Rewriting Pension History

Via WSJ (H/T Columbia Journalism Review).

Under current accounting rules, companies with defined-benefit pension plans, which promise to pay specified amounts to retirees, have the option to take several years to spread the cost of large pension gains and losses into earnings. That means that when a plan's investment results are much better or worse than expected—as with the 2008 market downturn—it can have a significant effect on earnings for years.

For that and other reasons, the system of accounting for pension results in earnings long has been widely criticized. The Financial Accounting Standards Board, the U.S. accounting rule maker, has examined the issue before but hasn't made any changes, though they may revisit it soon. AT&T, Verizon and Honeywell changed their accounting methods on their own initiative. While the details differ, all three said they would start recognizing some or all of their deferred losses in the year they occur, through a "mark-to-market" adjustment to fourth-quarter earnings to reflect their pension plan's returns for the year.

Click Here to Read: Rewriting Pension History

Apparently ‘The Purpose of Auditors Is Completely, Entirely, and Wholly’ to Look for Fraud and ‘Deloitte is the best. Period. End of Statement.’

Some Friday humor via Going Concern. This is very amusing...

Full Excerpt (via Going Concern). 

Remember China MediaExpress? That’s the company whose CEO – Zheng Cheng – responded to the accusations of fraud by evoking ‘reputable and well-known’ Deloitte to get the haters off their back. Even though the company is still taking heat, Mr Cheng will be happy to know that he’s got someone in his corner: Glen Bradford, CEO of ARM Holdings LLC, a Hedge Fund Advisory Company. The thing is, Mr Bradford seems a little confused about what an auditor’s purpose is (for fun, I added some emphasis):

I have received tons of messages that can be summarized by the belief that auditors do not look for fraud and that all they do is make sure things line up in the reports. I can say that this is not true simply by being practical. If we didn’t have auditors to verify the claims that companies make, then companies could claim whatever they want to. The purpose of auditors is completely, entirely, and wholly to look for indications of fraudulant activity — and to do their best to remove all possible doubt that the company is misrepresenting itself on its financial statements.

You can make of that what you will but then Glen continues:

Then, if things are OK, they sign off on them. Some auditors are better than others. Deloitte is the best. Period. End of Statement.

Well then! I’m sure Deloitte appreciates the ringing endorsement regardless if it comes from someone who is under the impression that “The purpose of auditors is completely, entirely, and wholly to look for indications of fraudulant activity.” At the very least, this is debatable point, so if you have a difference of opinion with anything above, feel free to share below.

Click Here to Read: Apparently ‘The Purpose of Auditors Is Completely, Entirely, and Wholly’ to Look for Fraud and ‘Deloitte is the best. Period. End of Statement.’ 

Is Neuroaccounting Waiting in the Wings?

By Jacob Birnberg & Ananda Ganguly.

Abstract:      

This paper reviews a recently published handbook on neuroeconomics (Glimcher et al. 2009H) and extends the discussion to reasons why this newly emerging discipline should be of interest to behavioral accounting researchers. We evaluate the achieved and potential contribution of neuroeconomics to the study of human economic behavior, and examine what behavioral accountants can learn from neuroeconomics and whether we should expect to see a similar sub-field emerge within behavioral accounting in the near future. We conclude that while a separate sub-field within behavioral accounting is not likely in the near future due mostly to practical reasons, the behavioral accounting researcher would do well to follow this discipline closely, and behavioral accountants are likely to collaborate with neuroeconomists when feasible to examine questions of mutual interest.

Click Here to Download: Is Neuroaccounting Waiting in the Wings?

How Did Citigroup’s Internal Controls Cut the Mustard with KPMG?

Via Going Concern.

Jonathan Weil writes in his column today about Citigroup and their “acceptable group of auditors,” (aka KPMG) and he’s having trouble connecting the dots on a few things. Specifically, how a love letter (it was sent on February 14, 2008, after all) sent by the Office of the Comptroller of the Currency to Citigroup CEO Vikram Pandit:

"The gist of the regulator’s findings: Citigroup’s internal controls were a mess. So were its valuation methods for subprime mortgage bonds, which had spawned record losses at the bank. Among other things, “weaknesses were noted with model documentation, validation and control group oversight,” the letter said. The main valuation model Citigroup was using “is not in a controlled environment.” In other words, the model wasn’t reliable."

Okay, so the bank’s internal controls weren’t worth the paper they were printed on. Ordinarily, one could reasonably expect management and perhaps their auditors to be aware of such a fact and that they were handling the situation accordingly.

Click Here to Read: How Did Citigroup’s Internal Controls Cut the Mustard with KPMG? 

The Myth of FASB Due Process: And the Fact of Undue Influence

Via The Accounting Onion. 

So the first point I want to make is that "due process" as a description of the FASB's policies is a misnomer. The FASB's use (along with that of the monkey-see-monkey-do IASB) of the term is merely another instance of its tactical use of weasel words and phrases to cast an aura of gravitas on a process without having to actually specify that process in any significant detail. Of course, the guarantees of due process in law are highly specified, even though they may be intensely debated. Among other things, they consist of the right to a full and fair trial, governed by rules of evidence, impartiality, burden of proof, etc.

There are no real rules for due process at the FASB, like we see in the law: rules of evidence, decision criteria, etc. All we are provided by the FASB's Rules of Procedure (page 5) are vague statements that pretty much allow the FASB to do what it wants, when it wants. Maybe a new standard will be evidenced-based, or maybe it won't. Maybe a new standard will be consistent with the concepts statements (although those are also like nailing jell-o to a tree), or maybe it won't.

And, in case you're wondering, the term due process is nowhere to be found in the securities laws or in the way the SEC, the main source of the FASB's legitimacy, describes its own rulemaking activities.  The SEC simply states that "the Commissioners consider what they have learned from the public exposure of the proposed rule, and seek to agree on the specifics of a final rule." In other words, SEC evaluation of public comments is not part of a "due process" (or a democratic process) but simply purports to be a learning process.

Click Here to Read: The Myth of FASB Due Process: And the Fact of Undue Influence

The FASB Could Rescue the Financial System – But It Won't

Via The Accounting Onion. 

Complacency exists in part because the certain cost of being anything more than passive is not expected to be offset by the uncertain benefits. The vast majority of investors choose to place their trust in the integrity of the financial reporting regulators – to have put in place a system that clearly signals when financial performance has lagged, or that excessive risks have been taken.

That the accounting standard setters have utterly failed to live up to the trust that investors have placed in them is the overarching theme of this blog. Only the notion of investor complacency can explain why investors have not yet stormed the FASB's headquarters, much as Egyptians demonstrated in Tahriri Square to protest a plutocracy operating behind the façade of democracy and due process.

I have no suggestions for altering the calculus leading to consistent investor complacency. The only solution is for regulators, most especially accounting standard setters, to embrace the reality that investors will not tend to exercise their right to be heard, rather than to exploit that vulnerability. For example, accounting standards should acknowledge that investor preferences dictate that disclosure – even under the best possible circumstances – cannot be an adequate substitute for financial statement recognition. They should also acknowledge that due process is clearly not working even though thousands of comments against a proposed standard have been received from issuers, largely with the objective of drowing out those few investors who care to be heard.

Click Here to Read: The FASB Could Rescue the Financial System – But It Won't

Auditors and Consulting: Claims Of No Conflict Strain Credibility

Via Francine McKenna.

The financial crisis and companies concerns over costs have driven audit fees to flat or down in all the firms, on average, worldwide. However, the independence issues that led three of the four to sell their consulting businesses by 2002 still exist, even more so with the contraction in the number of firms available in many markets to take on larger and more complex non-audit projects and engagements.

At the same time, the audit firms are behaving as if the requirement to be independent at all times is an annoyance rather than an impediment. That may be because auditors are not strictly prohibited from consulting in the UK, for example, as long as the company isn’t listed in the US. But since the PCAOB only recently gained inspection access to UK firms, we may find lax compliance once they catch up on inspections. For non- Sarbanes-Oxley companies, UK firms accept consulting engagements for audit clients at will and with only honor to guide them.

In the United States, in spite of prohibitions on a list of advisory services that can be performed by auditors of companies subject to Sarbanes-Oxley, the level of enforcement of these independence prohibitions is practically nil. Not only are the regulators loathe to single out a firm for large transgressions, they have limited time and budgets available to track them down at all, especially because of new the volume of matters generated by the financial crisis.

...

The hunger for more consulting revenue also causes the audit firms to forget they are audit firms first and foremost.  Aggressive sales activities and “relationship building” tactics common in the systems integrator business are tolerated by the audit firms for the sake of winning major long term engagements with prestige clients and realizing the return on big acquisition and practice-building investments.

Outside the US, the prohibitions in some countries on foreign ownership of their audit partnerships is breaking down and the international firms are taking control of everything else away from local partners who “cannot realize the growth potential.”

Click Here to Read: Auditors and Consulting: Claims Of No Conflict Strain Credibility

FDIC Makes A Case Against Auditors For Bank Failures

By Francine McKenna.

On the other hand, the auditors have one of the most powerful affirmative defenses known to third-party advisors – the doctrine of in pari delicto and the theory of imputation. We recently saw this defense used effectively to shoot down two cases against auditors under New York law – Teachers Retirement System of Louisiana v. PwC (a vintage AIG case) and Kirschner v. KPMG et al (a Refco bankruptcy case).

In the Refco case, the Bankruptcy Trustee brought claims against more than one third-party advisor. All were eventually dismissed.

The FDIC, as a receiver in bankruptcy, will stand in the shoes of the failed bank corporation. The in pari delicto doctrine is based on common law agency principles. The acts of fraudster bank executives are imputed to the bank corporation since they acted as agents of the corporation. They were authorized to act on its behalf unless it can be proven that they abandoned the corporation and their fraud was solely for their own interest.  That’s called an adverse interest exception. The doctrine of in pari delicto says that, “in a case of equal or mutual fault the position of the defending party is the stronger one."

Click Here to Read: FDIC Makes A Case Against Auditors For Bank Failures

Auditing, Fraud & Black Swans

Via Sonia Jaspal's RiskBoard. 

Since the auditors are not required to comment on 100% accuracy of the statements, they use various auditing and sampling techniques to find corroborating evidence regarding the fairness of the financial statements. Auditors are not required to look for or detect all frauds. Hence, the sampling techniques are selected based on normal population. Fraud as such is an exception to the rule; an unpredictable event in most industries (except banking and financial services where some level is expected) hence, can be considered a black swan.

Audit techniques are not designed to identify black swans and find a solution for them. They are all focused on a set number of transactions and auditing steps. The macro level views of the situation in not seen though auditors might have a list of inherent risks. Then we are shocked that mass scale fraud of an organization was not detected by the auditors. A post facto analysis in most cases shows that auditors had reasonable ground to suspect fraudulent activities and should have reported the same. Let me give you a couple of examples here to put my point across to you.

Click Here to Read: Auditing, Fraud & Black Swans

Auditors Must Treat Shareholders As Their Client

Via Accountancy Age.

"The board should set out the rationale and examples of why their business is a going concern," said Nisbet. "There should be an explicit opinion on that from the auditor."

The front half of annual reports should contain information on the company's ability to operate as a going concern. Rather than auditors signing off such as statement with the traditional "true and fair view", the audit opinion should instead be known as "balanced and reasonable, added Nisbet.

PwC head of assurance Richard Sexton defended the profession on a number of the points raised during the debate. He said that concerns of a lack of scepticism flagged up by the Audit Intelligence Unit were not necessarily accurate.

Click Here to Read: Auditors Must Treat Shareholders As Their Client

S.E.C. Hurt by Disarray in Its Books

This is sad. I wonder what auditors would find at the Federal Reserve....

Via New York Times (H/T Going Concern).

Since the commission began producing audited statements in 2004, the Government Accountability Office has faulted its reporting almost every year. Last November, the G.A.O. said that the commission’s books were in such disarray that it had failed at some of the agency’s most fundamental tasks: accurately tracking income from fines, filing fees and the return of ill-gotten profits.

“A reasonable possibility exists that a material misstatement of S.E.C.’s financial statements would not be prevented, or detected and corrected on a timely basis,” the auditor concluded.

The auditor did not accuse the S.E.C. of cooking its books, and the mistakes were corrected before its latest financial statements were completed. But the fact that basic accounting continually bedevils the agency responsible for guaranteeing the soundness of American financial markets could prove especially awkward just as the S.E.C. is saying it desperately needs money to increase its regulatory power.

Click Here To Read: S.E.C. Hurt by Disarray in Its Books

The Fed’s Financial Accounting Is a Beautiful Thing

Via Going Concern. 

Controllers, don’t you wish you had this sort of authority? Imagine writing your own financial accounting handbook (forget GAAP, it doesn’t apply here!), plugging your financial statements with all the footnotes you want and rewriting the rules in the middle of the reporting season just because you feel like it and, maybe in this case, because it will paint a rosier picture of your financial condition.

Wouldn’t it be great if we could do this with our checking accounts? You could just take the money that is owed to others (let’s call “bills” “negative liabilities” instead, even though in strictly technical terms a negative liability would be an asset, which we know bills are not) and change its name, give it a new presentation and VOILA! Instant solvency!

On January 6th, they tried to sneak a little change in presentation that, for now, doesn’t really matter but might when interest rates skyrocket and they are no longer handing out huge amounts of “profits” to the Treasury.

Click Here to Read: The Fed’s Financial Accounting Is a Beautiful Thing

Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils

Via The Accounting Onion.

Unlike many other topics I have been writing about where the points of contention are approaches to measurement matters, the heart of this matter seems to involve recognition, and most particularly recognition of 'executory contracts'.

Every accountant has been raised to observe two sacred and inviolable commandments: thou shalt not recognize executory contracts on the balance sheet; and thou shalt present on a 'net' basis receivables/payables with the same counterparty.

While these commandments were once inviolable, leases have become a very notable exception. First came SFAS 13 in 1976, requiring that a very limited number of executory contracts meeting the definition of a 'capital lease' would be grossed up to reflect a leased asset and a corresponding liability. Then, recently, the FASB has finally, finally come to timidly propose that failure to capitalize any lease contract unacceptably distorts financial statements. Even armed with an understanding of the political realities that the FASB operates under, it is hard not to be shocked and awed by the resistance to this simple idea from issuers and the leasing industry en masse.

Click Here to Read: Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils 

Big Wins Elude Investors in Auditor Lawsuits

Via Reuters (H/T Going Concern).

All of the "Big Four" auditors have been sued by investors who collectively seek to recoup billions of dollars lost in the financial meltdown. But while some key cases are yet to be resolved -- and a recent civil fraud lawsuit against Ernst & Young by New York prosecutors potentially opens a new front -- auditors so far have scored some significant court victories.

Lawsuits have been dismissed against Deloitte & Touche over its audits of mortgage financier Fannie Mae, as well as a case against PricewaterhouseCoopers accusing it of helping hide risks at insurer American International Group.

KPMG settled a lawsuit stemming from its audits of mortgage lender Countrywide Financial Corp, now part of Bank of America, for a relatively modest amount.

"Every time somebody comes up with a new fraudulent scheme, auditors miss it," said Andrea Kim, a partner at law firm Diamond McCarthy LLP in Houston who represents plaintiffs in auditor lawsuits. "The historical pattern is that they find a way to manage the litigation to limit their liability."

 Click Here to Read: Big Wins Elude Investors in Auditor Lawsuits

No Contact Between Watchdogs and Auditors in the Year Before Crisis

Via Accountancy Age.

The FSA candidly states in the memorandum that contact between the regulator and auditors fell away when the regulator took over banking supervision and said it admits that was "wrong".

The FSA adds that "we established supervisory specialists in-house, supported by further in-house specialists in policy, risk and sector-specific areas. This in-house expertise was designed to reduce the need for regular reporting by auditors on supervisory matters relating to individual firms.

"One consequence was that, over time, meetings between supervisors and auditors also became less frequent. There were still cases where FSA supervisors continued to meet with the auditors at least once a year, but this happened on a less structured basis. In line with our supervisory philosophy of that time, we made less use of third parties (i.e. use of section 166 reports) and placed more reliance on what firms [banks] told us."

Click Here to Read: No Contact Between Watchdogs and Auditors in the Year Before Crisis

Unveiling the Mystery of Forensic Accounting

Forensic Accounting 101 via Accounting Today. 

To many people the differences between a forensic accounting investigation and an audit may be unclear. The Statements on Auditing Standards No.1, guidelines for audits, states: “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by error or fraud, that are not material to the financial statements are detected.”

Because the role of auditors focuses on reasonable assurance that financial statements are free of material misstatements, they test financial transactions on a sample basis. An auditor reviews the books and records for reasonableness. A detail review of the nature of every transaction is not the goal of an audit.

However, in a forensic accounting investigation materiality is not a factor and does not affect the scope; sample testing is generally not done. A review of all records for a time period is typically performed to determine trends and identify patterns. Transactions of all sizes can be reviewed. In fact, even the smallest transactions can lead a fraud examiner to a potential fraudulent scheme.

Click Here to Read: Unveiling the Mystery of Forensic Accounting

The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality

By Michelle Hanlon, Jeffrey Hoopes, and Nemit Shroff @ HLS Forum.

Abstract: 

We examine the relation between tax enforcement and financial reporting quality. We proxy for financial reporting quality using the extent to which accruals map into cash flows and the magnitude of discretionary accruals. We measure tax authority monitoring in the U.S. using data on the probability of IRS audits. In addition, we use a regime shift in tax enforcement in Russia as an alternative test setting. The data provide evidence that higher tax enforcement is associated with higher financial reporting quality and that the relation is generally stronger when other monitoring mechanisms are weaker. Overall, we interpret our evidence as being consistent with the predictions from the Desai, Dyck, and Zingales [2007] theory that the tax authority provides a monitoring mechanism of corporate insiders. Our paper also adds to the literature on the determinants of financial reporting quality and how the relation between accounting standards and reporting outcomes depends on country level institutions.

Click Here to Download: The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality 

The Revenue Recognition Project: Death by a Thousand Comments

Via The Accounting Onion. 

One of the recurring themes of this blog is that exit prices (as opposed to entry prices) create accounting problems literally from Day One. Expensing transaction costs to acquire financial instruments is just one example the boards have had to cope with, but the even more vexing problem has turned out to be Day One gains from being able to settle performance obligations for less than what was received from the customer. For example, a company that sells an extended warranty on an automobile for $1,000 might be able to immediately subrogate their liability to some other company for a payment of $800. Thus, the fair value of the warranty is only $800, and the Day One gain is $200. The obvious (to me, at least) solution is to measure a performance obligation by the customer's replacement cost of its asset to receive warranty services over the extended period (still $1,000). But the boards traveled too quickly and too far down the fair value road to admit their errors without significant loss of face.

Consequently, in a desperate attempt to save their revenue recognition project (an integral element of convergence) from destruction, the boards pivoted away from fair value measurement and eventually settled on the time-worn notion of allocating the total arrangement consideration amongst the performance obligations in proportion to their respective fair values.

As with any allocation process in accounting, such an approach to measuring performance obligations has raised a whole host of ineffable questions. When is more than one contract an arrangement? When is one contract more than one arrangement? How to measure arrangement consideration? Most fundamentally, what attribute of the performance obligation is being measured?

Click Here to Read: The Revenue Recognition Project: Death by a Thousand Comments

Bankers Say Rules Are the Problem

Article posted back in 2009 via The New York Times (H/T Crooks and Liars). 

It is true, as the bankers argue, that valuing illiquid instruments is tricky. And it is true that markets can overshoot. Some of these securities may well be undervalued now. But the solution is not to go to what Robert H. Herz, the chairman of the Financial Accounting Standards Board, calls “mark-to-management” accounting.

I call it “Alice in Wonderland” accounting, after Humpty Dumpty’s claim in that book that “When I use a word, it means just what I choose it to mean, neither more nor less.” After Alice protests, he replies, “The question is, which is to be master — that’s all.”

Although you would not know it from the angry complaints, the accounting board’s Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining “market value” as meaning whatever they chose it to mean.

Click Here to Read: Bankers Say Rules Are the Problem

The Economics of Short-Term Performance Obsession

Must read! By Alfred Rappaport (H/T Ethics Sage).

Abstract:

In theory, discounted cash flows (DCFs) set prices in well-functioning capital markets. In practice, investment managers attach substantial weight in stock selection to short-term performance, particularly earnings and tracking error. Corporate executives blame this behavior for their own obsession with short-term earnings. Are stock prices likely to allocate financial resources efficiently when short-term earnings dominate investment decisions? Can investment managers who identify stocks as mispriced on a DCF basis earn excess returns? This article explains why maximizing long-term cash flow is the most effective way to create value for shareholders and charts a course for alleviating the obsession with short-term performance.

Click Here to Download: The Economics of Short-Term Performance Obsession