pricing adjustment uncertainties. First, I examine whether the incidence of earnings management is higher for companies that recognize revenue before their product return and pricing adjustment uncertainties are resolved. This expectation is motivated by the fact that more opportunities exist to manage earnings when revenue is immediately recognized under the sell-in method compared to when at least some revenue recognition is deferred under the sell-through and combination methods. Specifically, managers using the sell-in method (1) maintain (and have opportunities to manipulate) product return and pricing adjustment accruals, and (2) can boost earnings through channel stuffing activities.

Second, I examine whether earnings informativeness (proxied for with the earnings response coefficient) differs among the revenue recognition methods used by companies with product return and pricing adjustment uncertainties. On one hand, immediate revenue recognition more quickly incorporates new accounting information into the financial statements. If this new information is useful to the market, earnings should be more informative under the sell-in method compared to the other revenue recognition methods. On the other hand, more opportunities exist for both intentional performance manipulations and unintentional estimation errors when revenue is immediately recognized. Thus, if earnings are (or are perceived to be) more inaccurate under the sell-in method, earnings informativeness should be higher when revenue recognition is deferred until distributors have resold products to end customers.

In order to study these research questions, I limit my sample to semiconductor companies because they sell to distributors and naturally face product return and pricing adjustment uncertainties due to rapid product obsolescence and declining prices over product life cycles. I find that sell-in companies are more likely to meet or beat analysts’ consensus earnings forecast compared to sell-through and combination companies, suggesting that earnings management is more likely when companies immediately recognize revenue for sales to distributors. I also find that the earnings response coefficient is significantly larger (meaning the returns-earnings relationship is stronger) for sell-through companies compared to sell-in and combination companies. This finding suggests that earnings are more informative when revenue recognition is deferred until the distributor has resold the product to end customers. Collectively, these results suggest that revenue recognition should be deferred until all product return and pricing adjustment uncertainties are resolved.

This study should be of interest to the FASB and IASB as they finalize a joint revenue recognition standard. The current exposure draft of the new standard states that revenue recognition should occur when the customer obtains control of the product or service. Control, as described in the exposure draft, is likely to be transferred when a manufacturer delivers product to a distributor except for cases where a consignment agreement exists. At the time control is transferred, the standard directs the manufacturer to estimate variable consideration (e.g., product returns and pricing adjustments), determine the transaction price, and recognize revenue so long as receipt of the estimated transaction price is reasonably assured. Recent technical briefs from the Big 4 accounting firms suggest that the new standard’s provisions regarding variable consideration may require many manufacturers that have historically used the sell-through method to change to the sell-in method. Such a shift is concerning as my findings suggest that earnings management is more likely and earnings informativeness is lower when revenue is recognized at sell-in.

Question
Where did the missing MF Global $1+ billion end up?

Hint:
The the word "repo" sound familiar?
http://en.wikipedia.org/wiki/Repurchase_agreement

"MF Global and the great Wall St re-hypothecation scandal," by Chrisopher Elias, Reuters, December 7, 2011 ---
http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/

A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients. 

MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet. 

If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing. 

FINDING FUNDS 

Current estimates for the shortfall in MF Global customer funds have now reached $1.2 billion as revelations break that the use of client money appears widespread. Up until now the assumption has been that the funds missing had been misappropriated by MF Global as it desperately sought to avoid bankruptcy. 

Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF Global clients never get their money back. 

REPO RECAP 

First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules. 

MF Global used a version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it debt from Italy, Spain, Belgium, Portugal and Ireland. 

Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo? 

Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’ money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use of clients funds known as “re-hypothecation”. 

RE-HYPOTHECATION 

By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults. 

In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default. 

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital). 

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds. 

U.S. RULES 

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets. 

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500). 

This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions. 

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation. 

BEWARE THE BRITS: CIRCUMVENTING U.S. RULES 

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules. 

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation. 

Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules. 

LEHMAN LESSONS 

In fact this is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished. 

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement). 

These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE. 

MF RE-HYPOTHECATION PROVISION 

A similar re-hypothecation provision can be seen in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause: 

 “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.” 

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money but regulatory filings and letters from MF Global’s administrators contain some clues. 

According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”. 

CAUSTIC COLLATERAL 

Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules. 

Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction. 

Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities. 

Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds. 

OFF BALANCE SHEET 

As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering. 

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link. 

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing. 

The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added): 

 “Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral.Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged. 

We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. 

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion. 

HYPER-HYPOTHECATION 

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble. 

Jensen Summary of Repo Fraud and Deceptive Accounting Enabled by the FASB
The word "repo" is short for "repossession" of the title back to some asset that has been sold or used as collateral in a loan. For example, in states with lemon warranty laws, an automobile dealer may have to take back possession of a vehicle that turns out to be a real lemon. This is a bit different that the majority of warranty obligations that simply contract for repair of the sold item but not repossession of the item itself. There are also those "money back" sales contracts such as a contractual term that reads "use for 10 days and if you're not totally satisfied you money will be cheerfully refunded in full."

The overwhelming use of the word "repo" is the repossession of title to a creditor where the item sold is collateral on the loan. If a dealer loans money on a car loan, then the dealer may repossess the collateral if the customer defaults on the loan. Movies have been made about "Repo Men" who sneak into garages or driveways in the dead of night and drive away with repossessed cars. If the bank loan, than the bank must repossess the collateral on the loan rather than the dealer.

In the case of financial instruments sales such as the sale of mortgage note/bond investments, sometimes the instruments themselves are collateral on the loans. For example, in the famous case of Repo 105 and 108 deals by Lehman Brothers, Lehman needed to improve its cash liquidity position for about two weeks surrounding the year end closing of its books in order to show a better leverage position of liquidity to debt. So Lehman really borrowed millions from former Lehman employees (not exactly arms length transactions) using poisoned mortgages that it could not easily sell as collateral on the very short term borrowings (a week or two) for which Lehman contracted for either 5% or 8% returns to its former employees who loaned the cash.

But receiving cash offset by short term borrowing does not really improve liquidity and leverage on the balance sheet. So Lehman and its auditor, Ernst & Young, devised a really devious ploy that was enabled by a totally stupid clause in the FASB's

Based on the Bankruptcy Examiner’s report, Lehman’s Repo 105 and Repo 108 transactions were structurally similar to ordinary repo transactions. The transactions were conducted with the same collateral and with substantially the same counterparties. See Report of Anton R. Valukas, Examiner, United States Bankruptcy Court Southern District of New York, In re Lehman Brothers Holdings Inc., et al., Debtors, March 11, 2010, v3, pg. 746.

More from the examiner’s report:

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10-K and 10-Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet”; felt that “there was no substance to the transactions”; and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

I've oversimplified the Repo 105 and 105 transactions by Lehman Brothers. For a more complete explanation, see the following:
"Lehman's Demise and Repo 105: No Accounting for Deception," Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464

The collapse of Lehman Brothers in September 2008 is widely seen as the trigger for the financial crisis, spreading panic that brought lending to a halt. Now a 2,200-page report says that prior to the collapse -- the largest bankruptcy in U.S. history -- the investment bank's executives went to extraordinary lengths to conceal the risks they had taken. A new term describing how Lehman converted securities and other assets into cash has entered the financial vocabulary: "Repo 105."

While Lehman's huge indebtedness and other mistakes have been well documented, the $30 million study by Anton Valukas, assigned by the bankruptcy court, contains a number of surprises and new insights, several Wharton faculty members say.

Among the report's most disturbing revelations, according to Wharton finance professor Richard J. Herring, is the picture of Lehman's accountants at Ernst & Young. "Their main role was to help the firm misrepresent its actual position to the public," Herring says, noting that reforms after the Enron collapse of 2001 have apparently failed to make accountants the watchdogs they should be.

"It was clearly a dodge.... to circumvent the rules, to try to move things off the balance sheet," says Wharton accounting professor professor Brian J. Bushee, referring to Lehman's Repo 105 transactions. "Usually, in these kinds of situations I try to find some silver lining for the company, to say that there are some legitimate reasons to do this.... But it clearly was to get assets off the balance sheet."

The use of outside entities to remove risks from a company's books is common and can be perfectly legal. And, as Wharton finance professor Jeremy J. Siegel points out, "window dressing" to make the books look better for a quarterly or annual report is a widespread practice that also can be perfectly legal. Companies, for example, often rush to lay off workers or get rid of poor-performing units or investments, so they won't mar the next financial report. "That's been going on for 50 years," Siegel says. Bushee notes, however, that Lehman's maneuvers were more extreme than any he has seen since the Enron collapse.

Wharton finance professor professor Franklin Allen suggests that the other firms participating in Lehman's Repo 105 transactions must have known the whole purpose was to deceive. "I thought Repo 105 was absolutely remarkable – that Ernst & Young signed off on that. All of this was simply an artifice, to deceive people." According to Siegel, the report confirms earlier evidence that Lehman's chief problem was excessive borrowing, or over-leverage. He argues that it strengthens the case for tougher restrictions on borrowing.

A Twist on a Standard Financing Method

In his report, Valukas, chairman of the law firm Jenner & Block, says that Lehman disregarded its own risk controls "on a regular basis," even as troubles in the real estate and credit markets put the firm in an increasingly perilous situation. The report slams Ernst & Young for failing to alert the board of directors, despite a warning of accounting irregularities from a Lehman vice president. The auditing firm has denied doing anything wrong, blaming Lehman's problems on market conditions.

Much of Lehman's problem involved huge holdings of securities based on subprime mortgages and other risky debt. As the market for these securities deteriorated in 2008, Lehman began to suffer huge losses and a plunging stock price. Ratings firms downgraded many of its holdings, and other firms like JPMorgan Chase and Citigroup demanded more collateral on loans, making it harder for Lehman to borrow. The firm filed for bankruptcy on September 15, 2008.

Prior to the bankruptcy, Lehman worked hard to make its financial condition look better than it was, the Valukas report says. A key step was to move $50 billion of assets off its books to conceal its heavy borrowing, or leverage. The Repo 105 maneuver used to accomplish that was a twist on a standard financing method known as a repurchase agreement. Lehman first used Repo 105 in 2001 and became dependent on it in the months before the bankruptcy.

Repos, as they are called, are used to convert securities and other assets into cash needed for a firm's various activities, such as trading. "There are a number of different kinds, but the basic idea is you sell the security to somebody and they give you cash, and then you agree to repurchase it the next day at a fixed price," Allen says.

In a standard repo transaction, a firm like Lehman sells assets to another firm, agreeing to buy them back at a slightly higher price after a short period, sometimes just overnight. Essentially, this is a short-term loan using the assets as collateral. Because the term is so brief, there is little risk the collateral will lose value. The lender – the firm purchasing the assets – therefore demands a very low interest rate. With a sequence of repo transactions, a firm can borrow more cheaply than it could with one long-term agreement that would put the lender at greater risk.

Under standard accounting rules, ordinary repo transactions are considered loans, and the assets remain on the firm's books, Bushee says. But Lehman found a way around the negotiations so it could count the transaction as a sale that removed the assets from its books, often just before the end of the quarterly financial reporting period, according to the Valukas report. The move temporarily made the firm's debt levels appear lower than they really were. About $39 billion was removed from the balance sheet at the end of the fourth quarter of 2007, $49 billion at the end of the first quarter of 2008 and $50 billion at the end of the next quarter, according to the report.

Bushee says Repo 105 has its roots in a rule called FAS 140, approved by the Financial Accounting Standards Board in 2000. It modified earlier rules that allow companies to "securitize" debts such as mortgages, bundling them into packages and selling bond-like shares to investors. "This is the rule that basically created the securitization industry," he notes.

FAS 140 allowed the pooled securities to be moved off the issuing firm's balance sheet, protecting investors who bought the securities in case the issuer ran into trouble later. The issuer's creditors, for example, cannot go after these securities if the issuer goes bankrupt, he says.

Because repurchase agreements were really loans, not sales, they did not fit the rule's intent, Bushee states. So the rule contained a provision saying the assets involved would remain on the firm's books so long as the firm agreed to buy them back for a price between 98% and 102% of what it had received for them. If the repurchase price fell outside that narrow band, the transaction would be counted as a sale, not a loan, and the securities would not be reported on the firm's balance sheet until they were bought back.

This provided the opening for Lehman. By agreeing to buy the assets back for 105% of their sales price, the firm could book them as a sale and remove them from the books. But the move was misleading, as Lehman also entered into a forward contract giving it the right to buy the assets back, Bushee says. The forward contract would be on Lehman's books, but at a value near zero. "It's very similar to what Enron did with their transactions. It's called 'round-tripping.'" Enron, the huge Houston energy company, went bankrupt in 2001 in one of the best-known examples of accounting deception.

Lehman's use of Repo 105 was clearly intended to deceive, the Vakulas report concludes. One executive email cited in the report described the program as just "window dressing." But the company, which had international operations, managed to get a legal opinion from a British law firm saying the technique was legal.

Bamboozled

The Financial Accounting Standards Board moved last year to close the loophole that Lehman is accused of using, Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one designed to get at the intent behind a repurchase agreement. The new rule, just taking effect now, looks at whether a transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan and the assets stay on the borrower's balance sheet.

The Vakulas report has led some experts to renew calls for reforms in accounting firms, a topic that has not been front-and-center in recent debates over financial regulation. Herring argues that as long as accounting firms are paid by the companies they audit, there will be an incentive to dress up the client's appearance. "There is really a structural problem in the attitude of accountants." He says it may be worthwhile to consider a solution, proposed by some of the industry's critics, to tax firms to pay for auditing and have the Securities and Exchange Commission assign the work and pay for it.

The Valukas report also shows the need for better risk-management assessments by firm's boards of directors, Herring says. "Every time they reached a line, there should have been a risk-management committee on the board that at least knew about it." Lehman's ability to get a favorable legal opinion in England when it could not in the U.S. underscores the need for a "consistent set" of international accounting rules, he adds.

Siegel argues that the report also confirms that credit-rating agencies like Moody's and Standard & Poor's must bear a large share of the blame for troubles at Lehman and other firms. By granting triple-A ratings to risky securities backed by mortgages and other assets, the ratings agencies made it easy for the firms to satisfy government capital requirements, he says. In effect, the raters enabled the excessive leverage that proved a disaster when those securities' prices fell to pennies on the dollar. Regulators "were being bamboozled, counting as safe capital investments that were nowhere near safe."

Some financial industry critics argue that big firms like Lehman be broken up to eliminate the problem of companies being deemed "too big to fail." But Siegel believes stricter capital requirements are a better solution, because capping the size of U.S. firms would cripple their ability to compete with mega-firms overseas.

While the report sheds light on Lehman's inner workings as the crisis brewed, it has not settled the debate over whether the government was right to let Lehman go under. Many experts believe bankruptcy is the appropriate outcome for firms that take on too much risk. But in this case, many feel Lehman was so big that its collapse threw markets into turmoil, making the crisis worse than it would have been if the government had propped Lehman up, as it did with a number of other firms.

Allen says regulators made the right call in letting Lehman fail, given what they knew at the time. But with hindsight he's not so sure it was the best decision. "I don't think anybody anticipated that it would cause this tremendous stress in the financial system, which then caused this tremendous recession in the world economy."

Allen, Siegel and Herring say regulators need a better system for an orderly dismantling of big financial firms that run into trouble, much as the Federal Deposit Insurance Corp. does with ordinary banks. The financial reform bill introduced in the Senate by Democrat Christopher J. Dodd provides for that. "I think the Dodd bill has a resolution mechanism that would allow the firm to go bust without causing the kind of disruption that we had," Allen says. "So, hopefully, next time it can be done better. But whether anyone will have the courage to do that, I'm not sure."

Lehman's Ghost Has Been Named "Debt Masking"
The initials DM, however, stand for "Deception Manipulation"
"Debt 'Masking' Under Fire:  SEC Considers New Rules to Deter Banks From Dressing Up Books; Ghost of Lehman, by Tom McGinty, Kate Kelly, and Kara Scannell, " The Wall Street Journal, April 21, 2010 ---
http://online.wsj.com/article/SB20001424052748703763904575196334069503298.html#mod=todays_us_page_one

Lehman Repo 105/109 Scandal Involving Ernst & Young --- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Repo

"Lehman Troubles Not Over For Ernst & Young," by Francine McKenna, Forbes, December 13, 2012 ---
http://www.forbes.com/sites/francinemckenna/2012/12/13/lehman-troubles-not-over-for-ernst-young/

Ernst & Young chalked up one small victory in New York State Supreme Court this week over claims by the New York Attorney General that the firm committed fraud leading to the failure of Lehman Brothers in 2008. Justice Jeffrey Oing said the New York Attorney General cannot claim $150 million in fees that Ernst & Young earned from Lehman Brothers Holdings from 2001-2008, when the firm filed bankruptcy.

Attorney David Ellenhorn of the NYAG claimed the fees represented “disgorgement” of “ill gotten gains” since the Attorney General says Ernst & Young repeatedly committed “fraudulent acts” as auditor of Lehman Brothers all those years. When Ellenhorn tried to explain this to the judge, Oing told Ellenhorn he had the wrong remedy.

Not good when you have to explain too much to the judge.

Fortunately for the New York Attorney General, the fees disgorgement strategy is Plan B. (It’s literally “Letter B” in the list of remedies the NYAG seeks for Ernst & Young’s alleged fraudulent acts.)  The New York Attorney General can still pursue its request that Ernst & Young “pay restitution, disgorgement and damages caused, directly or indirectly, by the fraudulent and deceptive acts and repeated fraudulent acts and persistent illegality complained of herein plus applicable pre-judgment interest.”

The New York Attorney General, you may recall from my previous reports, has the powerful Martin Act on its side. Back in December of 2010, The Wall Street Journal’s Ashby Jones at the Law Blog explained just how powerful this law is.

In the lawsuit filed against accounting firm Ernst & Young, Andrew Cuomo brought four claims, three of them under New York’s Martin Act, one of the most powerful prosecutorial tools in the country. Technically speaking, the Martin Act allows New York’s top law enforcer to go after wrongdoing connected to the sale or purchase of securities. Nothing too noteworthy there.

But what is noteworthy is the power the act confers upon its user. It enables him to subpoena any document from anyone doing business in New York and, if he so desires, keep an investigation entirely secret. People subpoenaed in Martin Act cases aren’t afforded a right to counsel or the right against self-incrimination. “Combined, the act’s powers exceed those given any regulator in any other state,” wrote Nicholas Thompson in this 2004 Legal Affairs article.

And we haven’t even gotten to the kicker. Courts in civil Martin Act cases have held that “fraud” under the Martin Act “includes all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public, whether or not the product of scienter or intent to defraud.” In other words, in order to prove a Martin Act violation, the attorney general is not required to prove that the defendant intended to defraud anyone, only that a defrauding act was committed…

Mr. Ellenhorn, however, is all, “We’ll never make it…”, like Glum in Gulliver’s Travels. He worried aloud to the judge, according to Reuters, that the private class action litigation still facing Ernst & Young over Lehman will beat him to the punch in claiming compensation for investor losses.

In July of 2011, New York Federal Court Judge Lewis Kaplan decided to allow substantially all of the allegations against Lehman executives and at least one of the allegations against Ernst & Young to move forward to discovery and trial. That case is proceeding.

The remaining allegation in the class action litigation against Ernst & Young? That Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

Ellenhorn is worried because the NYAG’s remaining remedy is for investors’ damages. Investors, however, have their own ongoing lawsuits against Ernst & Young to recover the same damages. If the investors are successful first in their lawsuits, the state cannot pursue a double recovery for the same damages.

Ernst & Young claimed victory at the time of Judge Kaplan’s decision, too. To me, however, the threat of a trial is formidable. It’s costing Ernst & Young a lot of time and money to address.

Continued in article

Bob Jensen's threads on Ernst & Young ---
http://faculty.trinity.edu/rjensen/Fraud001.htm

Proposed New Repo Accounting Rules

The FASB tentatively decided this week to propose specifying the types of repurchase agreements (also known as “repos”) that should be accounted for as secured borrowings based on six criteria. These types of transactions would be an exception to the general guidance for derecognition of financial assets. The existing criteria for assessing effective control of repurchase
PwC In Brief
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=GBAD-8VQQLA&SecNavCode=MSRA-84YH44&ContentType=Content
 

Update
Repos Become Collateralized Borrowings Rather Than Sales:  No More Hiding the Extent of Leverage
"In brief: FASB clarifies scope of new repurchase accounting model," by PwC, October 5, 2012 ---
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8YS2LC&SecNavCode=MSRA-84YH44&ContentType=Content

Summary: At its October 3 meeting, the FASB decided to eliminate the existing guidance for evaluating if a repurchase agreement entered into as part of a "repurchase financing" should be considered linked to a previously transferred financial asset. The board's decision means that under its proposed amendments to the existing model, these repurchase agreements will be accounted for as secured borrowings.

The FASB also decided to limit the scope of the proposed amendments to the existing model to transfers of financial assets with an agreement to repurchase assets that are identical or "substantially the same." The scope includes repo to maturity transactions.

This In brief article provides an overview of the FASB's discussions.

 

Ernst & Young Takes Another Big (CBS Sixty Minutes) Hit for Putting Client Interests Above Investor Interests
The SEC and the Department of Justice Also Get Hammered for Doing Nothing Against Lehman and E&W in a "Debt Masking" Scandal
 

"The case against Lehman Brothers," CBS Sixty Minutes, April 22, 2012 --- Click Here
http://www.cbsnews.com/8301-18560_162-57417397/the-case-against-lehman-brothers/?tag=contentMain;cbsCarousel

Steve Kroft talks to the bank examiner whose investigation reveals the how and why of the spectacular financial collapse of Lehman Brothers, the bankruptcy that triggered the world financial crisis. Web Extras

The case against Lehman Brothers Kroft: When to give up on accountability Inside the SEC More »

Update: A statement from Ernst and Young: Lehman's bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity.

We firmly believe that our work met all applicable professional standards, applying the rules that existed at the time. Lehman's demise was caused by the global financial crisis that impacted the entire financial sector, not by accounting or financial reporting issues.

It's hard to overstate the enormity of the 2008 collapse of Lehman Brothers. It was the largest bankruptcy in history; 26,000 employees lost their jobs; millions of investors lost all or almost all of their money; and it triggered a chain reaction that produced the worst financial crisis and economic downturn in 70 years.

Yet four years later, no one at Lehman has been held responsible. Steve Kroft investigates the collapse of Lehman Brothers: what the SEC did and didn't know about the firm's finances, the role of a top accounting firm, and why no one at Lehman has been called to account.

The following script is from "The Case Against Lehman" which originally aired on April 22, 2012. Steve Kroft is the correspondent. James Jacoby and Michael Karzis, producers.

On September 15, 2008, Lehman Brothers, the fourth largest investment bank in the world, declared bankruptcy -- sparking chaos in the financial markets and nearly bringing down the global economy. It was the largest bankruptcy in history -- larger than General Motors, Washington Mutual, Enron, and Worldcom combined. The federal bankruptcy court appointed Anton Valukas, a prominent Chicago lawyer and former United States attorney to conduct an investigation to determine what happened.

Included in the nine-volume, 2,200-page report was the finding that there was enough evidence for a prosecutor to bring a case against top Lehman officials and one of the nation's top accounting firms for misleading government regulators and investors. That was two years ago and there have been no prosecutions. Anton Valukas has never given an interview about his report until now.

Steve Kroft: This is the largest bankruptcy in the world. What were the effects?

Anton Valukas: The effects were the financial disaster that we are living our way through right now.

Steve Kroft: And who got hurt?

Anton Valukas: Everybody got hurt. The entire economy has suffered from the fall of Lehman Brothers.

Steve Kroft: So the whole world?

Anton Valukas: Yes, the whole world.

When Lehman Brothers collapsed, 26,000 employees lost their jobs and millions of investors lost all or almost all of their money, triggering a chain reaction that produced the worst financial crisis and economic downturn in 70 years. Anton Valukas' job was to provide the bankruptcy court with accurate, reliable information that the judges could use to resolve the claims of creditors picking over Lehman's corpse.

Steve Kroft: Had you ever done anything like this before?

Anton Valukas: I've never done anything like Lehman Brothers. I don't think anybody else has ever done anything like Lehman Brothers.

Steve Kroft: So your job, I mean, in some ways, your job was to assess blame?

Anton Valukas: Our job is to determine what actually happened, put the cards face up on the table, and let everybody see what the facts truly are.

Valukas' team spent a year and a half interviewing hundreds of former employees, and pouring over 34 million documents. They told of how Lehman bought up huge amounts of real estate that it couldn't unload when the market went south -- how it had borrowed $44 for every one it had in the bank to finance the deals -- and how Lehman executives manipulated balance sheets and financial reports when investors began losing confidence and competitors closed in.

Steve Kroft: Did these quarterly reports represent to investors a fair, accurate picture of the company's financial condition?

Anton Valukas: In our opinion, they did not.

Steve Kroft: And isn't that against the law?

Anton Valukas: It certainly, in our opinion, was against civil law if you will. There were colorable claims that this was a fraud, yes.

By colorable claims Valukus means there is sufficient evidence for the Justice Department or the Securities and Exchange Commission to bring charges against top Lehman executives, including CEO Richard Fuld, for overseeing and certifying misleading financial statements, and against Lehman's accountant, Ernst and Young, for failing to challenge Lehman's numbers.

Anton Valukas: They'd fudged the numbers. They would move what turned out to be approximately $50 billion of assets from the United States to the United Kingdom just before they printed their financial statements. And a week or so after the financial statements had been distributed to the public, the $50 billion would reappear here in the United States, back on the books in the United States.

Steve Kroft: And then the next financial statement, they would move it overseas again, and file the report, and then move it back?

Anton Valukas: Right.

Steve Kroft: It sounds like a shell game.

Anton Valukas: It was a shell game. It was a gimmick.

Lehman misused an accounting trick called Repo 105 to temporarily remove the $50 billion from its ledgers to make it look as though it was reducing its dependency on borrowed money and was drawing down its debt. Lehman never told investors or regulators about it.

Steve Kroft: This is really deception to make the company look healthier than it was?

Anton Valukas: Yes.

Steve Kroft: Deliberate?

Anton Valukas: Yes.

Steve Kroft: How are you so sure of that?

Anton Valukas: Because we read the emails in which we observed the people saying that they were doing it. We interviewed the witnesses who wrote those emails, or some of those emails, and asked them why they were doing it, and they told us they were doing it for purposes of affecting the numbers.

Steve Kroft: Do you think that Lehman executives knew that this was wrong?

Anton Valukas: For some of 'em, certainly. There was concerns being expressed by-- at high levels about whether this is appropriate, what happens if the street found out about it. So, you know, there was a concern that there's a real question about whether we can do this, whether this was right or not.

One of those people was Matthew Lee who had been a senior executive at Lehman and the accountant responsible for its global balance sheet. Lee was one of the first to raise objections inside Lehman about the accounting trick known as Repo 105.

Matthew Lee: It sounded like a rat poison, Repo 105, when I first heard it. So I investigated what it was, and I didn't like what I saw.

Continued in article

Jensen Comment
Lehman executives took an interesting tack when defending themselves from the SEC. Their defense is that the SEC knew in advance about the Repo 105 and Repo 108 transactions and could've prevented those deceptions from happening in the first place. Hence if the SEC sues over these deceptions the SEC will end up bringing a lawsuit against itself.

In any case who cares about an SEC lawsuit. Director Mary Shapiro only throws marshmallows. Only the Department of Justice can throw people in Jail, which is what the Lehman Bankruptcy Examiner (Valukas) really wants in this case. But the DOJ is too busy trying to get itself out of the mess its in for sending terrifying weapons to the Mexican Drug Cartels.

Question
Were the Ernst & Young's auditors negligent or cleverly deceived or complicit in the deception by the Lehman Brothers?

More from the examiner’s report:

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet”; felt that “there was no substance to the transactions”; and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

"Report Details How Lehman Hid Its Woes as It Collapsed," by Michael de la Merced and Andrew Ross Sorkin, The New York Times, March 11, 2010 ---
 http://www.nytimes.com/2010/03/12/business/12lehman.html?src=me

Jensen Comment
Former employees of Big Four firms (alumni) have a blog that is generally upbeat and tends not to be critical of their former employers
However, with respect to the impact of the Lehman Bankruptcy Examiners Report, this Big Four Blog is unusually critical of Ernst and Young and predicts a very tough time for E&Y in the aftermath.

The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas’ statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits. E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive
"Ernst and Young Found Negligent in Lehman Report, Tough Consequences," The Big Four Blog, March 17, 2010 ---
http://bigfouralumni.blogspot.com/2010/03/ernst-and-young-found-negligent-in.html

There’s been so much press on the recently released report on the spectacular failure of Lehman Brothers by Anton Valukas, so we’ll just focus on the key elements which involve Lehman’s auditor Ernst & Young.

Valukas is highly critical of E&Y’s work, claiming that they did not perform the due diligence needed by audit firms, the ultimate watchdog of investors’ interests. He believes there is a case of negligence and professional malpractice against the firm. Though in a very limited sense Lehman perhaps followed standard accounting principles, and this is the basis on which E&Y signed off on their annual and quarterly filings, they wrongly categorized a repo as a sale to knowingly report a lower leverage ratio, they exceeded internal limits on the infamous Repo 105, and they found a loophole in the British system to execute these transactions, and keep them off the public eye.

Lehman was clearly at fault and grossly fraudulent in hiding this from investors, and then obfuscating answers to clear questions from analysts. Is Ernst and Young equally culpable?

E&Y should have been more rigorous in pursuing this issue, knowing that it was material, being misrepresented and highly abused. With full knowledge of its usage, and then signing off on SEC documents is definitely negligent.

E&Y is now being investigated by the FRC in the UK and very likely in due course by the SEC. The Saudi government has already cancelled E&Y’s security license in the kingdom. The law suits are yet to hit the wires, but they are coming. The key is whether a criminal indictment of the firm is likely, recall that this is what brought down Andersen. Dealing with civil suits is only a matter of money, but a criminal charge is going to send clients away in droves. The critical question is whether the industry can withstand the loss of a $20 billion accounting giant, the consequences of a Big Three are quite hard to imagine.

E&Y was recently hit with a $8.5 million fine by the SEC for its involvement with Bally Fitness, and in that settlement E&Y agreed to tighten internal procedures and refrain from audit abuse. So the SEC is unlikely to look favorably on this.

The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas’ statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits.

E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive consequences.

Bob Jensen's threads on the Examiner's Report aftermath can be found at
http://faculty.trinity.edu/rjensen/fraud001.htm#Ernst
Also see "Repo Sales Gimmicks" at
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm#Repo

"Lehman's Demise and Repo 105: No Accounting for Deception," Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464

Teaching Case on Repo 105/108 "Sales" That are 100% Certain to be Returned
This is really a test of whether an audit firm should follow FASB rules that, in a particular context, become deceptive for investors/creditors
Given a choice of choosing the client's interests versus the interests of investors and creditors, the auditor chose the client in this case.
From The Wall Street Journal Weekly Accounting Review on March 18, 2011

Lehman Probe Stalls; Chance of No Charges
by: Jean Eaglesham and Liz Rappaport
Mar 12, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Bankruptcy

SUMMARY: "In recent months, Securities and Exchange Commission officials have grown increasingly doubtful they can prove that Lehman violated U.S. laws by using an accounting measure to move as much as $50 billion in assets..." and debt off of its balance sheet. One year ago, a report by "...a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blame[d] 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."

CLASSROOM APPLICATION: The article is useful to discuss repurchase agreements ("repos"), auditors' responsibility to ascertain whether a client is utilizing appropriate accounting and has internal controls in place to ensure the sue of those methods, and the Lehman Brothers collapse that led to the financial crisis.

QUESTIONS: 
1. (Introductory) Who is the firm of Lehman Brothers? What happened to this firm? Hint: you may use related articles to answer this question.

2. (Advanced) What are "repos" or repurchase agreements? How can they be used to reduce debt on a balance sheet and therefore make a firm look healthier than it really is?

3. (Advanced) What is an auditor's responsibility for assessing whether financial statements are prepared in accordance with generally accepted accounting standards? What steps must the auditor take if he or she finds transactions not accounted for in accordance with generally accepted accounting principles?

4. (Introductory) How did the Lehman Brothers auditor, Ernst & Young, view the firm's use of repo transactions? Who has questioned their business purpose and the accounting for them? Why is the accounting for these transactions being questioned?

5. (Advanced) What are the potential implications for E&Y if the SEC had found evidence that Lehman Brothers executives intentionally misused accounting for repo transactions to improve the overall appearance of the financial statements?

6. (Advanced) Are U.S. accounting standards establish in U.S. law? Explain your answer.

7. (Introductory) How could Lehman Brothers executives have violated U.S. law and therefore have acted in a way that would bring an SEC enforcement action against them? Cite explanations in the article specifically related to the grounds on which the SEC would be able to bring a civil suit and perhaps lead the justice department to bring a criminal suit against these executives.
 

Reviewed By: Judy Beckman, University of Rhode Island

One Auditing Firm Has Become Better Known for Its Auditing Specialty Than Other Firms like Ernst & Young are only pretenders
"The Leading Indicator of Repurchase Risk Losses? Audited By KPMG," by Francine McKenna, re: The Auditors, April 25, 2010 ---
http://retheauditors.com/2010/04/25/the-leading-indicator-of-repurchase-risk-losses-audited-by-kpmg/ 

If you are a regular reader of this site, you may remember the first time I warned you about the poor disclosure practices surrounding repurchase risk. It was all the way back in March of 2007 and I was referring to the lack of disclosures surrounding New Century Financial. I warned you again seven months ago that another KPMG client, Wachovia/Wells Fargo, has the same disclosure issues with regard to repurchase risk. The latest announcements of potentially material losses due to forced repurchases of mortgages from Fannie Mae (Deloitte) and Freddie Mac (PwC) were made by JP Morgan and Bank of America – both audited by PwC. Maybe ya’ll should kick the tires a little more on Citibank’s big comeback

Continued in article

Also see Francine's update at
http://retheauditors.com/2010/09/27/auditors-arent-forcing-full-repurchase-risk-exposure-disclosure/

Conclusion
And now we see "repo" transactions forming the basis of another enormous Wall Street scandal --- the case of the missing $1+ billion at MF Global.

Question
Where did the missing MF Global $1+ billion end up?

Hint:
The the word "repo" sound familiar?
http://en.wikipedia.org/wiki/Repurchase_agreement

"MF Global and the great Wall St re-hypothecation scandal," by Chrisopher Elias, Reuters, December 7, 2011 ---
http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/

A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients. 

MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet. 

If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing. 

FINDING FUNDS 

Current estimates for the shortfall in MF Global customer funds have now reached $1.2 billion as revelations break that the use of client money appears widespread. Up until now the assumption has been that the funds missing had been misappropriated by MF Global as it desperately sought to avoid bankruptcy. 

Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF Global clients never get their money back. 

REPO RECAP 

First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules. 

MF Global used a version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it debt from Italy, Spain, Belgium, Portugal and Ireland. 

Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo? 

Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’ money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use of clients funds known as “re-hypothecation”. 

RE-HYPOTHECATION 

By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults. 

In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default. 

In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital). 

Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds. 

U.S. RULES 

Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets. 

But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500). 

This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions. 

In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation. 

BEWARE THE BRITS: CIRCUMVENTING U.S. RULES 

Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules. 

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation. 

Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules. 

LEHMAN LESSONS 

In fact this is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished. 

A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement). 

These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE. 

MF RE-HYPOTHECATION PROVISION 

A similar re-hypothecation provision can be seen in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause: 

 “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.” 

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money but regulatory filings and letters from MF Global’s administrators contain some clues. 

According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”. 

CAUSTIC COLLATERAL 

Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules. 

Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction. 

Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities. 

Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds. 

OFF BALANCE SHEET 

As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering. 

Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link. 

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing. 

The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added): 

 “Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral.Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged. 

We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. 

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion. 

HYPER-HYPOTHECATION 

With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble. 

Bob Jensen's threads on repo accounting scandals ---
http://faculty.trinity.edu/rjensen/Fraud001.htm#Ernst

Will IFRS in place of U.S. GAAP make matters worse?

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://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

Revenue Recognition Controversies

The AICPA is not so happy with the proposed joint FASB-IASB standard on revenue recognition --- Click Here
http://www.aicpa.org/InterestAreas/AccountingAndAuditing/Resources/AcctgFinRptg/AcctgFinRptgAdvocacy/DownloadableDocuments/December_13_2010_FinRec_Revenue_Recognition.pdf
Also at http://www.cs.trinity.edu/~rjensen/temp/Revenue_Recognition.pdf

Jensen Comment
I wonder myself about these issues such as auditor-client disputes about weighted average probability distributions.

From The Wall Street Journal Accounting Weekly Review, September 25, 2009

FASB, as Expected, Approves Accounting Changes That Benefits Tech Companies
by Michael Rapoport
Sep 24, 2009
Click here to view the full article on WSJ.com

TOPICS: FASB, Financial Accounting Standards Board, Revenue Recognition, Software Industry

SUMMARY: The article reports on FASB ratification of EITF Consensus positions developed at the EITF meeting on September 9-10, 2009. Issue No. 08-1, "Revenue Arrangements with Multiple Deliverables" is now included in Accounting Standards Codification (ASC) Subtopic 605-25; Issue No. 09-3, "Certain Revenue Arrangements That Include Software Elements" is now included in ASC Topic 985. The FASB decisions related to the ASC 605-25 Subtopic significantly expand disclosure requirements for multiple-deliverable revenue arrangements. The decisions related to ASC Topic 985 removes tangible products (e.g., computer hardware, smart phones, etc.) from the scope of software revenue requirements and provides guidance on when software included in the sale of such products is subject to software revenue requirements (formerly documented in AICPA SOP 97-2).

CLASSROOM APPLICATION: Questions relate to revenue recognition practices and related concepts in qualitative characteristics of accounting information, suitable for use in an advanced level financial accounting course.

QUESTIONS: 
1. (Introductory) The articles indicate that the FASB has "approved accounting changes." What process actually occurred at the FASB meeting on Wednesday, September 23, 2009? (Hint: access the FASB web site at www.fasb.org. Click on the Board Activities tab, then the Action Alert, then the summary of Board Decisions for that date. Scroll down to the topics reported on in this WSJ article.)

2. (Advanced) In general, what are the current requirements when sales of technology products, such as computers and smart phones, include both a hardware and a software component?

3. (Advanced) Describe how the accounting requirements described in answer to question 2 above has now changed.

4. (Introductory) According to the article, these changes are expected to increase profitability for tech companies. Was that the FASB's goal in approving changes to these accounting requirements? Explain. Include in your answer references to the qualitative characteristics of accounting information that you believe the FASB and its EITF are considering in making these accounting changes.

5. (Advanced) What are multiple deliverables in a software sale? What is the residual method for determining revenue recognition of these products? What is the change in accounting for these sales?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Accounting Shift Would Lift Tech Profits
by Michael Rapoport, Yukari Iwatani Kane and Ben Worthen
Sep 24, 2009
Page: M3

"FASB, as Expected, Approves Accounting Changes That Benefits Tech Companies," by Michael Rapoport, The Wall Street Journal, September 24, 2009 ---

Accounting rule makers approved a change that will give a boost to technology companies and other firms by allowing them to recognize some revenue, and profits, faster.

As expected, the Financial Accounting Standards Board signed off on a rule that helps companies that sell goods and services like smart phones and other high-tech devices combining hardware and software, or home appliances that come with installation and service contracts.

Under current accounting rules, companies often must defer large portions of revenue from such sales, recognizing them gradually over time, instead of immediately when the sale is made. The rule change would give companies more flexibility in crediting more of that revenue to results upfront.

The move wouldn't change the total revenue and earnings a company reports over time, and the cash flowing into a company remains the same. But companies contend the change would better align their reported results with the true performance of their business.

Apple Inc. is expected to be one of the beneficiaries of the new rules, because it would change how the company reports revenue from its iPhone. Currently, Apple recognizes iPhone revenue over a two-year period, and said recently that overall revenue and earnings in its latest quarter would have been much higher if it didn't have to defer revenue for the iPhone and its Apple TV product. An Apple spokesman couldn't be reached for comment.

Apple has pushed for the change; among the other tech companies that have publicly supported it are Cisco Systems Inc., Palm Inc., Xerox Corp., Dell Inc., International Business Machines Corp. and Hewlett-Packard Co.

The change will take effect in 2011 for most companies, though they will be allowed to adopt it earlier.

"New Revenue-Recognition Rules: The Apple of Apple's Eye? The computer company and other tech outfits are likely to cash in on revenue-recognition changes if the new regs take on an international flavor," by Marie Leone, CFO.com,  September 16, 2009 --- http://www.cfo.com/article.cfm/14440468?f=most_read

"How to predict Apple’s gross margins," July 18, 2009 ---
http://brainstormtech.blogs.fortune.cnn.com/2009/07/18/how-to-predict-apples-gross-margins/

Apple’s (AAPL) fiscal third quarter earnings are due out Tuesday, July 21, and once again the Street is focused on the big numbers — revenues, earnings and units sold for the Mac, iPhone and iPod.

But savvy analysts will be paying closer attention to the number that is the best measure of a firm’s profitability: gross margin, expressed as the ratio of profits to revenues. Or

(Revenue – Cost of sales) / Revenue

Apple’s gross margins, which have averaged 34.8% over the past eight quarters, are the envy of the industry. Dell’s (DELL) first quarter GM, by contrast, was 17.6% and the company warned Wall Street last week that it is expecting a “modest decline” next quarter.

In its April earnings call, Apple low-balled its guidance numbers as usual, forecasting a sharp drop in gross margins over the next 6 months. Specifically, it warned analysts to expect no better than 33% in Q3 and “about 30%” in Q4.

But Turley Muller, for one, doesn’t buy those numbers, and he should know.

Muller, who publishes a blog called Financial Alchemist, is one of a small group of amateur analysts who track Apple closely and publish quarterly estimates that are as good as — and often better than — the professionals’. In fact Muller’s earnings estimates for Q2 were the best of the lot, missing the actual results by just one penny (see here.)

For Q3, he’s expecting Apple to report earnings of $1.35 per share on revenue of $8.3 billion — far higher than the Street’s consensus ($1.16 on $8.16 billion).

Why the discrepancy?

“Again the story appears to be gross margin,” he writes. “Just like last quarter, when Apple blew out the GM number with 36.4% (just as I had predicted) this quarter’s GM (3Q) should be roughly the same as last quarter.

The secret, he says, is in the profitability of the iPhone, “which is through the roof.”

“Apple tries to deflect that,” he says, but the evidence is right there, buried in a chart he found in Apple’s SEC filings (see below). It shows Apple’s schedule for deferred costs and revenue for the iPhone and Apple TV, which for legal reasons are spread out over 24 months rather than being recorded at the time of sale. Because Apple TV revenue is so small relative to the iPhone, this chart is a pretty good proxy for the iPhone alone.

This is complicated stuff, but the bottom line, as Muller points out, is that iPhone profitability has been rising to the point where gross margins on the device are over 50%.

Continued in article

Bob Jensen's investment helpers are at http://faculty.trinity.edu/rjensen/bookbob1.htm#InvestmentHelpers

Bob Jensen's threads on revenue accounting are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

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

Bob Jensen's threads on Debt versus Equity ---
http://faculty.trinity.edu/rjensen/theory01.htm#FAS150

Revenue Recognition in Principles-Based Standards versus the EITF Unresolved Twigs

"Revenue Recognition: Will a Single Model Fly? Elements unique to long-term contracts pose a challenge for FASB and IASB in their bid to create one standard covering all customer relationships" by David McCann, CFO.com, July 2,  2009 --- http://www.cfo.com/article.cfm/13941548/c_2984368/?f=archives

Can U.S. and international accounting standard-setters realize their dream of fashioning a single revenue-recognition standard that would apply to all customer contracts? While the answer won't be known for some time, it's safe to say there are hurdles on the road ahead.

In a joint discussion paper issued last December in which the Financial Accounting Standards Board and the International Accounting Standards Board proposed a model for a lone standard, they acknowledged that an alternative approach could be needed for some contracts. The almost 200 letters they received in a comment period that ended June 19 did nothing to remove any doubts about whether having one standard will be viable.

Most of the letters agreed that the standards boards' goals are laudable. One main objective is to simplify and clarify FASB's revenue-recognition rules, which currently are scattered among more than 100 standards. Another is to offer more guidance than what's contained in IASB's broadly worded revenue-recognition principle.

In meeting those twin objectives, the boards would be advancing their overarching goal of converging U.S. and international standards. The major goals aside, however, many commenters registered alarm at specifics of the proposed model — especially concerning how revenue should be recognized under long-term contracts.

Today, entities typically recognize revenue when it's realized or realizable and the "earnings process" is substantially complete. The new model instead would direct the entity to record the gain when it performs an obligation under its contract, such as by delivering a promised good or service to the customer. (The contract need not be written; even a simple retail transaction involves an implicit contract in which the customer agrees to provide consideration in return for an item.)

In a simple example, if the entity had agreed to provide two products at different times, it would recognize revenue twice, even if the contract stipulated that payment would not be made until the second product was delivered. The discussion paper mentions several permissible bases on which revenue could be allocated to the different performance obligations. But the paper says the revenue should be in proportion to the stand-alone selling price of the good or service underlying a performance obligation. And for an item that's not sold separately, a stand-alone price should be estimated — something that the standards boards acknowledged could be hard to do.

A main purpose of the performance-obligation approach is to iron out many of the disparities in how businesses account for revenue, which the boards say make financial statements less useful than they should be. The discussion paper gave the example of cable television providers, which under FAS 51 account for connecting customers to the cable network and providing the cable signal over the subscription period as separate earnings processes. By contrast, under the Securities and Exchange Commission's SAB 104, telephone companies account for up-front activation fees and monthly fees for phone usage as part of the same earnings process.

"The fact that entities apply the earnings process approach differently to economically similar transactions calls into question the usefulness of that approach [and] reduces the comparability of revenue across entities and industries," the discussion paper stated.

Long Engagements Perhaps the thorniest issue arising from the standards boards' proposal involves long-term construction or production contracts. Historically, under many such arrangements the company recognizes revenue using the "percentage-of-completion" method — if it's a three-year project with costs of $3 million, and $1 million of that is expended in the first year, one-third of the revenue is reflected for that year.

The single-model proposal, on the other hand, says that revenue should be recognized as an entity "transfers control" of goods and services to the customer. But many comment letters noted that the discussion paper did not clearly define what constitutes a transfer of control.

A company that is constructing a building for a customer may regard the materials and labor being provided as a continuous transfer of goods and services, which under the proposed model could be construed as allowing them to continue to recognize revenue over the duration of the contract. But if the standard setters hold that "transfer of control" occurs when the building is completed and turned over to the customer, all of the revenue would have to be recognized in the final year of the contract.

Lynne Triplett, a partner and revenue-recognition expert at Grant Thornton, told CFO.com that the way the discussion paper is written, "There could be questions as to whether there is continuous transfer of control, and to the extent there's not, there is going to be a significant difference between the way revenue is recognized today versus how it might be recognized in the future."

That would create misleading financial statements, according to some of the comment letters. "The most concerning area of the discussion paper is the potential change to the accounting for long-term contracts," wrote Financial Executives International Canada. "Creating a model which results in 'lumpy' revenue recognition ... with a waterfall effect in one accounting period at the very end, is not useful to the readers of financial statements."

Continued in article

Jensen Comment
Most of the argument centers on timing of revenue recognition such a in long-term contracts. But the important issues concern whether or not some transactions should be recognized as revenue. Much of this debate was left in many EITF dead ends that need to be explicitly resolved --- http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

But the track record of the IASB is not very strong  about explicit resolution of problems. Instead the IASB likes principles-based standards that, in my viewpoint, leaves too much to subjective judgment. This is one of the reasons why the revenue recognition standards to date issued by the IASB arguably constitute the greatest weakness in IFRS.

Thank You John Anderson

You’ve given us the most penetrating critique to date of IFRS in the context of when (probably not if) international accounting standards should replace U.S. GAAP.

This seriously backs up Professor Sunder's argument that, not only should the IASB be given a world monopoly on accounting standard setting, it should not be given one before its standards are demonstrably better than other national standards, especially U.S. GAAP. I've always argued for at least giving the IASB more time to generate better standards. Year 2009 was just too soon, at least in the U.S., for IFRS-Lite and Year 2014 is just too soon for IFRS-Heavy.

You can read about the IFRS-Lite and IFRS-Heavy express trains at http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting

July 16, 2009 message from John Anderson [jcanderson27@COMCAST.NET]

I usually try to be very even-handed when discussing IFRS, but today please allow me to speak as a proponent of Convergence … but also an unbridled supporter of US GAAP! 

First off, thanks for your honest and candid email. 

I believe that this dramatizes the giant problem that I believe Tweedie and crew are all too belatedly realizing they have!  They have a lot to do!  This may account for some of the erratic comments and actions by IASB members over the last few months.  For example I am thinking of his colleague Mr. Smith from Fort Lauderdale who is really wigging-out at times!  Of course he has dedicated a decade or more of his life to the IASB so during those periods where the IASB could be confused with the Keystone Cops, we can all understand his justified frustration!  However, rather than focus more on any of these untoward actions or statements made by individuals, or at times their apparent threats to not proceed with Convergence as agreed, let’s just wish them well and hope they get down to business … as we in the US are waiting … and they now have the world spotlight on them that they seemed so determined to have. 

I will not attempt to summarize the US Revenue Recognition work of over the last 12 years, but I will make these comments.  The joint IFRS communiqué from the FASB and the IASB was less than a particularly rigorous piece of work!  It read more like it was a first draft.  They have recently referred to it as only a “discussion paper.”  It was not a valid step to Convergence with the US and gave no indication of how they might be transforming their current IFRS into something comparable in quality to current US GAAP in this area.  They did not demonstrate a mastery of the current US concepts and certainly didn’t come close to introducing more advanced thinking which would be the prerogative of the IASB.  Instead they started out by focusing upon hypothetical Contract Assets and Liabilities.  However, in some sections they spoke like these Contract Assets and Liabilities were not merely illustrative, but were instead actually being booked.  When their own illustrative tools boggle them, and nobody does a final read through, we end up with stuff like this! 

This was really only an elementary first step of introducing some of the concepts of Revenue Recognition to many people in other jurisdictions who have probably never given this subject any thought before!  I accept that this educational work by the IASB is needed, but they shouldn’t confuse this with Convergence with the US.  This dramatizes how in the area of Revenue Recognition, the IASB has a lot of ground to cover and must break their inertia.  The IASB not only has to cover this territory which may be somewhat new to some of their members, but they have to educate those around the world who are in the field and currently applying IFRS and make sure that they absorb this material.  It is always easier to start something and attend the parade … than to continue and sustain anything.  (It’s also much more fun to start something!) 

Then, to raise questions about their institutional competence and control, they published IFRS SME before they determined what course they will follow in IFRS.  Further, in earlier drafts, IFRS SME was more conservative on Revenue Recognition than was IFRS, and ignored these vexing Contract Assets and Liabilities.  I have informally confirmed that this SME group is essentially operating independently of IFRS’s main team.  Finally in SME’s Final Draft, Revenue Recognition adopts a style and structure somewhat reminiscent the SAB statements from the SEC with 26 Revenue examples sited in the final document with varying degrees of discussion and guidance.  (Rules!)  However, within IFRS, the IASB is apparently more and more convinced that one single standard will serve as Revenue Recognition for Software, Power Utilities, and anything else that comes down the pike!  (Converging SME and IFRS may be yet another task.)  

Here I am only discussing Software Revenue Recognition.  This is serious stuff in Boston, San Francisco, Seattle and other cities where we all know of companies where there are Ex-Management Teams that are currently doing time in US Prisons for violating these Accounting provisions.  They are not as prominent as Madoff, but they are in the same place.  Most will probably get out of prison within their lifetimes. 

During his last visit to the US, Sir David (Tweedie) tried to dramatize how you can get around any rule if you want to.  One of his anecdotes was probably an ill-advised selection.  He must understand that thousands are listening to him when he is on stage in a webcast.  Further, advisors with attitudes of getting around certain rules can get people in this country some serious periods of incarceration. 

In the US this is an area that is considered by many as very challenging.  However, it is an excellent area to study as it bares the bones of both systems and shows that US GAAP is more driven by the principle of Conservatism than is IFRS, at this time.  (Why can no proponents of IFRS ever tell me the Principles that these methods are based upon?  If they are particularly annoying I sometimes suggest it’s the principle of “Ease of Calculations!”  I have yet to get a response when doing this.  So I will supply this sort of Transparency as the apparent principle or basis of most of IFRS in this area, not stark Conservatism.  This is important, because it is time to stop pretending!  US GAAP is principles based … but it is not just bare principles!  I believe that IFRS also has some Rules!) 

To directly answer your question, I have recompiled and attached my portion of the AICPA’s response to the FASB regarding IFRS (not SME).  You will be able to look at the response regarding Software Revenue.  In this example this change is demonstrated to be more than dramatic! 

In the example Current Revenue is as follows:

US GAAP        $0

IFRS                $9.333M

In the Software Revenue Recognition you’ll see my SOP 98-9 Residual Method contrasted against my “apportion the discount numbers” where I used the proposed IFRS Revenue Method.  This approach is similar to the FASB’s EITF 00.21 which I personally feel muddied the genius of SOP 97-2 and 98-9 authored by the AICPA!  EITF 00.21 is not the main thrust of US GAAP; SOP 98-9 is along with the Deferral Method for VSOE is the main thrust.  (Many IFRS people make the fundamental  mistake of assuming that Pre-Codification US GAAP is as simply laid out as IFRS.  They go to the FASB Statements and think that is it.  Wrong!  There were 25 other potential sources!  Hence the need for Codification with is similar to the ARB’s compiled in the US around 1951.) 

 

IFRS Revenue shoots through the roof because front-end Revenue is not based only on the Principle of Conservatism and recognizing all discounts and Sales concessions or inducements on the Front-end! 

US GAAP has principles like Conservatism.  In my example US GAAP demands all discounts be taken on the first piece of revenue recognized upon delivery. 

However IFRS approach simply allocates like some practically trained Cost Accountant; not like a conservatively trained Financial Accountant!  

The irony is this!  SME is more conservative than the main body of IFRS!  In the earlier drafts of SME you could not have deferred revenue at anything other than your normal margin.  Whereas IFRS allows zero margin sales t be maintained in Deferred Revenue!  Incredibly daft!  Excuse me … incredibly Un-Conservative! 

Please prove to us how IFRS is more conservative, or else please suggest as to how you would remedy this dire GAP in the IFRS Methodology.  

Thanks for your patience! 

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

June 15, 2009 reply from Bob Jensen

Hi John,

You wrote:

*****Begin Quotation
During his last visit to the US, Sir David (Tweedie) tried to dramatize how you can get around any rule if you want to.  One of his anecdotes was probably an ill-advised selection.  He must understand that thousands are listening to him when he is on stage in a webcast.  Further, advisors with attitudes of getting around certain rules can get people in this country some serious periods of incarceration. 
*****End Quotation

In addition to incarceration in the U.S. for violating GAAP rules, there is the even more common and very expensive lawsuit risk for breaking GAAP rules and failure to detect these breaches in audits --- http://faculty.trinity.edu/rjensen/Fraud001.htm

I’ve always argued (and repeated in a recent message to the AECM) that the main advantage of rules-based standards lies in dealing with enormous clients like Enron that became bullies with auditors. Auditors could point to a rule and then say they “have no choice.”

In other words, the advantage of a rule is before the fact rather than after the fact!

Of course when dealing with companies like Enron that want to want to cheat on the rules it’s essential for auditors to verify compliance. The famous 3% rule for SPE accounting in U.S. GAAP was not properly verified by Andersen’s audit team at Enron, and this more than anything else, probably led to the implosion of Andersen (at least it was the smoking gun) --- http://faculty.trinity.edu/rjensen/FraudEnron.htm

Who knows what would’ve happened to Andersen and Enron under IFRS? There would not have been that smoking gun in an explicit 3% rule. At this point IFRS is too different on SPE accounting to predict what might have been the alternative scenario --- http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

Under IFRS we might still have both Enron and Andersen, and that would not necessarily be bad if Enron had pulled off most of its many leveraged gambles and Andersen had to be better auditors under SOX. Of course this is all speculation off the top of my head.

Although Enron tried to screw California, Enron was not unique. Everybody was screwing California.

Bob Jensen's threads on the express train's bumpy rails toward requiring IFRS-Heavy for public companies (Resistance is Futile) are at http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting

Issues of principles-based versus rules-based standards are discussed at
http://faculty.trinity.edu/rjensen/theory01.htm#Principles-Based

SEC and EITF Initiatives on Internet Accounting

In this document the wording of the "Issues" and several short quotations are taken from the following online document:

U.S. retail and property service Homestore.com joins the list of companies investigating possible accounting irregularities. In a recently-filed Form 8-K, the company said that it expects to restate its nine-month financial results and reduce the revenue figure by as much as $95 million to better reflect the nature of on-line advertising transactions that should have been accounted for as barter transactions. http://www.accountingweb.com/item/68490

Some SEC Rulings in Staff Accounting Bulletin 104

SECURITIES AND EXCHANGE COMMISSION Corrected Copy 17 CFR Part 211 [Release No. SAB 104] Staff Accounting Bulletin No. 104 --- http://www.sec.gov/interps/account/sab104rev.pdf

The FASB wants accounting rules to be neutral in terms of decisions, but this is an impossible goal

Accounting rules are blamed for failure to stockpile children's vaccines
Although opinions differ, it appears that the Pediatric Vaccine Stockpile has become an innocent bystander wounded in the government's crackdown on deceptive accounting practices. Vaccine supply dwindles No one has accused the vaccine manufacturers of wrongdoing. However, they can no longer treat as revenue the money they get when they sell millions of doses of vaccine to the stockpile because the shots are not delivered until the government calls for them in emergencies. Instead, the vials are held in the manufacturers' warehouses, where they are considered unsold in the eyes of auditors, investors and Wall Street . . .The ranking Democrat on the Committee on Government Reform, Waxman said he is willing to sponsor legislation to carve out a legal exception that would allow companies to "recognize" revenue from sales to the vaccine stockpile — if such a radical step becomes necessary. One of the companies, however, said its problem is not with "revenue recognition" but with the details of managing the vaccine inventory. Other parties were reluctant to discuss possible solutions or who, if anyone, is to blame for the empty shelves. The SEC, which enforces accounting practices, would not speak on the record. HHS officials would not make available the person talking to the SEC on the matter. The department referred questions to its subordinate agency, the CDC, whose officials said important decisions about the stockpile are being made at the department level.
"Pediatric vaccine stockpile at risk Many drug makers hesitant to supply government," Washington Post via MSNBC, April 16, 2005 --- http://www.msnbc.msn.com/id/7529480/

Accounting for Adjustable Mortgage Rate (ARM) Options

November 20, 2008 message from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]

Can someone give me a reference for the “existing GAAP” rules referred to below?

From http://www.revenuerecognition.com/industry/banking/ 

Phantom Revenues

Some commercial banks have created a mortgage for homeowners and investors that has raised concerns in the banking industry and the investment community. It is the option adjustable rate mortgage or “ARM.” In an option ARM, the mortgagor has four monthly payment options; for example:

· minimum payment, which doesn’t cover interest changes (resulting in the principal growing each period and creating negative amortization);

· interest only, with no interest added to the principal balance;

· regular (interest plus principal) payments on a fully amortizable 30-year loan; and

· regular (interest plus principal) payments on a fully amortizable 15-year loan.

Because the option ARM is attractive to cash-strapped home buyers and investment-return buyers, most mortgagors chose the minimum payment option. Under that option, the interest rate (which is growing each month) adjusts the loan balance. At some point, the loan principal is reset and a new amortizable balance is set over the 30-year term, resulting in a revised mandatory repayment amount that can readily be three or four times the original monthly payment.

Of concern to bank regulators and those investing in commercial bank stocks is the treatment of such loans by the mortgagees. Under existing GAAP, the mortgagee may book revenue on the option ARM at the fully amortized amount, despite the fact that the mortgagor is only paying the minimum amount (the negative amortization case). This booking of “phantom” future revenues is the disturbing result of option ARMs.

EXAMPLE

Mr. and Mrs. Smith enter into a $500,000 mortgage on a $550,000 Florida condominium. It is an option ARM and permits the Smiths, as mortgagors, to pay a minimum monthly amount of approximately $1,600. This does not result in the payment of any principal or the full amount of monthly interest on the 30-year term loan.

The fully amortizable monthly payment for the mortgagors is closer to $4,600, or about an additional $3,000 per month. The Florida bank books the interest portion of the $3,000 that it doesn’t receive as deferred interest revenue (many would say “phantom” revenue). At some point in the negative amortization process, the loan balance resets and the mortgagors must pay the new monthly amount of $4,600. However, in the Smiths’ case, the loan is “upside-down”; that is, the value of the investment condominium (because of a rapidly changing real estate market) is less than $500,000, so foreclosure is their only option.

If the commercial bank has a significant portion of its loan portfolio in such option ARMs, with a rising money market interest rate and declining real estate values, it is a prescription for trading losses. Such affected banks will follow GAAP and book the phantom revenues, increase earnings, and then move the non-performing option ARM mortgages to the held-for-sale marketable classification and, eventually, to collection agencies.

Amy Dunbar
Department of Accounting #431
School of Business
University of Connecticut
2100 Hillside Road, Unit 1041 Storrs, CT 06269-104
land line: 860-742-0672 cell: 860-208-2737

November 20, 2008 reply from Bob Jensen

Issue 8: 
Should the costs of website development be expensed similar to software developed for internal use in accordance with SOP 98-1? 

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 mentioned above for Websites are appropriate in theory.

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 accounting theory are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm

Bob Jensen's threads on e-Commerce and e-Business revenue accounting controversies are at http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

Deloitte Heads Up
 "Reconfiguring the Scope of Software Revenue Recognition Guidance,"  by Rich Paul, Ryan Johnson, Sam Doolittle, and Rebecca Morrow, Deloitte & Touche LLP, Deloitte Heads Up, October 23, 2009 ---
 http://www.iasplus.com/usa/headsup/headsup0910software.pdf

Revenue Recognition Controversies

From The Wall Street Journal Accounting Weekly Review, September 25, 2009

FASB, as Expected, Approves Accounting Changes That Benefits Tech Companies
by Michael Rapoport
Sep 24, 2009
Click here to view the full article on WSJ.com

TOPICS: FASB, Financial Accounting Standards Board, Revenue Recognition, Software Industry

SUMMARY: The article reports on FASB ratification of EITF Consensus positions developed at the EITF meeting on September 9-10, 2009. Issue No. 08-1, "Revenue Arrangements with Multiple Deliverables" is now included in Accounting Standards Codification (ASC) Subtopic 605-25; Issue No. 09-3, "Certain Revenue Arrangements That Include Software Elements" is now included in ASC Topic 985. The FASB decisions related to the ASC 605-25 Subtopic significantly expand disclosure requirements for multiple-deliverable revenue arrangements. The decisions related to ASC Topic 985 removes tangible products (e.g., computer hardware, smart phones, etc.) from the scope of software revenue requirements and provides guidance on when software included in the sale of such products is subject to software revenue requirements (formerly documented in AICPA SOP 97-2).

CLASSROOM APPLICATION: Questions relate to revenue recognition practices and related concepts in qualitative characteristics of accounting information, suitable for use in an advanced level financial accounting course.

QUESTIONS: 
1. (Introductory) The articles indicate that the FASB has "approved accounting changes." What process actually occurred at the FASB meeting on Wednesday, September 23, 2009? (Hint: access the FASB web site at www.fasb.org. Click on the Board Activities tab, then the Action Alert, then the summary of Board Decisions for that date. Scroll down to the topics reported on in this WSJ article.)

2. (Advanced) In general, what are the current requirements when sales of technology products, such as computers and smart phones, include both a hardware and a software component?

3. (Advanced) Describe how the accounting requirements described in answer to question 2 above has now changed.

4. (Introductory) According to the article, these changes are expected to increase profitability for tech companies. Was that the FASB's goal in approving changes to these accounting requirements? Explain. Include in your answer references to the qualitative characteristics of accounting information that you believe the FASB and its EITF are considering in making these accounting changes.

5. (Advanced) What are multiple deliverables in a software sale? What is the residual method for determining revenue recognition of these products? What is the change in accounting for these sales?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Accounting Shift Would Lift Tech Profits
by Michael Rapoport, Yukari Iwatani Kane and Ben Worthen
Sep 24, 2009
Page: M3

"FASB, as Expected, Approves Accounting Changes That Benefits Tech Companies," by Michael Rapoport, The Wall Street Journal, September 24, 2009 ---
http://online.wsj.com/article/SB125374225265535371.html?mod=djem_jiewr_AC

Accounting rule makers approved a change that will give a boost to technology companies and other firms by allowing them to recognize some revenue, and profits, faster.

As expected, the Financial Accounting Standards Board signed off on a rule that helps companies that sell goods and services like smart phones and other high-tech devices combining hardware and software, or home appliances that come with installation and service contracts.

Under current accounting rules, companies often must defer large portions of revenue from such sales, recognizing them gradually over time, instead of immediately when the sale is made. The rule change would give companies more flexibility in crediting more of that revenue to results upfront.

The move wouldn't change the total revenue and earnings a company reports over time, and the cash flowing into a company remains the same. But companies contend the change would better align their reported results with the true performance of their business.

Apple Inc. is expected to be one of the beneficiaries of the new rules, because it would change how the company reports revenue from its iPhone. Currently, Apple recognizes iPhone revenue over a two-year period, and said recently that overall revenue and earnings in its latest quarter would have been much higher if it didn't have to defer revenue for the iPhone and its Apple TV product. An Apple spokesman couldn't be reached for comment.

Apple has pushed for the change; among the other tech companies that have publicly supported it are Cisco Systems Inc., Palm Inc., Xerox Corp., Dell Inc., International Business Machines Corp. and Hewlett-Packard Co.

The change will take effect in 2011 for most companies, though they will be allowed to adopt it earlier.

"New Revenue-Recognition Rules: The Apple of Apple's Eye? The computer company and other tech outfits are likely to cash in on revenue-recognition changes if the new regs take on an international flavor," by Marie Leone, CFO.com,  September 16, 2009 --- http://www.cfo.com/article.cfm/14440468?f=most_read

Revenue Recognition

Issue 9: 
How should an Internet auction site account for up-front and back-end fees?